Long reads

How will Covid-19 re-write the demise of LIBOR?

Paige McNamee

Paige McNamee

Junior Reporter , Finextra

It’s difficult to encapsulate in a succinct, let alone enchanting way, the leading role that LIBOR plays across the global economy. The economic protagonist of sorts touches on approximately $400 trillion of contracts and lending products across the world, and the arrival of Covid-19 has made the challenge of disentangling associations with the rate all the more problematic.

This was confirmed with the Working Group on Sterling Risk-Free Reference Rates’ (RFRWG) recent announcement to delay the end-Q3 2020 target of halting all new sterling LIBOR linked loans to end-Q1 2021 due to pressures caused by Covid-19. In the same statement however, the watchdog alliance stressed that the ultimate end date would remain in place.

While the interim extension has been welcomed across the industry, the question remains, is this enough to mitigate the pressure the pandemic has placed on institutions’ plans to depart from LIBOR?

The great rate unravels  

In July 2017, then FCA chief executive Andrew Bailey announced that the FCA will no longer exercise its influence to facilitate the production of LIBOR after 2021. From this date the FCA will no longer compel banks to submit their daily rates to LIBOR and the alteration of this obligation to an optionality effectively means banks will not report. This will work to diminish the integrity of the rate into inevitable extinction.

Financial institutions across the UK and the globe have been working towards this deadline with varying degrees of progress.

Though banks may have outwardly held the position that they were on a clear path toward divergence from the rate, a light scratch on the surface reveals a different story altogether.

Even before the realities of Covid-19 were realised, it was widely believed that there was a very real prospect that not all markets and contracts would be able to transition away from LIBOR by end 2021.

Patrick Clancy, partner, Shearman & Sterling, says that having to balance resource allocation between LIBOR transitioning projects and managing the unexpected issues caused by Covid-19 is proving terrifically difficult for financial institutions: “for a couple of months LIBOR simply must take a back seat because there aren’t the people or resources to deal with it and firms also aren’t in a position to be hiring expertise to be able to expedite the transition.

“It is almost inconceivable that it will have no significant impact on the ability of financial institutions and users of financial products to be ready for a cessation of LIBOR at the end of 2021, especially as the available time to prepare was already very short.”

 

Delay is preferable to error 

Regulators hold a responsibility to maintain stability across financial markets and to smoothly manage events which threaten to cause destabilisation. This is of particular importance to the LIBOR departure.

Clancy warns that if “financial institutions and other users are generally not ready, then there will be widespread concern about financial market stability if LIBOR is to cease at the end of 2021. That concern will itself be destabilising.”

Flagging that timeline concerns were afoot, on 25 March 2020 the FCA, Bank of England and members of the RFRWG emerged to make a brief joint statement that the final end 2021 date remained in place, and while the group looked into the impact of Covid-19 on the transition, firms should not alter their LIBOR departure plans.

The FCA declined to comment on the update in March, waiting over a month to announce that it “will not be feasible to complete transition away from LIBOR across all new sterling LIBOR linked loans by the original end-Q3 2020 target.”

Working with the Bank of England and the FCA the RFRWG provided the industry with a list of recommendations:

  • By end September 2020 lenders should offer non-LIBOR linked products to customers;
  • From October 2020 lenders, alongside borrowers should include clear contractual arrangements in all new or re-financed loan products which reference LIBOR. This will facilitate conversion ahead of end-2021, through pre-agreed conversion terms or agree process for renegotiation to SONIA or other alternatives to LIBOR; and
  • New issuance of sterling LIBOR-referencing loan products expiring after the end of 2021 must cease by the end of first quarter 2021.

In a press release Caroline Stockmann, chief executive, Association of Corporate Treasurers responded to the announcement, noting that “the sequencing of the different deadlines for lenders and borrowers is helpful, to allow time for new conventions to be clarified and for systems software to be upgraded.”

Stockmann added that the statement “provides constructive guidance for new lending, for those involved in moving away from LIBOR. However, the ACT recognises that there is still much to be done to enable legacy transactions, currently referencing LIBOR that mature after 2021, to be re-denominated.”

 

 An uphill battle, Covid-19 notwithstanding

Stockmann elaborates that the non-Covid related challenges for corporates trying to finalise their LIBOR departures stem largely from the limited timeframe in which firms can upgrade their systems “once the conventions’ calculations have been established. But realistically, there is only Covid-19 on firms’ radars at present.”

While numerous challenges or risks regarding the LIBOR transition itself are not born from COVID-19 difficulties, Clancy observes, the pandemic undeniably makes it more difficult to tackle the list of risks because the market is simply focussed on other things.

This means that a “resolution of market questions is likely to be delayed and partly because most corporates are both fighting for their own lives and are also on the back foot by virtue of having a work force either furloughed or working from home.”

Specifically, Clancy points to external challenges such as the lack of a vibrant risk-free-rate (RFR) based loan or derivative market, uncertainty about term RFR rates and their availability, risk of predatory investors buying up bonds with a view to litigation, lack of clear support from financial institutions and regulators, insufficient time to comprehensively reorganise financial liabilities, uncertainty about fairness of credit spread adjustments, and hedge accounting.

 

Banks may just be crying wolf 

Chris McHugh, director, Centre for Sustainable Finance, London Institute of Banking and Finance has less patience for the timing plights currently espoused by UK institutions.

McHugh says that banks were told, across the board, in no uncertain terms, that they were expected to get on top of this transition in 2017: “If institutions are now saying the timeline is not achievable, unless there is some systemic or prudential reason as to why it makes sense for the regulators to delay, then the transition should continue as planned.”

Despite this, McHugh recognises the pressures the pandemic has sustained on banks, such as reduced headcount and restrictions stemming from employees having to work from home and he notes that there are justifiable reasons for asking for timing relief. However, these reasons are narrow and would be tied to the flow of resources being directed to critical operational tasks rather than the transition.

After all, banks are sophisticated institutions with the capacity to navigate complex global events and would need to demonstrate that they are not simply sitting on their hands and waiting for the storm to pass.

In this way, McHugh does not view the RFRWG’s statement last week as a “deadline change,” but as a “very encouraging, clear, pragmatic statement that clarifies for financial institutions what the core, remaining issues are.

“It clarifies that the work toward transition must carry on, and while there may have been people within institutions who hope that the final demise of LIBOR will be delayed, as has been the case since 2015, I think that this confirmation may just have needed to be repeated. Perhaps the impact most importantly goes to dispel any remaining hope that it would be delayed.”

While McHugh observes that the letter’s phrasing certainly leaves wiggle room for the potential of an extension with “the central assumption is that firms cannot rely on LIBOR,” regulators are acutely attuned to avoiding any encouragement of the idea that a delay may lead to a different outcome.

“This likely stems from the lack of acceptance that LIBOR will actually end. I don’t think everybody really believes it will.”

 

The extension attraction 

Speaking directly with Finextra Research in April, Stockmann pre-empted the interim postponement: “At present, there is nothing to suggest that the end 2021 won’t be achieved. However, the final deadline is one thing and the ceasing of use of LIBOR as a reference benchmark for new loans from September 2020, another – this may be why the FCA is saying the end date stands and milestones may move.”

Clancy believes that the easiest short-term solution for the markets would be to delay the final date by up to a year. However, in order for such a delay to prove effective to firms, it would need to be announced early.

What’s more is that given the nature of the Benchmark Statement, a public statement released by the LIBOR Administrator outlining its approach to changes to LIBOR publication, firms relying on this document will be expecting 12 months’ notice to such changes.

This means that if the regulators do decide to provide an extension to the ultimate deadline, firms would expect to be notified about such a change by December 2020. While the timeframe isn’t set in stone, Clancy argues that the market would certainly expect significant notice to any change.

If stability is at the forefront of the regulator’s mind, altering that framework by any less than what the market expects holds potential to disrupt.

Noting that there are examples in recent history of implementation dates under European financial  regulation being delayed at the last minute, Clancy insists that “If a decision to put off the transition date is communicated to the market too late, then the very communication itself would destabilise things and that would be counter-productive.”

 

Are regulators pulling their weight? 

Commercial players across the industry have lamented the position taken by regulators as an uncompromising enforcer, failing to provide clear guidance and support, to assist institutions in implementing their transition strategy.

It is Clancy’s impression that financial institutions aren’t receiving a lot of support in terms of managing the transition: “As I see it, their feet are being held to the fire. The FCA are coming across publicly as being unbending on the matter.”

Conversely, when asked if the regulators are doing enough, McHugh reverses the premise: “Why should the regulators change anything? I think they’ve been crystal clear from the beginning; the banks need to make the transition. I don’t see why the regulator would need to grant an extension.

“To justify changing the end 2021 deadline there would have to be a systemic reason for doing so. I don’t see this as a systemic problem, some individual firms will be ready for the transition others won’t be.”

Within their recent announcement, the RFRWG agreed that despite the difficulties Covid-19 presents, progress toward the transition can also continue to be made in other areas, and that the FCA, the Bank of England and the Chair of the RFRWG would support the delivery of the RFRWG workplan in key areas that will continue the momentum on LIBOR transition.

This includes: 

  • Publishing the RFRWG's analysis on, and considerations for, dealing with 'tough legacy' contracts; 
  • Building on the strong consensus on how to calculate a fair credit spread adjustment in legacy cash products to assist transition from LIBOR in cash markets; and 
  • When plans and working arrangements disrupted by the Coronavirus begin to stabilise, the RFRWG and its members will intensify communication with customers needing to move away from LIBOR as part of transition. 

The guidance seems supportive but tends to raise more questions than it answers. For instance:

When will guidance be provided as to ‘tough legacy’ contracts?

Is there, in reality, consensus that calculation of a ‘fair credit spread adjustment’ truly fair in today’s market?

What constitutes ‘intensified’ communication?

How can financial institutions possibly be expected to meet hard deadlines when the most concrete timeframes regulators can commit to is put as broadly as “when plans and working arrangements disrupted by the Coronavirus begin to stabilise”…?

It could be another month at least before the RFRWG provides its next announcement addressing these concerns, but who knows. Given that we don’t know if ‘plans and arrangements disrupted by Coronavirus’ will stabilise in 3, 6, 12 months or more, this is rather difficult to predict.

Use of LIBOR is endemic. The global financial system is riddled with the rate and while the risks associated with the rate are unanimously understood and progress has been made, the journey to achieving full LIBOR decommissioning remains significant.

A stark interpretation tends to depict financial institutions throwing their hands in the air in exasperation as regulators cast monumental demands, and having each side call the other’s bluff in a race to the deadline will inevitably lead to disaster.

No-one stands to benefit from a deadline passing by with minimal or hastily patched together compliance; the regulators cannot penalise every single non-compliant institution but equally cannot be the ‘emperor with no clothes.’

Banks cannot afford not to prioritise operational business costs born from the Covid-19 pandemic, yet they face the possibility of arriving at the deadline only to be met with hefty penalty.

 

Read more about 2020’s most significant regulatory updates here

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