Financial Markets

Preparing for the demise of Libor is a resource intensive process and one strewn with legal pitfalls. But there are measures firms can take to reduce the potential legal fallout. By Brett Aubin at Konexo, a division of Eversheds Sutherland

First posted in 1984, the London interbank offered rate (Libor) is the average rate at which large banks lend short term money to each other. Libor is comprised of five currencies and seven different maturities, providing the market with 35 different interest rates which are used to construct a universe of financial products, ranging from derivatives through to personal loans. Many describe Libor as the beating heart of the London trading floors. 

All, however, is not well with Libor. Through the financial crisis, banks stopped lending money to each other for a period of time, so it was impossible to observe transactions and derive an average rate. Post-crisis regulation has pushed banks to fund themselves in different ways, pushing down market interbank lending volumes. But the fatal blow to confidence in Libor was the revelation that key investment banks were rigging the Libor rate, to manipulate market outcomes. Interbank market volumes are now so low that banks are having to submit rates based purely on “expert judgement” not direct observation – this exacerbates credit spreads and liquidity premiums, which is unhelpful for a benchmark referenced by so many financial products.  

Hence the UK’s Financial Conduct Authority (FCA) has been trying to phase out Libor since 2014, with the drum beat on these efforts increasing incrementally with each passing month. The FCA is now very clear with all market participants: the death of Libor should not be seen as a ‘black swan’ event – it is going to happen, make preparations! 

If Libor is to disappear, it must be replaced by another rate. In the UK it was decided to replace Libor with the Sterling overnight index average (Sonia). 

The problem with Sonia, as has been observed on a number of occasions, is that it often looks quite different to Libor. This should raise concerns among banks. 

For example, if a client had bought a financial instrument expecting Libor performance, but experienced Sonia performance for a significant portion of the instrument’s life, there is a chance they would look for redress if the outcome was not as expected based on their original Libor expectations.   

In fact, some commentators are beginning to do analysis based on conservative market assumptions and the early indications are startling – Libor is so embedded in both the retail and professional markets that the extent of litigation could, over a five year plus period, dwarf the UK’s payment protection insurance scandal, which could cost UK banks more than £50bn ($62bn). 

So what can financial services participants do to avert this legal disaster? 

  • Get board level focus on the Libor transition – make peace with the reality that the Libor transition will be a time consuming and expensive exercise. Lowballing this work could cost far more in litigation and reputational damage than a reasonable programme budget. Board level recognition, sponsorship and monitoring will be critical in getting this right.
  • Review products and customers – determine who/what is impacted by the Libor transition. The real disaster will be the odd couple of thousand customers who are not detected or engaged with appropriately; these are the high probability litigation cases.
  • Review customer and product data – if a firm suspects that it has data quality issues (which would not be unusual for most banks), everything necessary must be done to fix it, including sourcing the original contracts/agreements/term-sheets and running data extraction routines if called for. If  there is no accurate data and product and sensitivity analysis cannot be conducted accurately, then this significantly increases operational and legal risks.
  • Engage with impacted clients – this should be done early. They should be updated and educated and must know their rights. They need to be able to review proposals for replacing Libor, when appropriate. Taking such actions could be pivotal to potential litigation outcomes. 
  • Define a legal strategy for each impacted product type and customer segment – for professional counterparties, this may entail a full bilateral renegotiation of a contract or use of an industry protocol. On the retail side, education and an update to the terms and conditions may suffice. Rather unhelpfully, the appropriate industry bodies, particularly those covering derivatives and loans, are yet to fully agree candidate fallback language to cover Libor disappearing. 
  • Get ready for a large-scale client outreach – whatever legal strategy is in place, it will involve engaging with customers on an unprecedented scale while preserving those relationships. This involves having well trained staff, high levels of data quality and top-class technology to support complex reviews. 

Whatever feelings of nostalgia Libor may evoke in some, unless there is a very unlikely death row reprieve, this venerable benchmark is not long for this world. It is critical that the reality of this demise meaningfully lands with all financial services participants and that they do what is required of them by virtue of their position in the ecosystem. Failure to do so could have a very public reputational impact and potential balance sheet implications that could affect levels of provisioning and capital adequacy.

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