Scenes from the movie ‘The Wolf of Wall Street’ that feature traders on the brink of a nervous breakdown rushing to outbid each other by hastily placing phone orders, can no longer pose as a realistic sketch for a typical day on Wall Street. It’s been years since high-frequency trading stepped in, and traders in neat offices far away from ‘the Big Apple’ continue to turn millions in a New York second. LIBOR, the London Interbank Offered Rate, once a Wall Street darling, might soon become anachronistic, an ancient relic of the old trading days. The Alternative Reference Rates Committee in the US has been busy drafting guidelines on how to replace LIBOR with a risk-free Broad Treasury Financing Rate. Andrew Bailey, head of the UK Financial Conduct Authority, has called for a five-year timeline of abandonment of the long-standing benchmark.
Liberating the World from LIBOR
Moving away from LIBOR seems like a logical move, considering how scandal-tainted and embroiled in legal controversy the old benchmark is and how few real short-term borrowing transactions back it. However, things get a bit more complicated when we face the size of LIBOR footprint in over-the-counter (OTC) derivatives market, which is estimated above $100 trillion. This notional amount of LIBOR-linked bilateral trades may be even higher in reality. This twelve-digit market estimate relies on a number assumptions which may or may not be true. In addition, a substantial number of derivatives are booked bilaterally on an uncleared basis, and the inability to assess the volume of such non-centrally cleared trading drives the precision of any estimates down.
Despite the dominance of LIBOR, up until recently the Dodd-Frank and subordinate legislation in the US had not embraced the benchmark, and both the composition of the index and its usage in derivatives trading remained untouched by regulators. In other words, asset managers, banks, and other traders could link derivatives instruments to LIBOR or any other rate of their choosing. Now, if Mr. Bailey’s statements become reality and the benchmark is no longer produced, the reference rate in all open trades worldwide would be called into question. Counterparties to a swap contract would have to renegotiate a new benchmark, putting a large flow of payments under existing OTC derivatives on hold until such new reference rate is agreed upon and embedded into their contracts. The lack of clarity as to the new reference rate may trigger a spike in LIBOR-related litigations. In every contractual legal relationship, a litigation-prone party (or both parties) may attempt to benefit from the uncertainty created by the abandonment of LIBOR by litigating their interest rate swap contracts. It is difficult to ascertain the number of suits which might be brought under contracts quoting LIBOR if the regulators fail to ensure a smooth transition to a fallback rate.
Additional Margin Costs
Another issue regarding migration of LIBOR-linked trades to a new benchmark stems from the obligation to exchange collateral by both sides to a derivatives trade. This requirement to collateralize the open trades is imposed by the margin rules in the US and worldwide. The obligation to post margin takes effect on different compliance dates, which run up until 2020. There is a catch in the effective US margin rules: amendment to an existing trade could be treated as a novation, turning the contract into a new (novated) transaction. Therefore, trades restructured to incorporate a LIBOR substitute after a margin compliance date would become subject to the obligation to exchange collateral, resulting in a substantial expense for the participants of derivatives market.
In light of the margining cost problem, any specific deadlines of abandonment of LIBOR, which are in close proximity to the margin compliance dates, may pose a threat to the industry. Recent calls that LIBOR may disappear in a four-to- five-year timeline seem disturbing, as the year 2021 is close to the last initial margin compliance date of September 1, 2020. Following the variation margin regulatory forbearance declared earlier in ‘no-action letters’ from European and American regulators, there is a likelihood that the last phase of margin compliance may be extended. Overlap in the regulatory initiatives would result in a substantial repapering burden for the industry. It could also bring about additional margin costs, as reference rate restructuring may trigger the obligation to post collateral for instruments currently out-of-scope for margining.
All in all, the LIBOR paradox, the large scale of its unrestrained use, cannot be resolved by simply putting an end to the existing benchmark. Any malfunctioning of derivatives would trigger a disruption of the important function they serve – shifting a party’s interest rate exposure to the other side – and would prevent them from being an effective hedge. Forcing an abrupt, regulatory mandated switch versus a smooth voluntary transition would open the entire derivatives market to significant risks and unwarranted costs.
The post is based on the article ‘Liberating the World from LIBOR: Implications for Non-Cleared Derivatives’, which is available here.