Title LIBOR Evolution: Is the change in submissions methodology fuel to the fires of potential litigation

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A critical evaluation of the LIBOR Evolution project implemented on 1st April 2019. The paper explores the potential motivations underlying the implementation of the project, the project's risks and pitfalls, and any resulting legal causes of
    Title LIBOR Evolution: Is the change in submissions methodology fuel to the fires of potential litigation? 1. Introduction   1.1 Executive Summary  On 1 April 2019 the Administrator of the LIBOR Benchmark, ICE Benchmark Administration Ltd (‘IBA’), announced that it had successfully completed the transition of LIBOR panel banks to the ‘Waterfall Methodology’ 1 . This statement is in reference to the implementation of the LIBOR Evolution Project which has been under development for the  past 4-5 years. This study seeks to analyse: i.   the motivation behind the project ii.   its potential effects on market participants and derivative transactions iii.   whether the associated risks outweigh the perceived benefits and iv.   whether these give rise to any legal cause of action. 1.2 LIBOR Overview and Definition   1.2.1 Background LIBOR has often been referred to as the most important number in the world 2  and underpins approximately $400 trillion 3  notional value of contracts. Given its prominence, it is important to realise that even perceived minor changes to its structure and methodology are likely to have a profound effect on a widely diverse user-base not renowned for its reluctance in  bringing legal action against alleged perpetrators 4 . Furthermore, any scandal, potential lawsuit or realistic legal cause of action is likely to have serious reputational ramifications for the financial industry, regulatory bodies and various government departments. It is precisely for these reasons that decisions taken to vary LIBOR’s definition or methodology should not be 1  ICE Benchmark Administration, ‘ICE Benchmark Administration Successfully Completes the Transition of LIBOR Panel Banks to the Waterfall Methodology’ Business Wire (1 April 2019) <https://www.businesswire.com/news/home/20190401005432/en/> accessed 3 April 2019. 2  Liam Vaughan, ‘Libor: The Rise and Fall of ‘The World’s Most Important Number’’ Bloomberg (27 July 2017) <https://www.bloomberg.com/news/articles/2017-07-27/libor-the-rise-and-fall-of-the-world-s-most-important-number> accessed 13 March 2019. 3  Andreas Schrimpf and Vladyslav Sushko, ‘Beyond LIBOR: a primer on the new benchmark rates’ BIS Quarterly Review (5 March 2019) <https://www.bis.org/publ/qtrpdf/r_qt1903e.htm> accessed 24 March 2019. 4  James O’Toole, ‘Lawsuits against banks loom in Libor scandal’ CNN Money (10 July 2012) <https://money.cnn.com/2012/07/05/investing/libor-lawsuits/index.htm> accessed 20 March 2019.   1 taken lightly. Even if justified, an incorrect classification of a change in rate magnitudes, and their subsequent effects on outstanding derivatives transactions, may create further legal risks for the decision-maker. In conducting an analysis of these changes and classifications, a  preliminary understanding of the definition, composition and potential uses of LIBOR is essential. According to the IBA website: ICE LIBOR (formerly known as BBA LIBOR) is a widely used benchmark for short-term interest rates, providing an indication of the average rates at which LIBOR panel  banks could obtain wholesale, unsecured funding for set periods in particular currencies. 5  The benchmark has traditionally been used in financial instruments which provide exposure to floating short-term interest rates. Over time the use of these instruments expanded to the hedging of long-term interest rate risk and the structural translation of asset and liability currency and maturity profiles. To clarify by way of example, a bank’s mortgage lending  portfolio, consisting mainly of collateralised long-term fixed-rate loans, is likely to be exposed to fluctuations in the underlying market interest rates. The interest receipts generated from the mortgage portfolio can be hedged by swapping them into short-term floating-rate interest receipts, benchmarked against LIBOR, via an interest rate swap transaction. As the LIBOR credit quality curve has traditionally been the interest rate reference by which institutions measure their profit and loss, such a swap transaction has the effect of converting a risky portfolio into what would be deemed as a more market neutral one. An interest rate swap transaction would also have the effect of changing the interest rate maturity profile of the mortgage portfolio from long-term fixed-rate into short-term floating-rate interest receipts, or in the case of a currency basis swap, the long-term capital and interest cashflows from one currency into another. The above IBA quote reflects the end result of a process of collating and trimming individual  panel bank submissions, and calculating the final LIBOR fixings for every currency/tenor combination. Its significance should be distinguished from the definition implied by the LIBOR acronym and the question that panel banks are obliged to answer in arriving at their individual daily submissions. 1.2.2 Definition implied by the LIBOR acronym LIBOR, which stands for the London Interbank Offered Rate, is a rate based on interbank unsecured money market deposit transactions around 11am London time. London’s historical 5  ICE Benchmark Administration, ‘LIBOR' <https://www.theice.com/iba/libor> accessed 13 March 2019.   2  prominence as the main financial centre for unsecured money market loans and deposits  justifies its representation as the first letter of the LIBOR acronym. The term ‘Interbank’, represented by the next two letters, depicts the credit quality of this interest rate benchmark - the most liquid short-term unsecured interest rates market has traditionally been facilitated by the investment banks with broadly homogeneous short-term credit quality. Note that short-term unsecured money market quotes and prices are affected by a number of factors including: •   the day-to-day perceived risk of institutions’ ability to honour their loan obligations •   the market’s overall desire for funds and •   the market’s underlying levels of liquidity. The term ‘Offered Rate’, represented by the last two letters of the LIBOR acronym, is used as a conceptually consistent and methodologically certain measure of short-term interest rates across the various LIBOR currency/tenor combinations. 1.2.3 Definition implied by the LIBOR question The various terms represented within the LIBOR acronym are further encapsulated within the  pre-transition LIBOR question which the panel banks were obliged to answer when setting their day-to-day LIBOR submissions: At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am? 6  References consistent with the meaning and interpretation of the corresponding letters of the LIBOR acronym include: i.   ‘borrow’ and ‘offers’ denote unsecured cash deposit offered rates, quotes and prices ii.   ‘interbank’ denotes LIBOR’s inherent credit quality iii.   ‘reasonable market size’ has, in the past, been deliberately left undefined due to the varied nature of the different LIBOR currencies and tenors and the varying nature of market conditions and circumstances – a transient measure that requires constant review and re-evaluation iv.   ‘11am’, referencing the London time-zone, sets the location and time-zone of considered transactions and submissions. It is important to appreciate that, as a matter of design, points (i) and (iii) require submitter  judgment and perception. Point (i) requires that transactions are scrutinised to establish their 6  ibid.   3 qualification as offer-side transactions. Point (iii) requires an adaptive approach in filtering out transactions below a pre-defined minimum size. Under the old regime, these factors acted as bars to the elimination of judgment and perception, and the complete automation of the rate setting process. 1.2.4 Was a change in methodology required? In a speech delivered on 27 July 2017, the FCA Chief Executive, Andrew Bailey, highlighted: i.   the desirability of benchmark calculations anchored in transactions, ii.   the apparent illiquidity of the unsecured money markets and iii.   LIBOR’s growing lack of suitability due to a decided absence of qualifying transactions. 7  This speech was widely interpreted as marking the end of the LIBOR Benchmark post-2021. Within the same context, the LIBOR Evolution Project had already set out stricter objectives for benchmark rates to be, to the greatest extent possible, based on actual underlying transactions rather than submitter perception and judgment. Given the constraints created by the lack of liquidity in the underlying markets and the impossibility of eliminating submitter  perception and judgment under the old regime, some of the IBA’s main objectives could only  be met by expanding the qualification requirements for eligible transactions and by changing the LIBOR definition. The motivation for benchmarks to be based on transactions is illustrated by both Andrew Bailey’s speech: The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets … In our view it is not only potentially unsustainable, but also undesirable, for market  participants to rely indefinitely on reference rates that do not have active underlying markets to support them. 8  and the Financial Stability Board’s (‘FSB’) objectives in its July 2014 report on Reforming Major Interest Rate Benchmarks 9 . It is, however, equally prevalent that neither organisation excludes the use of judgment, nor state that its elimination be an overriding objective of any reform. In fact, the wider FSB 2014 reports emphasise the importance of avoiding additional risks of manipulation as part of reform efforts and imply a requirement for the proposed reforms to be honestly classified into 7  Andrew Bailey, ‘The future of LIBOR’ (27 July 2017) <https://www.fca.org.uk/news/speeches/the-future-of-libor> accessed 27 March 2019. 8  Ibid. 9  Financial Stability Board, ‘Reforming Major Interest Rate Benchmarks’ (22 July 2014) 3-4 <http://www.fsb.org/wp-content/uploads/r_140722.pdf> accessed 27 March 2019.   4 one of four categories; seamless, successor-rate, market-led or parallel-with-cutover  10 . Barring the seamless classification, all other classifications have certain, but significant, transitional requirements that require differing degrees of costs, resources and effort. 2. The New Calculation Methodology (The LIBOR Evolution Project) 2.1 The New Methodology (Post-April 2019)  The IBA’s stated objectives for the implementation of the LIBOR Evolution Project are: •   Produce a wholesale funding rate, anchored in unsecured, wholesale funding transactions to the greatest extent possible; •   Publish a standardised, transparent and robust LIBOR methodology and a single, clear and comprehensive LIBOR definition; •   Ensure the rate can adapt to changing market conditions and stakeholder needs; and •   Evolve LIBOR through a seamless transition. 11  A seamless transition is stated by the IBA as being one of its objectives. However, whether the adopted methodology achieves such a transition is largely a matter of opinion and interpretation. If a literal interpretation of the classifications outlined by the Market Participants Group 12  is to be adopted, it may well be concluded that such an implementation does not fit naturally into the seamless category. If so, then the assertion of a seamless transition may constitute a misrepresentation that has robbed users of the opportunity to novate offending contracts, thereby avoiding any consequential loss. The IBA’s motivation for such a classification, on the other hand, may perhaps be better explained by a lack of support for a methodology which would involve a requirement for widespread contract novation. This is indicated in a consultation feedback paper on the then proposed LIBOR Evolution methodology 13 . Equally important, the IBA seems to place great emphasis on the effective mandatory inclusion of an expanded set of transactions, with an expanded set of eligible criteria, within a 10  Market Participants Group on Reforming Interest Rate Benchmarks, ‘Market Participants Group on Reforming Interest Rate Benchmarks – Final Report’ (March 2019) 13-14 <http://www.fsb.org/wp-content/uploads/r_140722b.pdf> accessed 27 March 2019. 11  ICE Benchmark Administration, ‘ICE LIBOR Evolution’ (25 April 2018) 9 <https://www.theice.com/publicdocs/ICE_LIBOR_Evolution_Report_25_April_2018.pdf> accessed 28 March 2019. 12  Market Participants Group on Reforming Interest Rate Benchmarks, ‘Market Participants Group on Reforming Interest Rate Benchmarks – Final Report’ (March 2019) 13-14 <http://www.fsb.org/wp-content/uploads/r_140722b.pdf> accessed 27 March 2019. 13  ICE Benchmark Administration, ‘Evolution of ICE LIBOR feedback statement’ (1 May 2015) 3-4 <https://www.theice.com/publicdocs/IBA_LIBOR_Feedback_Evolution_Statement.pdf > accessed 28 March 2019.
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