Since 2015, Mike Trippitt has been engaged as an independent banking consultant and as an expert witness on a number of high profile banking litigation cases. Mike has thirty years’ experience in banking, including 22 years as a bank equity analyst. He has worked for a number of investment banks including HSBC where he led the global banks equity and fixed income research teams. During this time he was also seconded to the UK’s Association of British Insurers (ABI) to write a report on the Investability of Banks following the Global Financial Crisis.
Prior to becoming an analyst Mike worked for TSB Group, initially as Head of Corporate Planning. Latterly he was TSB’s Group Financial Controller, responsible for financial reporting, capital planning and investor relations.
Life after LIBOR
The mention of LIBOR still evokes memories of the Global Financial Crisis and the highly publicised investigations into alleged LIBOR rate fixing. After multiple regulatory enquiries, multi-billion-dollar fines, and high-profile criminal cases, the final LIBOR chapter, if not managed properly, could be an industry disrupter. The final chapter is entirely unrelated to the ‘LIBOR scandal’ but to the transition from LIBOR to alternative benchmark rates.
LIBOR provides the reference rate for some $400 trillion of financial contracts including derivatives, bonds and loans. The problem, expressed in his 2017 speech by Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA), is that the underlying market that LIBOR seeks to measure - the market for unsecured wholesale term lending to banks – is no longer sufficiently active. Mr. Bailey further remarked: “In our view it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them.” The FCA has said it will no longer be necessary to compel or persuade panel banks to make LIBOR quotations after 2021. After end-2021 all markets will need to transition to an alternative reference rate. The UK will transition to the use of SONIA (Sterling Overnight Index Average). There appear to be three key risks in the transition process:
Fallback language. Fallback language articulates the contractual process through which a replacement reference rate can be identified, if a particular benchmark rate is not available.
The language will relate to the fallback trigger events, benchmark replacement and benchmark replacement adjustment. EY’s 2019 report (“Fallback language – addressing the legal and contractual challenges off IBOR transition”) highlighted how regulated firms will also need to consider other contractual features including maturity date, the firm’s role in the contract, benchmark use, amendment and consent provision, governing law and jurisdiction and force majeure provisions.
New York Federal Reserve’s VP and General Counsel Michael Held in February last year made similar points but rather more forcibly, in a widely publicised speech: “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 190 trillion dollars’ worth of those contracts. this is a DEFCON 1 litigation event if I’ve ever seen one.” Extraordinary language from a regulator. His broad message to market participants was firstly, to stop writing contacts on LIBOR and start using SOFR (the US Secured Overnight Financing Rate) or another robust alternative (such as SONIA in the UK) - if market participants need to keep using LIBOR, they must ensure contracts have “strong and workable fallback language”.
Secondly, market participants must address the trillions of dollars of existing contracts that extend past 2021 and do not have effective fallbacks.
Does one size fit all? The US’s Structured Finance Association highlighted a remark made by the Financial Stability Board’s chairman that risk-free benchmarks may not be appropriate for all lending products, the inference being that for certain legacy instruments, the extension of some form of LIBOR may be required.
Execution risk. In January, the Bank of England, the FCA and the Working Group on Sterling Risk-Free Reference Rates published a ‘to-do’ list for LIBOR transition in 2020. The transition requirements include: (i) ceasing issuance of cash products linked to sterling LIBOR by end-Q3 2020; (ii) taking steps throughout 2020 to ensure that compounded SONIA is easily accessible and usable; (iii) taking steps to enable a further shift of volumes from LIBOR to SONIA in derivative markets; (iv) establishing a framework for the transition of legacy LIBOR products, in order to significantly reduce the stock of LIBOR referencing contracts by Q1 2021; and (v) considering how best to address “tough legacy” contracts.
The to-do list is demanding and non-trivial. The last point relating to tough legacy contracts is crucial and potentially presents significant litigation risk. The SFA commented in a presentation late last year that litigation risk is likely to correlate directly with the extent to which the LIBOR transition – whatever path it may follow – is perceived to change the economics of an instrument.