Cadwalader attorneys analyzed a discussion paper by the Bank of England ("BoE") on exposure related to collateral referencing LIBOR. In particular, the paper reviewed the exposure to the collateral that banks and other financial firms are asked to provide when borrowing from the BoE under the Sterling Monetary Framework ("SMF"), where the BoE lends only against collateral of sufficient quality and quantity in order to protect itself from counterparty credit risk.
As explained in the Cadwalader memorandum, the discussion paper (the "Paper") advises firms that:
- newly issued sterling collateral should reference an alternative risk-free rate ("ARFR") rather than LIBOR;
- firms that have existing LIBOR-linked sterling collateral maturing beyond 2021 should seek, where possible, to have it re-referenced to an ARFR; and
- at a minimum, the BoE expects LIBOR-linked collateral to include adequate fallback language specifying an alternative rate in the event LIBOR ceases to exist.
In addition, the Cadwalader memorandum lists the following risk management approaches for collateral linked to interbank offered rates being considered by the BoE.
1. Option A: The BoE may announce, at some future point, that all collateral that references LIBOR and matures beyond 2021 would become ineligible, regardless of its issue/origination date (unless mitigated by adequate market solutions such as fallback language).
2. Option B: The BoE may make ineligible all collateral that references LIBOR and matures beyond 2021 that was issued/originated after a certain date (unless mitigated by adequate market solutions such as fallback language).
3. Option C: The BoE may apply additional haircuts, and/or a haircut that increases over time, to all collateral that references LIBOR and matures beyond 2021.
Comments to the Paper should reach the BoE by September 27, 2019. Participants in the SMF who wish to maintain the strongest possible level of borrowing capacity at the SMF should participate in the feedback process.
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