Libor changes spark swaps concerns

(This story previously appeared on IFRe.com, a Thomson Reuters publication)

By Helen Bartholomew

LONDON, Sept 27 (IFR) - Major changes to the way Libor is set could trigger years of legal wrangling between derivatives counterparties to determine what effect those changes have on existing contracts.

The rate to which USD350trn over-the-counter swaps contracts are benchmarked is about to embark on the biggest overhaul of its 26-year history as Martin Wheatley, managing director of the UK's Financial Services Authority, presents his recommendations for the future of Libor on Friday.

Given the controversy surrounding a methodology that has been shown to be open to widespread manipulation - Barclays was fined USD453m for fixing Libor rates and a host of other banks are under investigation - changes to the way that Libor is regulated and calculated have been widely supported across the industry.

FSA recommendations are likely to focus primarily on tighter regulatory oversight and improvements that link the rate more directly to real lending activity as well as a shift away from a one-size-fits-all approach.

But derivatives experts are concerned that replacing Libor across the universe of outstanding OTC derivatives contracts is an enormous undertaking, particularly considering the long-dated nature of some swaps - Disney and Coca-Cola have outstanding bonds that mature in 2093 - and anything beyond minor tinkering will have lawyers licking their lips in anticipation of litigation between counterparties.

"Documentation is not completely standardised, and in some contracts it's not clear what happens if Libor goes away," said Rohan Douglas, CEO of risk management firm Quantifi. "Even if it's impossible for Libor to go away altogether, changes made could be significant enough to trigger legal issues."

"Over the last few years, after the credit crisis, the cost of funding has become a more critical component of pricing, and the trend is to diversify towards a set of different rates," said Douglas. "The really big deal is what to do with the existing contracts. The existing market tied to Libor is so large that even if regulators make the transition as smooth as possible, there's going to be a lot of volatility."

Stephen O'Connor, chairman of the International Swaps and Derivatives Association, told the body's London conference this month that any changes should be handled with great care. "At some point, market participants might claim that the nature of their contracts is fundamentally different from the point when they were negotiated," he said.

"There is some talk of a transition period from an existing to a modified Libor, but it would need to be very carefully planned and managed," added O'Connor, who is also head of client clearing at Morgan Stanley.

The majority of OTC derivatives contracts represents hedges of specific risks. For some of those hedges, replacing Libor with a modified tool could change the nature of the hedge or even render it irrelevant.

"If an exact or very good hedge for something turns into something completely different, that is no longer a good hedge, it could have an impact on contracts," O'Connor said. "If it is just a case of tweaking the methodology then it should be alright, but there is a spectrum to the way that it could be changed, and where the tipping point is would be hard to say."

THERE'S A PRECEDENT

But adapting the Libor methodology is not without precedent. In 1998, the BBA changed the question asked of contributing banks. Prior to that time, banks were asked to submit the rate at which they thought one prime bank would lend to another, but that was altered to determine the lending rate at which the bank itself could borrow funds.

"When the last changes were made 15 years ago, no one tried to claim that it changed the nature of an outstanding contract," said ISDA CEO Robert Pickel.

"If the definition of the rate published on the page, or if the rate published was suddenly Fed funds, then it would be materially different, but the kinds of adjustment the British Bankers Association is considering shouldn't fundamentally change the Libor rate," he added.

Regulators face an uphill struggle in implementing changes that balance the needs of all industry participants, while responding appropriately to the intense scrutiny over methodology and oversight.

"This is a classic example of idiosyncratic wrong-way risk as one counterparty has the ability to influence the value of that trade and that's not been a widely recognised failure," said Douglas. "The rate at which Libor is set is not observable and that's been understood for a number of years, but it's a very tough problem to address."

Nonetheless, the first step is already in place. The BBA, which has controlled Libor submissions since inception, has now agreed that it would support a change of responsibility if deemed appropriate in the Wheatley review.

"The BBA seeks to work with the Wheatley review team as they complete their consultation on the future of Libor. If Mr Wheatley's recommendations include a change of responsibility for Libor, the BBA will support that," the association said in a statement. (Reporting by Helen Bartholomew)