Moves to change interest rate benchmarks trigger contract concerns

What is happening?

Moves to shift interest rate benchmarks from the Interbank Offered Rate (Ibor) towards more robustly calculated reference rates such as the Sterling Overnight Index Average (Sonia) in the UK and the Broad Treasury Financing Rate (BTFR) in the US are, on the face of it, good news. 

The result should be that interest rate-based financial products are priced properly, meaning that both parties in the transaction get a fairer deal. 

But, as is always the case when changing something that has become deeply embedded in the financial infrastructure, even when doing so is a good idea, there are likely to be some unintended consequences. 

One of them, highlighted in a recent note from Standard & Poor’s, is that long-term contracts, which are based on Ibor references, could become mired in some tricky contractual issues because they do not contain clauses allowing for non-Ibor reference rates. The UK, for example, wants the London rate, Libor, phased out by 2021 and replaced by Sonia for sterling. 

This could be a problem for some longer dated bonds, derivatives and structured finance products. 

There is sufficient industry concern around such issues that the International Swaps and Derivatives Association has been prompted to begin a comprehensive analysis of ways to smooth the transition towards these new benchmarks and to tackle any contractual challenges. Indeed, the association warns there could also be liquidity implications arising from the shift if it is not carefully executed. 

Why is it happening? 

The reason regulators are so keen for this to happen is because they quite rightly do not trust how the Ibor was calculated. After the 2007-09 global financial crisis, it transpired that the rate had been widely manipulated by bank dealers so they could boost their personal bonuses, and evidence was uncovered of widespread collusion among individuals at the different participating banks. 

Fines on both sides of the Atlantic resulted, along with some jail sentences, and action to make sure such an occurrence could not happen again. 

Regulators want to move towards rates that are based more on real transactions rather than the opinions of bank dealers and include a more robust methodology (though Ibor is now much more thoroughly monitored and compiled in a more robust fashion). 

However, Sonia is based on overnight transactions, while Ibor comprises a range of maturities. Admittedly, for some maturities on some interest rates there is often insufficient data to calculate the rate with complete confidence.

What do the bankers say?

Bankers and the investment community have accepted the need to tidy up interest rate benchmarks. Some are concerned about the transition period and what they will be transitioning to, because the calculation methodologies for the new rates contain differences. For example, could those new methodologies create unexpected anomalies?

Contractual issues are certainly a concern for some long-dated financial products, particularly if the new benchmark produces different rates to the old one, implying winners and losers and therefore tensions between issuers and investors. 

Typically, clauses in these agreements provide for other Ibors if the rate being referenced becomes unavailable, say, London’s instead of New York’s, or a different maturity, say one month instead of three months. But they almost never have provisions for a completely different benchmark.  

Should legal disputes arise, they could to an extent undermine confidence in these products. This is something the industry is very keen to avoid. But the change’s strong regulatory backing does make it more likely that solutions will be found to manage any potential teething problems.  

Will it provide the incentives?

If the aim is to produce a more robust, fairer and more resilient reference rate, then this is a move in the right direction. However, the new rates are not without their own problems. There could be issues in gathering enough reliable transaction data for some reference rates, and some regulators are looking at combining dealers’ estimates with real transactions or widening the pool of deals that can be included. 

These approaches, along with methodology differences, could produce variations from the old approach, which might be unpredictable. 

Hopefully what will emerge from these efforts is a permanent reduction in dishonest behaviour and deliberate rate manipulation. This would be enhanced by the more strict conduct regimes, which come with tough punishments for miscreants, that are emerging in certain jurisdictions, alongside genuine efforts by many banks to inculcate a more ethical corporate culture in line with regulators’ expectations.