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In these uncertain times, we take a look at the potential implications of COVID-19 on the LIBOR transition, currently scheduled for the end of 2021.
The anticipated impact of COVID-19 on the LIBOR transition can be divided into two parts. There is the immediate and operational effects that the virus will have on banks’ transition timeline, and there is the longer-term structuring implications that this period of uncertainty will create. There is also the question as to whether 2021 will remain the deadline for the transition.
Immediate and operational effects
There are two key immediate effects of the virus on the LIBOR transition. The first is the banks’ bandwidth, this is currently (and understandably) being taken up by dealing with markets, staff and IT, which is diverting resources and focus away from the LIBOR transition. The second is operational, and relates to those products which are multiparty instruments (i.e., bonds, securitisations and syndicated loans), and which require the input or consent of several parties. Whilst regulated entities and financial institutions have greater resilience around working arrangements, many borrower companies do not, and this will significantly slow down the execution process. Additionally, and often as an overlay, there may be jurisdictional issues to contend with in regions where the validity of electronic signatures or consent by email are not yet established.
Longer-term structuring implications
In order to transition from LIBOR to risk free rates (RFRs), a combination of overnight RFRs and term rates is needed. In order for term rates to be based on overnight RFRs, a credit/term spread is required to be added. The current proposal is to use a five-year look back on the historic spread differential between LIBOR and the RFRs in order to produce an algorithm to calculate this spread. However, this approach has already been criticised for not including the effects of the financial crisis of 2008/2009. The dislocation of the spreads between the overnight RFRs and term rates in the current markets is causing a debate as to whether, or how, to factor current spread differentials into the longer-term calculations. In some respects the problem is more complicated than in 2008/2009, not only because of liquidity issues and central bank responses, but also because stimuli are being injected directly into affected countries’ economies by way of tax holidays, cash grants and loans direct from governments, bypassing the conventional market routes of lending.
The Financial Conduct Authority (FCA) has secured the commitment of the panel banks which currently quote LIBOR until the end of 2021. It is uncertain whether the banks will stay committed beyond that. Even if some banks agree to continue and others drop out, the FCA has made it clear that it will not use its powers under the Benchmark Regulation to compel LIBOR to be published. Whilst there have been calls to postpone the 2021 deadline, the UK regulators have been firm in holding the line. The UK regulators are currently placing the greatest focus on the financial impacts of the virus on consumers and SMEs, and so have yet to focus directly on the effects of prolonged exposure to the virus on the LIBOR transition. If the measures run for months rather than weeks, then calls for an extension of the deadline will increase. However, the counter argument – that LIBOR is no longer representative, is strengthened not only by the introduction of rate cuts and stimuli measures by central banks, which distort rates, but also by liquidity injections, which in turn distort the lending and borrowing markets.