Tackling Tough Legacy



ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

How to handle ‘tough legacy’ LIBOR contracts that are all but impossible to amend or renegotiate has been an issue that has worried regulators and market participants ever since it was revealed the benchmark may cease to exist after the end of 2021. The UK has now announced its solution to this problem – one that will see the UK Financial Conduct Authority (FCA) given powers via legislation to force a change in LIBOR’s methodology in the event it is no longer representative in order to allow a ‘synthetic LIBOR’ based on the new methodology to continue to be used for tough legacy exposures.

This is a big announcement, so it’s worth exploring what it means – and what it doesn’t mean. First, it’s important to note that this won’t have an impact on ISDA’s work to develop robust new fallbacks for derivatives that reference interbank offered rates (IBORs). Timing and content will remain unchanged: we will publish a supplement to the 2006 ISDA Definitions and a protocol to allow firms to incorporate the fallbacks into new and legacy IBOR derivatives trades once we’ve received approvals from the relevant competition authorities and regulators, with a target launch at the end of next month. As per the results of multiple market consultations, fallbacks based on compounded in arrears risk-free rates (RFRs) plus a spread adjustment will apply for contracts that continue to reference an IBOR following a permanent cessation of that benchmark or, for LIBOR only, a determination that LIBOR is no longer representative of the market it measures.

In its statement and the accompanying FAQs, the FCA emphasizes that the continuation of LIBOR with a revised methodology should not be viewed as an alternative to transition or contractual fallbacks – in fact, it states that firms should continue amending contracts to incorporate replacement rates and implement industry agreed fallbacks wherever possible. Instead, the revised LIBOR is specifically meant to reduce disruption to holders of a small pool of tough legacy contracts, where renegotiation and contractual amendment isn’t an option.

The publication of a ‘synthetic LIBOR’ would only occur if LIBOR is no longer representative and its representativeness will not be restored, and if publication of such a rate is considered necessary to protect consumers or the integrity of the market. The FCA notes there would be a legal prohibition on new business using a benchmark that is no longer representative, but says the legislative changes will give it the power to permit continued use of the revised LIBOR in legacy contracts “where it considers this appropriate”. It’s worth pointing out, though, that these prohibitions would only apply to UK-regulated entities unless similar restrictions are implemented in accordance with local laws elsewhere.

So, what could this revised version of LIBOR look like? The FCA says it will consult with stakeholders on possible methodology changes based on RFRs, and will seek views on the consensus already established globally on the calculation of a spread adjustment. A stated criterion is to find a methodology that reduces the risk of divergence between the values of LIBOR and the fallbacks that would come into effect following a non-representativeness determination.

However, it seems likely there will be some differences. For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears “may not be possible to replicate within the restrictions of the existing LIBOR framework”.

The FCA will come out with further policy statements to clarify its thinking following consultation with market participants and global regulators. In the meantime, ISDA will push forward with its efforts to finalize fallbacks for derivatives, which will significantly reduce the potential for market disruption in the event LIBOR or another IBOR ceases to exist.

Interested in LIBOR transition? Attend ISDA’s Path Forward for LIBOR Transition virtual conference for free.

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