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Fitch: Structured Finance Faces LIBOR Coordination Risk.

London: Stronger provisions in transaction documentation ahead of LIBOR's discontinuation are an important step to limit the number of legacy structured finance (SF) contracts, Fitch Ratings says. However, much still needs to be done before the end of 2021 when forced LIBOR panel participation will end.

Fitch has reviewed new template language from trade associations and LIBOR phase-out wording in recently closed SF transactions. A new benchmark rate concept is being added along with the process to change it; noteholders are only being asked to participate actively if they disagree with the change. Template language from the Association for Financial Markets in Europe also introduces a possible adjustment to the effective margin paid to noteholders, which Fitch expects will be necessary since risk free rates (RFRs), which do not include an element of bank risk, should trade at levels below LIBOR.

The widespread adoption of language addressing LIBOR discontinuation is important, because transactions have continued to reference LIBOR despite the upcoming changes. However, the added language does not yet provide certainty on how a change to a new benchmark rate would occur in practice, because the final replacement rate, and how discrepancies between it and LIBOR will be addressed, are not yet known.

Regarding loans, the Loan Market Association updated certain provisions related to the replacement of a screen rate such as LIBOR in its template documents last month. Other loan documentation, in particular for consumer loans, does not have an industry-based template. Unlike derivative documentation, which could be addressed by a protocol if both sides of a contract agree, most loan documentation would require amendment on an individual basis. SF derivative contracts could benefit from a protocol but may still face major challenges. Transaction parties, such as the trustee, would need to agree to a protocol for each SPV, while swaps based on amended benchmarks could lose grandfathered status, risk breaches of other contractual terms and/or face revised accounting and tax treatment.

In our view, the 3.6 years left to address the risks of a LIBOR phase-out for future and legacy SF notes, assets and swaps through market-let solutions is ambitious, although we do not expect regulators to allow substantial market disruption. On the positive side, progress is being made on alternative RFRs. The Secured Overnight Financing Rate (SOFR) in the US began trading in March and futures trading began in May. In the UK, the SONIA benchmark was reformed in April and three-month futures trading started in 2Q18. The futures trading may lead to derived term structures that can be used in various SF-related contracts.

Any potential future SF rating impact will depend on the timing and nature of benchmark rate replacement, how technical and administrative challenges are addressed, the credit protection in place and transactions' remaining weighted average lives after 2021. If the underlying rates for SF notes, asset and swaps do not all change at the same time, SF transactions could be affected by increased basis risk and changed levels of excess spread.

The administrators of LIBOR and EURIBOR are taking steps to continue them as benchmarks, potentially in an amended form. The continuation of these benchmarks would allow markets to focus on solutions for new transactions rather than legacy contracts, but will be challenging considering that these benchmarks cannot be truly-transaction based, in line with regulators' wishes. The UK's Financial Conduct Authority has suggested that a synthetic LIBOR concept be explored, which could be based on an RFR plus a fixed margin that would act as LIBOR under legacy contracts, if it proved to be legally possible.
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Publication:Daily the Pak Banker (Lahore, Pakistan)
Geographic Code:4EUUK
Date:Aug 28, 2018
Words:594
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