A taskforce belonging to the Financial Conduct Authority and Bank of England's Working Group on Sterling Risk-Free Reference Rates has shed more light on the problems of 'tough legacy' issues that are bound to hamper the UK's transition away from the scandal-struck London Interbank Offered Rate to other rates.

The old interest rate benchmark - discredited forever by the revelations of 2012 - is expected to cease at the end of 2021. Exchange-facing private banks, brokers and other firms must move to alternative rates before that time. The FCA and its working group are still insisting on financial firms removing "Libor dependencies" from their contracts before the end of 2021, after which Libor may no longer continue. The case for further governmental action of some kind has, in its eyes, been strengthened by the effect on the market of the Coronavirus infection because the deadline remains the same but there is less time available in practice to meet it.

Howard Taylor of Capco told Compliance Matters: "The 2021 date will force people to change the rates on their products. If the relationship manager or investment cousellor recives the product from his product department, he might have a problem on his hands. If somebody has a contract going beyond 2021, the firm will have to change the terms in the middle of the contract and it'll have to explain that to the HNW client. If you are a wealth manager, you ought to do an impact assessment of Libor on your client base and work out how to communicate with them about it. You can't necessarily avoid having a contract that goes beyond 2021. If you do have a contract that does, you are stuck with the job of changing it."

Derivative contracts

The taskforce (which, amusingly, always awards itself a capital T in its pronouncements) considers that derivative contracts may be 'tough legacy' contracts, as it calls them, but whether they are or not depends on the circumstances.  Parties to uncleared derivatives are able to negotiate pro-actively with each other bilaterally or multilaterally (e.g. through compression) to change or replace contracts so that their Libor-based exposures are changed to a risk-free rate (RFR), or something else. The risk-free rate is the theoretical rate of return on an investment with zero risk.

These pro-active approaches are considered a better means of transition than the use of a trigger to activate a 'fallback' rate (on Libor’s cessation or before). This may be particularly true in relation to such derivatives as non-linear products.

Fallback provisions in a contract lay out the process by which the parties can identify and use a replacement rate if a benchmark rate such as Libor is not available, perhaps because of a computer failure that affects the designated screen page or a temporary market disruption.

Parties to uncleared derivatives are also able to embed new fallbacks by using the long-expected IBOR fallback documents from the International Swaps and Derivatives Association or by the simple means of bilateral negotiation, while the clearing houses have announced their intention (subject, in some cases, to consultation) to incorporate fallbacks for derivatives subject to clearing into their rulebooks, comparable to those to be published by ISDA. On 15 April ISDA published the latest preliminary results of a consultative exercise on the subject.

Parties to derivatives can also use basis swaps, compression and other methods to pro-actively convert Libor exposures into RFR exposures. Many derivatives will not, therefore, be ‘tough legacy’ contracts. However, the taskforce recognises that the use of the ISDA protocol can only be voluntary for uncleared derivatives and is therefore no universal panacea. Firms are also likely to hedge exposures that are themselves considered to be 'tough legacy' or form part of more complex structures in which the derivatives are subject to the same or similar constraints as the instruments they are used to hedge, thus making the derivatives 'tough legacy' as well. For non-linear products, fallbacks are quite possible but may require more amendments than those likely to be found in the ISDA protocol. It therefore, ideally, would like HM Government to step in with legislation.