WHY THE DEATH OF LIBOR IS A "DEFCON1 LITIGATION EVENT" / THE FINANCIAL TIMES

Why the death of Libor is a ‘Defcon 1 litigation event’

Companies and investors are unprepared for a shift to new lending benchmarks

Katie Martin


One sure-fire winner will emerge from the mess that is financial benchmark reform: lawyers. It is hard to imagine an overhaul of market infrastructure more suited to their needs as this process lumbers towards an inevitable flurry of disputes.

Bankers will cop the blame, naturally. But for once, perhaps, the mess is not really their fault.

At issue is Libor, the benchmark borrowing rate that is embedded in everything from floating-rate debt to derivatives to mortgages and anything in between. The rate touches the most sophisticated hedge funds and the average homeowner. But the order has come down from on high: Libor, in all its different currency forms, must die.

Some of the reasons for this death sentence from regulators are obvious; abuse of the methods for calculating interbank borrowing rates has landed people in jail. It turned out, to the shock of people who were naive or not paying attention, that leaving traders to set a rate from which they can profit based on numbers they plucked out of thin air, is a bad idea.

The skulduggery that led to the sprawling Libor scandal is only part of the problem, however; authorities are keen for a new rate to be based on something that is traded. The “thin air” element needs to be removed so the rate cannot be so easily gamed, but it is also common sense.

The problems have set in already with the implementation of a new regime. Even the New York Fed’s general counsel Michael Held this week referred to the mess as “a defcon 1 litigation event if ever I’ve seen one”.

In late January, Edwin Schooling Latter, director of markets at the UK’s Financial Conduct Authority, said in a speech that the “best and smoothest transition away from Libor will be one in which contracts that reference Libor are replaced or amended” before the rate disappears, which it wants to see by the end of 2021.

That will require co-operation from banks’ clients, which is not necessarily an easy task. Mr Schooling Latter also conceded that “there may, because of historical issuance, still be a material volume of such contracts in cash markets into the 2030s.”

This matters. Imagine you hold a floating-rate note, which you have bought specifically to help hedge against inflation. Its returns track Libor. But Libor dies. So the interest payments stick at the last published rate for ever. That burns the investor if the underlying rate rises. But it is a windfall for the borrower.

“This is not a very satisfactory solution to either the issuers or the borrowers,” said New York Fed’s Mr Held, adding that for derivatives, “there simply may be no further fallback. You can imagine the litigation risk when the reference rate for a 20-year contract disappears and there’s no clear path to replace it. Now imagine $190tn worth of those contracts”.

It all “invites litigation . . . on a massive scale”, he said.

It would help here if every stakeholder had formed a plan of action. But they have not. Far from it.

As the deadline draws near, bankers are increasingly frustrated. “I just can’t see a way to escape this mess,” says one. “There are big potential conflicts and even potential claims of misconduct.”

The FCA has, with the best of intentions, really dug in. Chief executive Andrew Bailey has turned up the volume on his warnings that banks must abandon the old rate. The Bank of England has backed him up. But how? Banks must sort it out between themselves. There will be no legislation to force all stakeholders to make the leap — a silver bullet that would solve most of the problems. The unwillingness of national authorities to set out a solution is leading to exasperation.

The optimist’s view on how this will pan out is to rely on the alternative rates that have already gained some favour. Bonds referencing the “Sonia” overnight borrowing rate in the UK, for example, are hitting the market increasingly frequently, and investors are certainly not balking (although growth is coming from a very small base and borrowers are said to often hedge back into Libor.)

In a perfect world, Sonia, and Sofr in the US, would now form the basis of new derivatives and new products that banks can use to keep hedging existing Libor-based contracts.

But that is all more easily said than done. The likely replacements for Libor, a so-called “term” instrument that locks in prices for three or six months at a time, are generally overnight rates. This is an effort to cram square pegs into round holes.

Bankers say they are doing what they can to explain the difficulties to regulators, as are industry bodies. But banks are worried that their motives are doubted and their concerns are unheeded.

In the months before the big switch-off, they are doing what they can to educate clients and drum up liquidity in new benchmarks. They are also mentally preparing themselves for legal battles with clients stretching out for years.