Both banks and corporate issuers are struggling to sell various products that mature after the proposed reform of Libor. A range of different approaches has emerged instead of industry-wide consensus.
The Financial Conduct Authority’s announcement last summer that it would begin phasing out the London Interbank Offered Rate in 2021 has created confusion over the implications for a wide range of products, from vanilla fixed income to perpetual bonds to swaps.
The planned transition away from the world’s most famous number affects both legacy deals that reference Libor, and new deals being sold now that mature after 2021.
“Since there’s nothing in the market at the moment that looks like a viable Libor replacement, we’ll probably end up maintaining these types of benchmarks but incorporating some kind of transaction-based approach over time,” said Peter Chatwell, European head of rates strategy at Mizuho. “In the meantime that means a huge amount of uncertainty for so many products.”
In an effort to offset this uncertainty some banks have begun inserting provisions in the documentation allowing the issuer discretion to later choose a new rate to base the transaction on, according to a senior lawyer at a City firm. “People are basically trying to crystal ball gaze because no one knows at this point in time how any replacement rate would operate in respect of a bond issue,” she said.
Others still are suggesting the use of an independent agent to determine an appropriate new rate as and when the time comes for Libor. How this will be received with investors is not yet entirely clear, but some have allegedly raised concerns over possible conflicts of interest between the bond calculation agent and the issuer – if the agent is an affiliate of the issuer, for instance – exposing banks to litigation risks.
“Then there are some that are just burying their heads in the sand and assuming there will either be a market-led solution or a legislative intervention,” added the lawyer. “But there’s just no guarantee that they won’t need to amend their bonds at a later date.”
At the moment a market-led solution is looking more likely than legislation, as the latter would have to be on a global basis.
All this uncertainty has already manifested in the pricing of swaps. “At the moment it’s an uncertainty premium, because the market isn’t able to move firmly in one direction or another,” said Chatwell.
And when it comes to floating rate notes, fixed-to-floating and perpetual deals, some are choosing to avoid selling them altogether for the time being, amid concerns these will later be mispriced and the protections they supposedly offer void, leaving them difficult to redeem.
- Banks are struggling with a market-wide approach to the FCA’s proposed Libor reform, hitting various products that mature after 2021, from bonds and swaps to business loans and mortgages;
- Buyside resistance to contract amendments of any kind – but particularly to legacy deals – is a major obstacle;
- According to rates trading heads, hedge funds and senior lawyers, practically all new deals are still benchmarked against Libor because there’s just no viable alternative yet;
- Many banks are including terms in the documentation that allow for a new rate to be used in future, but this has been unpopular with the buyside so far;
- The bigger problem is the approximate $370 trillion worth of legacy deals, which could at worst require the biggest repapering exercise of all time;
- That would be inordinately expensive, arduous and would expose banks to various litigation risks, so alternative approaches are being sought out;
- Many in the market believe Libor is here to stay, albeit alongside alternative rates.
But others are continuing with business as usual. “If we need to sell a bond tomorrow but don’t know what possible alternative rate we should use, obviously we are going to stick with Libor until someone tells us otherwise,” said Eske Traberg Smidt, global head of rates trading at Danske Bank.
Amending the terms
The main issue with the clause allowing for future amendments to the rate is investor sentiment.
“If a bank came to me and asked to amend an old contract I’d just say ‘no’,” a hedge fund manager told Practice Insight. “On a legacy fixed-to-floating swap frankly I’m just not in the mood to change the rate, unless there’s a considerable financial incentive. But if there’s no legal incentive to modify an existing contract, why would I?”
It’s that lack of legal obligation on any party that’s a particular obstacle in the Libor phase-out. “It’s highly likely that the buyside will look at Libor and then at any possible replacement and have no interest in shifting - especially if there’s a material pricing difference,” said one source.
Considering the amount of legacy deals in the market – an approximate $370 trillion worth of derivatives, loans and mortgages are tied to Libor, with new transactions being done every day – a transition away from Libor, however phased, could cost banks a considerable amount of money.
For new trades, Traberg Smidt said that including a possible future amendment in the terms of any documentation is a sensible approach to take, although his firm has not yet done so.
“But the real concern is legacy trades,” he said. “A lot of people have a portfolio of swaps that you’re not allowed to hedge anymore so disrupting that could create a lot of disturbances in the market. We get a lot of questions from clients on this, and to be honest we also have more questions than answers.”
The general consensus is that having to go back to old deals to amend the terms would take up far too much time, expose banks to too much risk, and open up a Pandora’s box of renegotiations. For each individual bond it would be recalling a bondholder meeting, and for every individual swap, a renegotiated bilateral agreement. But it’s not just capital markets that would give banks a headache – certain types of mortgages are based on Libor too, and amending their terms would require written consent from each individual customer.
It’s a huge job, and with just three years to go until the proposed phase-in of new rates – and no viable alternative yet – market participants think it may just not happen.
“Best efforts to transition are now being made, but the mass repapering of legacy deals is rather unlikely because of the legal uncertainty, costs and risks, as each of these have the potential to be significant,” said Alex Mcdonald, CEO of the European Venues and Intermediaries Association. “Libor may well have to keep ticking away in the background because the transition to the alternatives will be so arduous for everyone, unless formalised by trading across the basis to OIS."
And it’s not just the trouble of amending terms that could cost banks money. It’s generally thought that if Sonia is to be the benchmark of choice – which looks likely for sterling-based derivatives, at least – that Sonia will price lower than Libor historically has.
“If investors were to have their coupon or underlying benchmark replaced with something marginally lower then they need to be compensated for that,” said Chatwell. “So in theory these products with a clause giving the issuer discretion to later pick a new rate should be trading cheaper than those that don’t.”
A report published by Oliver Wyman yesterday found that the transition away from Libor could cost some banks up to $200 million.
Where benchmarks will go
A strictly transaction-based rate such as Sonia poses considerable problems for the swaps market. According to Chatwell, all existing Libor-based swaps would need to be replaced – involving significant market risk. Plus, overnight index swaps (OIS) do not reflect banks’ unsecured funding costs; the so-called canary in the coalmine long viewed as one of Libor’s main appeals.
“We assume in the future that we’ll see a Libor swap curve as we do now, as well as an OIS-based curve and a fairly active market in the spread between the two,” said another market participant. “That would make the transition a new trade, which is less messy than a mass repapering exercise.”
A so-called benchmark transition roadmap published jointly by five industry associations highlights the key challenges of shifting from an interbank offered rate to a risk-free rate; seen as the first step in the market-led approach.
While a viable alternative is still far from agreed, some lessons can be learned from the European Money Markets Institute’s (EMMI) attempts to reform the euro’s Libor equivalent, Euribor, beginning in 2014.
Attempts to replace Euribor with a transaction-based alternative – the general direction of travel for regulators at the moment on Libor – found the latter to be lower than Euribor. That prompted the EMMI to opt against overhauling the methodology altogether after a pilot exercise with 31 banks, claiming that market conditions made it unfeasible.
“Even for interest rate derivatives, because of anticipated buyside resistance it’s just not set in stone that 2021 or any later date will be the end of Libor,” said the anonymous source. “More likely is a composition of benchmarks with a range of different curves, perhaps even with competition emerging between those curves.”