Graham A.D. Broyd
July 18, 2018
The Federal Reserve Board of New York’s Alternative Reference Rate Committee (ARRC) published a letter in recent days that is symptomatic of the issues surrounding the replacement of the London Interbank Offered Rate (LIBOR) interest rate benchmark, and the impact that will have on $350 trillion of linked debt and derivatives. The letter asks regulators to clarify the treatment of certain existing derivatives contracts.
In doing so, the ARRC’s letter addresses a concept that is simple, though explaining the extent of the issue and its impact requires enormous detail and subtlety (which makes it a tough read if you are not a lawyer). The letter also highlights once again the difficulty of progressing successfully down the LIBOR replacement road, when the whole process can be tripped up by any number of people, issues, or institutions (in this case multiple domestic and international institutional interpretations of Dodd-Frank Act Title VII requirements).
What is the simple concept? Legacy (or preexisting) derivatives contracts have not been subject to the many new regulatory requirements that came with Dodd-Frank Title VII. These include all the swap margin, collateral, real-time reporting, record-keeping, portfolio reconciliation, clearing, trade execution, and confirmation requirements that financial entities have had to apply over the last several years to new transactions. Anyone involved in that process will need no explanation from me about the extent of work, time, and resources that were required to ensure the compliance of derivatives transactions with all these regulatory requirements.
If a participant “amends” a contract (which would normally relate to rolling a trade over, or repricing a transaction), then that transaction would be considered a new transaction and therefore in scope of these new regulatory requirements. It could be considered an “amendment” to alter a contract to change or add language to protect against any cessation of LIBOR or other IBORs by adding a “fallback amendment” (i.e., “if LIBOR ceases to exist, then we will use this alternative benchmark”) or to change the contract to reference a new and alternative risk-free reference rate (like the ARRC-designated Secure Overnight Financing Rate, or SOFR). This would bring all the outstanding legacy derivatives contracts into scope of Dodd-Frank Title VII requirements, which would translate into millions of contracts, mountains of additional work, and untold complexity.
A quick look at who is supporting this letter (Mnuchin, Powell, Giancarlo, Clayton, Quarles, Otting, etc.) and a second look at the addressees who could derail this process (Mulvaney, Carney, Draghi, Maijoor, etc.) shows how important and complex the issue of LIBOR (and other IBORs) replacement will be.
Replacing the LIBOR benchmark has to be done. It may not be exciting reading, but it will be impactful if it goes wrong. This will be just one of many very careful balancing acts in its delivery that need to be thoughtfully approached by all institutions that have derivatives contracts outstanding.
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This Advisory was provided by Graham A.D. Broyd.
Graham Broyd, Senior Advisor at Treliant, leads the firm’s Financial Markets Conduct and Compliance practice, working with regulators, large international banks, and law firms on preventing, remediating, and investigating conduct and compliance issues stemming from banks’ trading floor activities.
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