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LIBOR Transition Comparison: UK vs. US (Round II)

This article summarizes the significant problems with the LIBOR transition in the US as compared to the UK (and the rest of the world).
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General

This summary is based upon the keynote speech at the United Kingdom Financial Conduct Authority (UK FCA) in connection with the transition from LIBOR to SONIA in the UK.[1]

LIBOR Transition Interest Rates

No Need for Credit Sensitive Rates

Concern was recently expressed in the UK on the use of credit sensitive rates in financial instruments geared towards less sophisticated borrowers.

Since the complex and relatively opaque risks may not be understood by such less sophisticated borrowers, regulated entities should evaluate these risks and raise these risks with their UK FCA supervisors before implementation of credit sensitive rates with such borrowers.

No Need for Forward-Looking Rates

The experience of utilizing overnight SONIA in bonds, securitizations, swaps and loans, rather than forward-looking rates, worked better than LIBOR as the International Swaps and Derivatives Association (ISDA) developed a fair replacement formula according to the UK FCA.

Flaws of SONIA Alternatives

Credit sensitive rates, such as Bloomberg’s Short Term Bank Yield Index (BSBY), share many of the flaws of LIBOR since they are derived largely from transactions in commercial paper and certificates of deposit markets.

These markets have not been robust in periods of stress as most recently occurred in March 2020 during the pandemic when yields spiked. By contrast, SONIA (and SOFR) remained stable during this period.

Special Government Powers

General

Last year, the UK FCA was given new powers to maintain continuity of difficult legacy LIBOR contracts that cannot be timely converted to a new benchmark.

‘Zombie’ LIBOR

For certain difficult legacy contracts, the UK FCA is in the process of developing a policy to implement synthetic LIBOR rates.

Transition Timeframe

In no uncertain terms, the UK FCA wants to avoid the risks of getting caught in:

a pre-Christmas rush – where we could see a squeeze in IT, legal or other resources, or would simply have too little time to adjust to unexpected hurdles

to implement the LIBOR transition before the year-end deadline.

UK vs. US Comparison

The following are the implementation differences between the UK and the US in the LIBOR transition:

  • the government recommended replacement benchmark in the UK (SONIA) is widely being utilized whereas the government recommended replacement benchmark in the US (SOFR) has not been widely adopted
  • there is, according to the UK FCA, a fair spread adjustment in the UK whereas no such fair spread adjustment exists in the US (in fact, the spread adjustment is typically determined in the sole and absolute discretion of financial institutions)[2]
  • an inordinate amount of time in the US is focused on the flaws of SOFR rather than the benefits of any benchmark other than LIBOR even though the UK FCA believes that credit-sensitive rates and forward-looking rates are not necessary (and LIBOR is being phased out as a direct result of its manipulation over the years)
  • the widespread locking-in of LIBOR in the US for the next two (2) years through ‘industry-standard’ documentation – the ISDA Protocol and bank transition documentation  even though the US regulators have insisted that there should be no LIBOR-based instruments issued after 2021
  • the lack of special powers in the US to deal with legacy contracts through the use of, among other things, synthetic LIBOR rates
  • the general lack of information about the LIBOR transition from financial institutions to borrowers in the US

[1] ‘LIBOR – 6 months to go’ delivered on July 5, 2021, at the UK Finance’s Commercial Finance Week by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the UK FCA.

[2] See the section entitled ‘No Fair Credit Spread Adjustment Recommendations’ in ‘LIBOR Transition Comparison: US vs. the UK (Focusing on Interdealer Brokers)’ dated June 14, 2021.

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