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FCA: LIBOR’s tough legacy contracts are a ‘knotty problem’

Speaking at the Association of Corporate Treasurers’ International Treasury Week, Edwin Schooling Latter, director, markets and wholesale policy, FCA, said firms must push forward with LIBOR departure projects despite uncertainties regarding certain LIBOR linked loans.

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FCA: LIBOR’s tough legacy contracts are a ‘knotty problem’

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The demise of the London Interbank Offered Rate (LIBOR) has been set in stone since summer 2017, when then FCA chief executive Andrew Bailey announced that the FCA will no longer exercise its influence to facilitate the production of LIBOR after 2021. The endemic rate is tied to approximately $400 trillion of contracts globally and the battle to unpick association with the rate has been met with varied success across markets.

Updating market players on the status of the LIBOR devolution, Schooling Latter elaborated on the issue of ‘tough legacy contracts’, an area of concern throughout the market and one which remains to be solved by the Working Group for Risk Free Rates (RFRWG).

When asked how to address the nervousness surrounding the feasibility of transitioning certain legacy deals away from LIBOR to Secured Overnight Interbank Average Rate (SONIA) or an alternate risk-free-rate by the end of 2021, Schooling Latter says a different set of challenges presents itself.

“Sometimes it will be possible and practicable to convert some outstanding stock of legacy instruments, such as in the case of conversions. There are also contracts which will not be feasible or practical to convert before the end of 2021. That’s a particularly knotty problem.”

He commented that members of the RFRWG have proposed that authorities or those in government should take this problem away.

“Some people on the [webinar] will be aware of a proposal of that shape, which has been put to the New York State Legislature to give the payer of the interest rate safe harbour from legal disputes if they take a particular solution toward continuing that LIBOR referencing contract after the end of LIBOR.

“This is an issue that we’re going to have to discuss further in the working group, and indeed with the government here.”

A fundamental concern lies in the differences in methodology (or conventions) used to calculate LIBOR and alternate risk-free rates. LIBOR, a forward-looking rate, ensures that interest payable is known from the outset of the agreed interest period. Other rates such as the UK’s preferred LIBOR replacement, SONIA, functions as an overnight backward-looking rate, meaning the interest payable is unknown until the final days of the interest period.

In practical terms, this can result in legacy contracts being more advantageous to one party over the other according to the rate used. A groundswell of legal proceedings brought by dissatisfied parties could cause significant disruption.

Jamieson Thrower, head of syndicated loans agency and LIBOR transition business lead, NatWest, added that while some contracts contain fallback provisions in the circumstance that LIBOR is unavailable for reference, these often do not account for permanent inaccessibility of LIBOR which may lead to uncertainty and therefore risk of disagreement.

He argued that even a fallback provision which explains how to navigate through a scenario where LIBOR doesn’t exist cannot be sufficiently relied upon for comfort, nor to ensure that a contract remains survivable and operable on a longer-term basis when LIBOR ceases.

David McNally, IBOR transition director, corporate banking, Deutsche Bank continued that across lending markets parties simply do not have adequate fallbacks, “not least because to rely on the fallback concentrates the transition effort for loan lenders and borrowers all toward the end of December next year. This feels like a Y2K event on steroids to me and one which we should all try to avoid.”

That is to say, it would be well advised to assume that there is no such thing as an adequate fallback provision and that firms should seize the time between now and end 2021 to refinance or amend existing agreements to be compliant with a market that operates without LIBOR.

The RFRWG’s recent statement reinforces this approach, as it requests that lenders and their borrowers should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021. This is a far more involved requirement than merely relying on fallback provisions.

While Schooling Latter did not provide further commentary into the timing or outcome of the RFRWG’s questions into managing tough legacy contracts, he concluded that above all else, the pertinent point continues to be that if firms want to have control over what their interest rate obligations and entitlements are going forward, then waiting for legislative relief is not the solution.

“Don’t wait for legislation. If you can convert your legacy stock, do. That’s the only way in which you are going to have full control and remove any uncertainty on what might happen to those legacy contracts.”

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