Commercial lawyers have joined a chorus of concern over what impact reform of the London interbank lending rate could have on existing financial contracts as a review into Libor by the City watchdog draws to a close.
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While welcoming efforts to make the rate-setting process more transparent, lawyers warn that altering how Libor – used in many debt and derivative contracts – is calculated could create confusion, even as they caution that establishing how many of those contracts could be affected by changes will prove difficult.
“It’s potentially massive,” Marek Petecki, a partner at law firm Bristows, says of making changes. “Its hard to quantify how many contracts there are out there that refer to Libor, as many (if not most) of them are private, but you’re talking about thousands and thousands of contracts.”
Investors have already sounded alarm bells over radical and rapid reform of Libor rates triggering chaos for $300 trillion in existing financial contracts based on the interbank lending benchmarks, as the Financial Services Authority’s review headed by Martin Wheatley prepares to present its conclusions at the end of the month.
“The main issue is the uncertainty changes would create, because it is very difficult to get a very clear picture of the extent of Libor-linked obligations,” says Tim Strong, partner in the commercial disputes group at international law firm Taylor Wessing. But he adds: “It is a big issue because Libor appears in so many contracts, and it has become built into contracts over such a long range of time.”
Mr Wheatley’s suggestions for reform include scrapping Libor altogether and replacing it with a borrowing rate based on actual trades, but he has said that his review would consider carefully the consequences of any recommendations for pre-existing contracts.
The contracts of most concern are those linked to commercial lending, especially interest rate swaps in which the rate is expressed as ‘Libor plus X percent’.
“At the time of entering into an interest rate swap, the counterparties will take a view on where Libor is and where it is likely to go,” says Mr Petecki of Bristows. “If you retrospectively go back and tinker with how Libor is calculated, you’ve moved the goalposts of the commercial deal.”
Solicitors also suggest that alterations could make it harder for banks to price risk when lending to companies, as interest rates for loans price in the possibility that Libor can change, a risk that would be exacerbated if uncertainty over how Libor is calculated is introduced into the mix.
One suggestion raised is to base rate submissions on actual transaction data. However, solicitors say this approach would be difficult given the paucity of interbank lending.
“Trade sizes and trading levels will vary, day to day and from bank to bank, so it’s not as though you can take a nice clean snapshot of each bank’s borrowing costs at a particular point in time,” says Mr Petecki. “It’s difficult to see how you can completely remove human judgement from the process.”
With the Wheatley review expected to publish its final recommendations for regulating and improving Libor within the next fortnight, the issue is rising up the agenda.
“Ultimately I think people would be arguing over very small differences in the percentage rate,” one lawyer notes. But he adds: “Something that is different is inevitably going to lead to a winner and a loser.”