Big Issuers, Big Challenges: Where are Banks and Corporates in LIBOR Transition?
Five learnings from an insightful webinar hosted by Risk.net.
29 July 2020
I recently participated in LIBOR and Big Issuers, a webinar about LIBOR readiness among banks and corporates, the FCA pre-cessation announcement and dealing with legacy LIBOR contracts. Other panelists included leaders from the European Bank for Reconstruction and Development (EBRD), the Structured Finance Association (SFA), the Securities Industry and Financial Markets Association (SIFMA) and the Commercial Real Estate Finance Council (CREFC). Below are highlights from that session.
Readiness for LIBOR Transition
Readiness depends on the size of the firm, according to Kristi Leo, president of Structured Finance Association. Big investment banks may have an entire team (30 people or more) dedicated solely to that task while smaller firms have limited staff multi-tasking between LIBOR transition, their day job and COVID-related activities. I pointed out that Europe is ahead of the U.S. in LIBOR transition, to which the other panelists agreed.
Jasper Livingsmith, director, treasury at the EBRD, suggested that one of the reasons for this is that SONIA (the U.K. LIBOR replacement rate) has been around since 1997 and is thus far more established than SOFR (the U.S. replacement rate) which has only been in existence for two years. He also stressed readiness depends on systems — trading, booking, etc. — that need to support conventions which are still emerging in the market. It is hard to modify a system without a target end state, add to this the fact that LIBOR conventions had 20+ years to evolve. Kristi pointed out that on the investor side the portfolio managers are managing the transition, and they have been more focused on market volatility.
Breaking News: FCA (Financial Conduct Authority) Pre-Cessation
Just a few days prior, the FCA announced LIBOR pre-cessation potentially by the end of this year. In simple terms, this means U.S. markets will have the information they need to convert systems and amend legacy contracts to SOFR going forward. This will end the current stalemate in the market where participants are reluctant to convert to a new reference rate until they know the spread adjustment. If the pre-cessation announcement pushes through, it will give the markets an entire year to convert with certainty.
Ending the Legacy
I pointed out that from a security point of view, legacy LIBOR presents two conflicting requirements. On one hand, the contracts contain highly confidential information and as such need to be locked down. But given the large number of contracts, banks and corporates will need to share contracts with external counsel to get fallbacks implemented by December 2021. This conflict represents a big challenge for banks and corporates.
I went on to say that unfortunately, bank legal departments (usually core to LIBOR transition) rely on antiquated methods for sharing confidential information outside the corporate firewall, such as sending encrypted CDs via FedEx, secure email and thumb drives. These external sharing mechanisms are expensive, (e.g. USD 15 per FedEx package x 1 million contracts) and the process is rife with data loss. Imagine someone replacing your music streaming service with an overpriced Bee Gees Greatest Hits 8-track tape.
To address this challenge, banks and corporates are centralizing contracts into a secure virtual repository that has external sharing capabilities. Artificial intelligence (AI) and search, either native or integrated, are then utilized to cull out non-relevant documents before sharing with external counsel.
With this initial culling, contracts are also given a classification — fallback language, product, client, expiration date, etc. — that is used to facilitate the amendment workflow. The contracts are shared with internal and external teams that amend the contracts with new fallback language, all while ensuring document protection as well as access controls. This addresses the two conflicting requirements I emphasized earlier: protecting the data while sharing the data.
As an added benefit, this same secure repository can also be used to share the amended contracts with clients and counterparties for signoff.
Jasper said that the GFC (2008 global financial crisis) brought home the need to have contracts in an accessible and sharable digital format. Not only did the GFC expose LIBOR as easily manipulated, artificial and risky, but it also exposed the flaw in the pricing of almost all derivatives.
The market as a whole had not been using the ISDA Collateral Support Annex (CSA) specified discount rate, which is pretty fundamental considering the CSA is the document that dictates the economic relationship between two derivative counterparties. As Lehman Brothers were circling the drain, the immediate questions facing firms with active derivative contracts were: where is the CSA? Where is our firm on the relevant economic terms contained within the CSA for the remuneration of collateral and default provisions? How are we going to securely map these terms so they feed our systems and ultimately share the document with our counterparts to facilitate renegotiation?
Hard Habit to Break: Tough Legacy (Contracts)
Tough legacy are contracts that do not currently have adequate fallbacks and are deemed too difficult to amend by the end of 2021. The FCA with the Bank of England in the U.K. and the ARRC in the U.S. are proposing a governmental legislative solution for these contracts. A good example of tough legacy in the U.S. is capital market bonds. Identifying and gaining consent from all bondholders by December 31, 2021, will be difficult.
The proposed legislation will enforce the adoption of the new benchmark rate for tough legacy contracts and provide safe harbor from litigation or breach of contract for the issuers. In the U.S., the legislation is being proposed in New York State given New York law governs most financial contracts.
Both Jasper Livingsmith and Chris Killian, managing director at SIFMA, pointed out that it is a dubious proposition for firms to depend solely on legislative solutions to address tough legacy. Chris noted that the New York legislature currently has its hands full dealing with COVID-19, while Jasper noted that tough legacy (should the legislation pass) will apply only to a small minority of very difficult-to-amend contracts. And for contracts based on British pound LIBOR, Jasper pointed out that in addition to COVID-19 the U.K. parliament also has Brexit on its to-do list!
Don’t Delay the Inevitable
COVID-19 may have thrown a wrench into the financial world’s already delayed transition out of LIBOR, but regulators in the U.S. and U.K. are holding firm to the December 2021 date.
In a June 23, 2020 statement, the Chancellor of the Exchequer, Rishi Sunak, said that the U.K. government “must continue actively transitioning away from LIBOR.” He also said that “legislative steps could help deal with ‘tough legacy’ contracts that cannot transition from LIBOR.”
New York Fed President John C. Williams echoed Sunak’s statement. In a webinar held this month by the New York Fed and the Bank of England, Williams said: “It doesn’t matter whether you’re a large global bank or a local company with a handful of employees, you need to be prepared to manage your institution’s transition away from LIBOR.”
He added, “The transition from LIBOR is so great that despite the effects of COVID-19, the overall timeline remains the same: There are now 537 days until the existence of Libor can no longer be assured. The clock is clicking.”
Governmental determination to move ahead and the discussion at the “Big Issuers” webinar underlined the heightened challenges in two key areas. First, smaller institutions with limited and/or redirected LIBOR resources. Second, those with exposures to cash products that involve highly complex contract remediation, including incorporating “waterfall” fallback language and obtaining unanimous consent from noteholders.
As the adage goes, time and tide wait for no man.
Dominic Brown is a field technology head at Intralinks in Waltham, MA. Dominic employs his 15 years of compliance and IT experience, along with Intralinks’ unique technology, to help organizations address challenges with sharing, distributing, and collecting highly confidential data. Dominic helps organizations understand and change internal procedures to deploy technology solutions that dramatically reduce the risk and expense associated with secure data exchanges. He has spent his career working with the Fortune 1,000 and North America’s largest government agencies.