Many private banks that use the outgoing London Interbank Offered Rate do not trade on exchanges. Even in derivatives LIBOR is used extensively in the OTC market which is not exchange-based and whose transactions are often not cleared through the clearing houses. The rate is due to evaporate late next year, but HM Government is trying to temporise with the side-effects of its disappearance.

In a statement on 23 June, the British Chancellor of the Exchequer crushed any hopes for a government-sponsored extension of the London Interbank Offered Rate at the end of 2021. At the same time he introduced legislation that, when passed, will give the regulator new powers to instruct the ICE Benchmark Administration, the authorised benchmark administrator which currently produces the LIBOR rate, to use a synthetic LIBOR rate – 'synthetic' because it is to be derived from other benchmarks and data instead of submissions of data to the authorities by banks - for a limited period of time. The idea is to bring some integrity to the markets.

The FCA, then, will be able to call for the publication of a rate based on other rates such as SONIA (the Sterling Overnight Index Average) plus a computed spread.

Tough legacy

Banks have long been reluctant to keep contributing to the LIBOR benchmark (a 'contributor' is the term for a bank that provides its rates for use in the computation of an index) because the interbank overnight lending market that underpinned it has largely ceased to trade and also because compliance is costly and they might damage their reputations. As a result, since 2012, British authorities have been using their powers (or the threat thereof) to ensure that no bank ceases to contribute. This will cease by the end of 2021 and it is expected that this will lead to the rate's rapid demise. This is why financial regulators have been pressing the financial industry to migrate to alternatives before that date.

It has also become increasingly clear that there are several so-called "tough legacy" contracts that refer to LIBOR. These contracts are bound to make any transition to an alternative rate hard or impossible to achieve. Such contracts may be floating-rate notes (FRNs) that can only move to a new rate with the consent of the majority of investors, who may be unwilling to oblige. Some firms are refusing even to take part in preliminary conversations on the subject - a particular problem for note issuers, who require 100% agreement from note holders to be able to make the change. As a result, a task force of the Bank of England's Sterling Risk-Free Reference Working Group reviewed these issues and published its findings in May. Because it uncovered some complex problems, some people thought that the authorities might eventually be forced to diverge from their stated goal of completing the transition at the end of 2021.

New powers, old deadline

In the event, HM Government was prepared to be flexible about the dates of minor deadlines (or "interim transition milestones") in the run-up to the end of LIBOR, but stuck to the main deadline.

It did, however, choose another tactic to buy more time for market participants as they struggled to find solutions to the problems that their "tough legacy" contracts posed. This tactic was to give the FCA new powers to allowing it to require the administrator of LIBOR to change its methodology, creating synthetic LIBOR rates and effectively putting the benchmark on life-support for a period of time. "Tough legacy" contracts will therefore be able to continue to use LIBOR as a reference for some time after 2021 without fear of it disappearing overnight.

The FCA will consult interested parties about the details over the next few months. However, a likely scenario in which it could use its powers is already clear. At the beginning of 2022 it is expected that certain banks will start to withdraw from LIBOR, or at least from certain currency panels, which means that the calculation of the rate will be based on ever fewer submissions. Some panels already have low numbers of contributors. If the regulator declares a "cessation event" (i.e. if it decides that LIBOR is not representative of the real borrowing costs in the market because too few banks contribute their data towards it), the publication of LIBOR will not be viable for much longer and it will probably have to be stopped within six months or so, according to most observers.

It is at this point that the FCA will be able to intervene and force a change to the way in which LIBOR is calculated for the affected currency panels. It will probably allow the administrator to provide a synthetic LIBOR rate for the struggling currency and maturity using established methods such as the compounding of overnight rates to arrive at a forward-looking interest rate. That ought to remove the requirement for banks to submit rates for these maturities, but that in turn means that the published rate for that maturity would have to be computed from data that is not directly observed. The data might therefore be far-removed from the real-world costs of bank borrowing which LIBOR is supposed to measure. The FCA says that it will therefore only allow this to go on for a “reasonable time period.” In addition, only those contracts which qualify as "tough legacy" will be allowed to make use of the synthetic LIBOR, although nobody knows how the FCA is going to enforce this rule.
 
If the FCA makes use of its powers, it will in effect have put LIBOR on life support in the hope that firms will use the extra time to address the problem of "tough legacy" contracts.

A palliative and not a cure

Such government intervention by itself is not a complete solution to these problems but it may help to offset them in one of two ways. Firstly, "tough legacy" contracts may simply expire during the lifetime of synthetic LIBOR. FRNs, for example, have a typical maturity of two-to-five years and therefore may mature in the six months after the end of 2021. Secondly, in some cases the delay is likely to give firms more time to renegotiate their contracts and find alternative benchmarks.

A compulsory transition?

Ultimately, those contractual arrangements to which the parties can find no alternative may cease to perform. Shortly before that point is reached, the UK's authorities will be faced with another difficult decision. They may have to choose the other option proposed by the Bank of England's task force: a new law to make the transition to an alternative compulsory. This may produce winners and losers, in effect picked by the Government – an outcome that is unlikely to appeal to the Treasury, the Bank of England and the FCA. These bodies probably only see this as a last resort to be taken if financial stability and the integrity of markets are under threat.

This is why the authorities will continue to push financial firms to migrate to alternatives of their own accord, without waiting for their counterparties to tell them what to do, and to rewrite as many "tough legacy" contracts as possible in the time remaining. For users of LIBOR the message is clear: try to do this now to obtain the best possible results.

* Florian Nitschke can be reached on +44 207 089 0860 or at florian.nitschke@duffandphelps.com