Tough legacy contracts are those that do not have robust fallbacks and prove unable to be amended ahead of Libor discontinuation, which remains set for the end 2021. Tough legacy is not an issue specific to one IBOR currency or country, it is a largely global issue that could adversely impact the financial stability of an interconnected financial system if left unaddressed. Market participants should not wait for potential state or national legislative solutions and instead should proactively renegotiate contracts.
Many financial instruments linked to Libor do not envision a permanent or indefinite cessation of Libor. As a result, the contract language that underpin these products either do not have fallback language that adequately addresses a permanent Libor cessation or have language that could create unintended economic outcomes if Libor is discontinued.
Although existing contracts may be amended, such an amendment process might be practically challenging, if not impossible, for certain products. To compound the problem further, it has become clear that solving the tough legacy problem is beyond the power of financial regulators. This effectively passes the baton to lawmakers.
In the United States, there are hundreds of thousands of tough legacy contracts held by a wide variety of market participants. The co-chair of the outreach and communications working group of the Alternative Reference Rates Committee (ARRC) commented in his recent article in American Banker “many existing contracts either lack any provisions that deal with Libor’s end or have provisions that would cause significant, unintended economic impacts”.
The ARRC has worked hard to produce a legislative proposal at the New York state level aimed at minimizing legal uncertainty and adverse economic impact associated with LIBOR transition. The ARRC then held a webinar to provide a more in-depth overview of the proposed legislation and are currently seeking signatories for a draft industry letter of support for the legislation addressed to Governor Cuomo, Majority Leader Stewart-Cousins, and Speaker Heastie via the Securities Industry and Financial Markets Association (SIFMA). SOFR Academy has agreed to endorse the draft letter by acting as a signatory.
At a December 2019 House Financial Services Committee hearing in Washington DC, US Treasury Secretary Steven Mnuchin suggested a role for the legislative branch at the Federal level to “suggest some regulatory language and law to deal with this” but stopped short of committing to any tangible action.
Turning to the United Kingdom, it was the then CEO of the Financial Conduct Authority (FCA) now Bank of England Governor, Andrew Bailey, who first coined the term ‘tough legacy’ in a speech at a July 2019 SIFMA conference in New York. In that same speech, Governor Bailey noted that there were a range of options to address tough legacy contracts but had the foresight to note that none would be “easy”.
Governor Bailey called for further exploration and analysis to see if and where consensus exists, so relevant authorities could share and consider the feasibility and consequences of potential paths. In response, the Working Group on Sterling Risk-Free Reference Rates established a Tough legacy Taskforce (Taskforce) to provide market input to help identify issues around tough legacy.
The Taskforce was chaired by the FCA and was comprised of more than 30 individuals representing multi-national investment banks, Big-4 consulting firms, major industry associations and Magic Circle law firms. The Taskforce achieved their mandate by taking into account a wide range of considerations across an array of products and distilling them down to arrive at the conclusion that there is a case for action to consider what can be done to address tough legacy. The report on the identification of tough legacy issues was made public on the June 5th.
The Taskforce report suggests that other solutions to the tough legacy problem should be pursued in parallel. For example, the Taskforce has considered the scenario of Libor being stabilized via a so called ‘synthetic methodology’ for a wind down period following panel bank departure. This would probably require an administrator willing to modify the methodology for Libor which raises some new questions. We also know from an April 2020 International Swaps and Derivatives Association (ISDA) consultation that derivative market participants would generally not want to continue referencing Libor in existing or new contracts following a statement from a supervisor that it is no longer representative of the underlying market.
The report also makes the important point that the case for action has been strengthened by the market impact of the COVID-19 pandemic. The Bank of England’s May 2020 Interim Financial Stability Report noted that recent market volatility had highlighted the long-standing weaknesses of Libor benchmarks. In fact, on Monday March 16th, ‘transaction based’ Level 1 submissions in three-month sterling Libor fell to zero meaning that the rate was entirely reliant on ‘expert judgement’.
The second reason is something that the FCA’s Edwin Schooling Latter has often spoken about. The COVID-19 pandemic saw Libor rates increase in line with interbank credit spreads while around the same time official cash rates were quickly lowered. Questions exist around whether or not it makes sense to have non-financial market participants and consumers paying higher borrowing costs which are linked to Libor.
In terms of the next developments for tough legacy contracts, it will be important to understand the level of prioritization and timing that UK Government and New York State Legislature allocate to potential LIBOR transition legislation. In the UK, consistent with the recommendations in the Taskforce report, the Government and Her Majesty’s Treasury announced an intention to bring forward legislation that would empower the FCA to direct the administrator of LIBOR to change the methodology to help protect those who cannot amend their contracts. This could help to facilitate a wind-down period for Libor.
Both jurisdictions are diverting attention and resources to managing the COVID-19 pandemic and social unrest drive by recent racial issues. Brexit and the upcoming US has a Presidential election further complicate issues of prioritization and timing.
Even if legislative solutions in the UK and US could be achieved in the near term, they would not be all-encompassing solutions for tough legacy contracts. The goal of the potential legislation is only to minimize legal uncertainty and adverse economic impacts associated rather than eliminate risks entirely. We expect that financial regulars on both sides of the Atlantic will eventually be asking institutions about the size and nature of their tough legacy exposure in order to form an aggregate view on tough legacy risk at a macro level.
To achieve a successful and orderly transition away from Libor for the global financial market the transition must be broad-based, resolving tough legacy issues is a key dependency. Institutions must take action now to achieve legal and economic certainty through active amendment of tough legacy contracts. Proactive institutions will use this as an opportunity to deepen client relationships and demonstrate their Libor transition preparedness to regulators. In in doing so they will reduce transitional risks and future proof their businesses.
Mr Burnett is the Director of SOFR Academy and was involved in the Tough Legacy Taskforce chaired by the UK’s Financial Conduct Authority.