US regulators and government officials last week appeared en masse before a congressional committee to make a plea over the country’s sluggish transition away from scandal-hit interest rate benchmark Libor.
Without an act of Congress, they said, there could be chaos.
“If this Libor transition does not go well, people may not know what their mortgage payment is if it is linked to Libor, they may have their credit card payments disrupted,” Brian Smith, deputy assistant secretary for federal finance at the Treasury, told the House financial services committee.
“Financial markets may be disrupted. Lending to businesses may be disrupted,” he said. “Litigation will take over.”
Thousands of loan, bond and derivatives contracts, adding up to a boggling $200tn of notional value, still use the US-dollar version of the London Inter-Bank Offered Rate to govern interest payments. This more than a decade after a rate-fixing scandal revealed Libor’s shortcomings and prompted the effort to switch to a better, market-based alternative.
In fact, the number of contracts overall referencing Libor has increased in recent years, rather than decreased, according to the Alternative Reference Rates Committee, an industry group set up by US regulators to steer the transition.
UK regulators, who oversee the benchmark, are phasing out most currency versions of Libor by the end of 2021, but US dollar Libor has been given a reprieve. All new contracts will have to use an alternative reference rate from next year, but existing contracts have until mid-2023 to be switched.
The ARRC estimated that 33 per cent of current contracts would still be outstanding when the mid-2023 deadline hits. Some of these contracts have pre-agreed language written into them to govern what happens if Libor goes away, but the ARRC said $1.9tn lack “effective means” to transition to a different benchmark.
“The goal here is to get to a place where borrowers and lenders have certainty,” said Tom Wipf, vice-chair of institutional securities at Morgan Stanley, who chairs ARRC. “If we don’t get that, imagine the number of disputes we would get across products. The entire financial system could be affected to some degree.”
The ARRC has endorsed an alternative to Libor — the Secured Overnight Financing Rate, or SOFR — for certain derivatives and other financial contracts. But using it in every contract that currently references Libor has proved unfeasible.
Since the rate that eventually gets plugged in to all these old contracts could make a big financial difference, and the losers would surely want to sue, legislation would be able to give legal safe harbour to counterparties that switch to a federally-approved benchmark.
Jay Powell, Fed chair, and Janet Yellen, Treasury secretary, have already united to call for Congress to act. At Thursday’s financial services committee hearing, officials from the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Federal Housing Finance Agency added their names to the list.
In Europe, legislation was passed in February to provide a fallback from Libor to interest rates selected by the European Commission.
The New York state legislature also passed legislation stipulating that replacement rates recommended by regulators can be used in Libor contracts currently lacking the relevant guidance.
The vast majority of contracts under the purview of US regulators are written under New York law, but a significant number are covered by other local state laws, especially for consumer products like mortgages.
That makes a national solution a “requirement”, according to Joseph Abate, a strategist at Barclays. “[New York] provides a template and covers a lot of securities and contracts, but it doesn’t cover everything.”
Many corporations “are getting nervous that everything is going to be very last-minute, which will make [an] orderly transition very difficult,” said Sarah Boyce, an associate director at the Association of Corporate Treasurers, a UK lobby group.
Industry players holding out hope of further delays to the switchover may be disappointed. Randal Quarles, the Fed’s vice-chair of supervision, hinted in a speech last month that entities continuing to issue new Libor contracts after year-end could face penalties, and the full court press on Congress suggests a desire to resolve the issue once and for all.
“We have long suspected that American regulators would soon be switching to the stick-hand on Libor reform after the carrot failed to mobilise sufficient production away from Libor,” said Daniel Krieter, a director in the fixed income strategy group at BMO Capital Markets. “It appears that process has begun.”
Regulators at last week’s hearing appeared to have already convinced some lawmakers to back a national rule, with support coming from both sides of the political aisle.
“This is a very important transition for our financial markets,” said Steve Stivers, Republican representative of Ohio. “Republicans and Democrats both want to get this transition right, and we stand ready to work with the administration and the SEC, FHFA and the Federal Reserve in any way we can.”