The main derivatives trade group is considering industrywide fixes for the disarray that the demise of Libor could bring to more than $350 trillion of markets.
The International Swaps and Derivatives Association is looking at setting up standard contractual language that companies, banks, investors, and other parties can use to update their derivatives agreements that are based on Libor, according to Rick Sandilands, ISDA's senior counsel for Europe. These industrywide fixes, known as protocols, could potentially save thousands of parties from having to individually negotiate new terms one-on-one.
The discussions underscore the confusion in financial markets after a British regulator last month said that at the end of 2021 it will no longer force banks to help set Libor, a scandal-plagued benchmark rate. Libor has become so deeply entrenched in financial markets that even after it was rigged and manipulated, there's no consensus on what could effectively replace it.
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Coming up with a long-term fix that traders can agree on is critical for keeping trading volume high, said Jeffrey Robins, a partner at law firm Cadwalader Wickersham & Taft in New York whose practice includes advising on derivatives transactions.
"We'd never have the volume and liquidity in the derivative markets that we have if there wasn't a lot of standardization people rely on," Robins said. "Regulators want to motivate the transition from Libor, but there are risks with that transition."
Under ISDA protocols, market participants sign onto standardized changes that apply to all their derivatives contracts with other parties that have also signed up for the protocol. The trade group has set up the agreements for other market-wide problems. For example, after the new euro launched at the start of 1999, many older contracts still referred to pre-euro currencies. An ISDA protocol determined the exchange rates for pre-euro currencies in those contracts, helping the transition to happen smoothly.
Two Types
Two different types of protocol have been discussed, Sandilands said. One may allow traders to simply switch swaps to a Libor replacement automatically, while the other may specify a fallback rate that kicks in once Libor ceases to exist, he said.
"ISDA is open to creating protocols that help the industry deal with the impact on legacy trades from changes to benchmarks, provided there is sufficient demand for them," Sandilands said. "There would be thousands of bilateral negotiations without a protocol."
To determine the protocols, market participants have to work out what replacement rates will become the new standards. This could leave derivatives markets fractured, with multiple benchmarks across different countries, Bank of America Corp. strategists wrote last month.
Regulators are looking at alternatives based on market transactions. In the U.S., for example, a Federal Reserve-sponsored group called the Alternative Reference Rates Committee recommended replacing Libor with a new, broad Treasury repurchase agreement rate. The U.K. has proposed using a reformed version of the Sterling Overnight Index Average, or Sonia, a near risk-free rate.
Switching benchmarks could result in gains and losses for different market participants, because any replacement rate will likely diverge from traders' expectations for Libor, said Locke McMurray, a derivatives lawyer at Jones Day in New York. Banks will likely embrace the decision because their net overall exposure in most markets is relatively low and they'll want to avoid the legal and administrative hassle of renegotiating thousands of contracts. Other participants may decide they are better off not signing any protocol, he said.
"A protocol won't fix everything here," McMurray said. "I anticipate having to renegotiate a lot of contracts."
Synthetic Rate
Market participants have discussed modifying new benchmark rates to more closely align them to Libor. Andrew Bailey, head of the U.K.'s Financial Conduct Authority, suggested "a synthetic rate" could be used to better reflect bank credit risk. This could be a combination of Sonia in the U.K. plus a proxy bank credit rate, Bailey said in a Bloomberg interview last month.
Libor historically was based on daily polls of the rates that 20 banks estimate they'd pay to borrow funds from one another in five different currencies across seven time periods. The FCA's Bailey said that at the end of 2021, banks will no longer be compelled to continue submitting to polls.
The current Libor administrator, Intercontinental Exchange Inc., is ready to keep the rates alive. It has introduced governance changes, surveillance improvements and new technology to run the Libor process on a daily basis, Finbarr Hutcheson, president of ICE Benchmark Administration, said in an emailed statement. For example, Libor now includes market transactions in addition to poll data.
Libor will likely remain quoted after 2021 "given the undue hardships its cessation would cause throughout the financial system," Citigroup interest-rate strategists wrote in a July 28 note. Many financial contracts include some sort of contingency language in case Libor ceases to get published, although the specifics of how these backup provisions will work are sometimes vague, according to the report.
But if the FCA steps back from requiring banks to support Libor, they could implicitly stop it, the report said. Over the long term, it's clear the rate is going away, even if that complicates markets, said David Felsenthal, a lawyer at Clifford Chance in New York who deals with derivatives transactions.
"The U.K. regulators in particular seem pretty adamant that Libor will stop," Felsenthal said. "The market will come up with replacement rates, and unfortunately there are no magic answers."
Bloomberg News
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