The UK government unveiled its recommendations for changes to the London Interbank Offered Rate on September 28. The British Bankers Association has already said it would no longer compute the benchmark, in the wake of the rate-rigging scandal that has cost Barclays millions and is likely to do the same for many other entities involved in Libor’s calculation.
Derivatives counterparties have been sharpening their lawyers in anticipation of any change that could call into question the existing terms of the $350 trillion interest rate swap market, most of which is tied to Libor. Those counterparties that are underwater on their swaps could try to wriggle free of them, using the benchmark change as an excuse.
While the Wheatley Review of the Libor issue, authored by FSA managing director Martin Wheatley, has recommended reviving, rather than abandoning Libor, it is also possible that implementing its recommendations, and any further tweaking, could require derivatives counterparties to renegotiate their swaps. This would be an enormous undertaking. The International Swaps and Derivatives Association (ISDA) believes the resurrection of Libor will go forward without requiring changes in swap contracts; but they are, more or less, paid to say things like that. However, the Wheatley plan not to replace the benchmark was based, in part, on the desire to avoid such a wholesale need for renegotiation.
Corporates – even those underwater on interest rate swaps – could find themselves on the wrong side of this argument. Since corporates use swaps to hedge, there is little incentive to rejigger the contracts in order to gain some profit. They should be performing as expected, even when underwater – that is, they should be offsetting changes in hedge items’ values.
But hedge funds and broker/dealers – entities that run books of derivatives for their own sake as investments (or product) have less incentive not to seek a better deal, or to lock in gains. Treasurers would do well to keep a close eye on how the Wheatley recommendations are implemented by the UK government.