Most recently, and perhaps more significantly, in a speech on 27 July 2017, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority (FCA), announced the regulator’s expectation that Libor will no longer be sustained in its current form, beginning 31 December 2021 at the latest. The FCA has statutory powers to require panel banks to contribute to Libor where necessary and has decided not to ask, nor to require, that panel banks continue to submit contributions to Libor beyond the end of 2021.

Less than a week after Bailey’s announcement, J Christopher Giancarlo, chairman of the US Commodity Futures Trading Commission, and Jerome Powell, a governor of the US Federal Reserve, similarly voiced support for phasing out Libor. Although European markets have only recently begun to question the sustainability of Libor, regulators in the US have, almost from the beginning of the investigations into Libor manipulation, signaled the need to replace the benchmark.

The Financial Stability Oversight Council (FSOC), a US government organisation created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, pointed out in its 2013 annual report that there has been a continued decline in banks funding themselves with unsecured short-term funding – the funding market that is the source of Libor quotations.

Since this time, and in response to recommendations made by the FSOC, the Federal Reserve Board and the Federal Reserve Bank of New York have convened an Alternative Reference Rates Committee (ARRC) to discuss and identify alternatives to Libor.

While alternatives have been discussed that are intended to be “more robust and resistant to manipulation”, a replacement has not yet been determined. The ARRC has stated, however, that one of its high-level priorities for 2017 would be to finalise its selection of a single alternative overnight reference rate to recommend to the market. But the ARRC has also said that choosing the right rate is important and that it will not be rushed into making a decision.

While the successor to Libor has yet to be decided upon, Libor’s demise appears to be inevitable. Whatever Libor replacement is adopted, Australian residential mortgage-backed securities (RMBS) issued globally will face a direct impact.

These RMBS transactions typically use Libor as a benchmark for floating-rate securities issued in US dollars. The currency swap is used to hedge basis risk between the index on the swapped interest rate on the underlying Australian housing loans, usually the Australian bank bill swap rate, and the Libor-based interest rate on the securities.

This poses a unique issue for the Australian RMBS market since the existence of a currency swap further complicates the solution for how to handle uncertainty about Libor’s replacement for transactions that were closed prior to the establishment of any replacement benchmark, but where it is relatively certain that the replacement will be established during the active life of the deal.

In Australian RMBS, the participants not only need to account for the risk associated with Libor’s uncertainty but also need to ensure the currency swap and interest rate on the bonds have the same fallback provision in order to avoid any basis risk.

Potential solutions to alleviate these concerns include:

1. Linking the interest rate on the Libor notes to the rate under the currency swap so the fallback provisions for Libor under the International Swaps and Derivatives Association agreement will apply to both.
2. Including permissive amendment standards in the documents so that Libor, as it applies to both the Libor notes and the currency swap, can be easily amended once a successor is in place.
3. Structuring the transaction so that the issuer of the securities, or an affiliate, is the calculation agent for the purposes of Libor and will thus determine what successor substitute rate to use, subject to certain reasonableness standards.
4. Requiring the trustee to determine whether to use a substitute or successor rate comparable to Libor – bearing in mind any industry-accepted successor rate.
5. Any reasonable combination of the above approaches.

While we can expect to see the above approaches taken on future transactions, it is likely market participants will develop other strategies as well – some of which may first be tested in the US domestic securitisation market.

Also affected, of course, are already-closed transactions that issued Libor-indexed securities. To the extent that the life of any transaction extends beyond the phaseout of Libor, the transaction parties will need to take a pragmatic approach in determining a new index for the securities while at the same time calibrating the currency swap to provide the hedge necessary to make the transaction work.

Given a close relationship between deal parties in Australian RMBS transactions, we expect the market to develop a collective approach towards addressing this potential challenge that resembles some of the options presented above for deals currently under construction. For these reasons, coupled with the uncertainty of timing for Libor’s replacement and the need for all parties to agree upon Libor’s successor, it is likely that Australian RMBS transactions – both issued and to be issued – will be grappling with this unique issue for the foreseeable future.

The Libor issue illustrates a larger point that has emerged in securitisations since the global credit crisis. No matter how careful drafters are to take into account future contingency events, it is impossible perfectly to predict the course of history. For securitisation transactions, which are designed to be completely closed systems, unanticipated events almost always cause interpretive issues for transaction parties, who are not always aligned as to the solution.

A recent example of unanticipated events was the possibility of negative interest rates in several jurisdictions throughout the world. Securitisations were generally constructed to pay out cash flows, but a negative interest rate might have the effect of requiring a payment back to the transaction from securityholders, particularly if a swap was embedded in the transaction that would have permitted negative interest rates and therefore caused a reverse payment flow from the deal to the swap counterparty.

This problem was solved in new transactions by preventing interest-rate indices from dropping below zero. But the issue remains for deals that did not provide a zero interest-rate floor and made no provision for reverse payments.

A similar issue emerged in US residential-mortgage transactions as a result of the unique rules governing the servicing of defaulted loans, which emerged after the global credit crisis and after many US RMBS transactions were constructed. In this case, the US Treasury issued guidance on how its programme should be implemented in outstanding transactions, in effect overriding contractual provisions with US Treasury mandates.

As the world evolves and economies change, similar issues will arise in securitisation transactions – including Australian RMBS transactions – that will demand pragmatic and common-sense decisions. To date, the solutions that have emerged in response to these challenges have caused minimal market disruption. We have no reason to believe that the accommodation of changes to Libor, even with respect to already-issued transactions that did not contemplate Libor’s disappearance, will be any different.