The Short Road from LIBOR's Death to 'Armageddon'

When law firm Linklaters decided to organize a seminar about the forthcoming demise of LIBOR, it planned to hold the event in its London auditorium, which seats about a hundred people. After more than 500 attendees signed up, it was forced to move to a larger venue.

Thursday's packed attendance at the Honourable Artillery Company's headquarters strikes me as testament to how corporate treasurers, bankers, accountants, and consultants are belatedly realizing the scale of the task finance faces in replacing what was dubbed—and still arguably is—the world's most important interest rate. But the awakening may still have come too late to avoid a chaotic and expensive denouement to the benchmark.

The London interbank offered rates (LIBOR) are embedded throughout the DNA of finance. Untangling them, after the Financial Conduct Authority's (FCA's) announcement two years ago that they'll be phased out by the end of 2021, is proving difficult through a combination of apathy, complexity, and a lingering hope that LIBOR will somehow limp on in some form or other.

In the worst-case scenario, the disappearance of LIBOR could lead to the courts ruling that some existing contracts are deemed to have been frustrated. In legal terms, that happens when an event either makes enforcement of a contract impossible or completely undermines the contract's original intentions. This would place the market in largely uncharted territory—“contractual Armageddon,” in the words of Rick Sandilands, senior counsel, Europe, at the International Swaps and Derivatives Association (ISDA).

The most extreme outcomes could be for the frustrated contracts to be unwound as if they never happened in the first place, or a court trying to account for the various benefits that had accrued during the contract's life, in order to come up with a settlement that treated parties to the agreement fairly.

It's an unlikely, though not impossible, scenario. But many of the legal experts who spoke at the Linklaters conference discussed the need for flexibility when writing or amending contracts that run past LIBOR's end date, because it's still not 100 percent clear what form the replacement interest rate will eventually take, especially given that different countries are seeking different solutions.

And where a lawyer sees elasticity, a hedge fund may see potential profit. There's a non-negligible risk that where a contract change creates a winner and a loser in financial terms, litigiously minded mischief makers may try their luck.

Even without that doomsday outcome, rewriting contracts that refer to LIBOR is fraught with byzantine convolutions. Take, for example, a syndicated loan that pays interest based on LIBOR and is used to finance a toll road in Spain. Changing the terms would probably require the consent of the syndicate of banks that arranged the loan, as well as the borrower, as well as the providers of any hedging agreements undertaken, and maybe the agreement of the Spanish local authority that leased or sold the land the road is on. Now multiply that across the entire project finance universe to see the complexity of the shift to new benchmark borrowing costs.

There has been some progress in persuading U.K. companies to adopt the Sterling Overnight Interbank Average rate (SONIA), the preferred replacement for LIBOR. Last month, Associated British Ports Plc switched its 65 million pounds ($81.4 million) of floating-rate notes to making interest payments tied to SONIA rather than LIBOR. And last week, National Express Group Plc took out the first SONIA-based loan, from Royal Bank of Scotland Group Plc's NatWest unit.

While both are desirable developments in the shift to the overnight benchmark, a few deals do not a transition make. Linklaters estimates as much as $2 trillion of loans risk being left “in limbo” by LIBOR's demise. And while more than 40 new sterling floating-notes tied to the new benchmark have been sold this year, there are billions of dollars, pounds, and yen of outstanding notes that still base their payments on LIBOR—as much as $864 billion worth, according to the International Capital Markets Association (ICMA).

The logistical difficulty of rounding up the disparate investors in those securities to get them to agree to change the reference benchmark is daunting, to say the least. Moreover, even when the paperwork contains language about what to do if LIBOR isn't available, that documentation was designed for brief periods of absence, rather than envisaging a world without LIBOR. In many cases, the interest payments revert to a fixed rate based on the final LIBOR determination—again creating the prospect of legal action from financially disadvantaged actors, legitimate or otherwise.

Edwin Schooling Latter, the FCA's director of markets, warned last week's conference participants that they can expect “a lot of supervisory interest” if the regulator decides customers are being gouged by members of the finance community gaming the changes. He was adamant, meantime, that participants should come up with market solutions to the realignment rather than relying on the regulator to intervene.

“I love deadlines,” wrote Douglas Adams, the British author of books including the Hitchhikers Guide to the Galaxy. “I love the whooshing noise they make as they go by.” With less than two and a half years before LIBOR's scheduled death, the explosion in the world of finance if it arrives at the deadline without more preparation than is currently happening will be somewhat louder than a whoosh.

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