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"Hidden" swaps and zero LIBOR floor language - not yet regulated

14/04/2015

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United Kingdom

The "FCA regulation" cloud is floating above the UK financial industry often bringing heavy thunderstorms, especially when it comes to fixing interest rates under various lending arrangements. However, there are certain financial arrangements which look like regulated products but are not (yet?) regulated.

The implication of this for lenders is that care needs to be taken in considering whether a particular financial product is regulated or not regulated and treat that financial product accordingly.

Set out below are two examples of traditional lending products which have evolved in the market in a manner which raises a question as to whether they should be "regulated" – these are break costs operating as "hidden" swaps and zero LIBOR[1] floor.

1. "Hidden" swaps: loan arrangements with similar features to interest rate hedging products

It has been confirmed by the Financial Conduct Authority (FCA)[2] and by the two leading silks, namely Mr Charles Flint QC and Jonathan Fisher QC[3] that loans with similar features to interest rate hedging products fall outside of the FCA's regulatory remit.

Standalone interest rate hedging products are subject to the FCA's regulatory regime as contracts for difference ("CFD") under Article 85 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 ("RAO") because their purpose is to secure a profit or avoid a loss by reference to fluctuations in "an index or other factor designated for such purpose", such as interest rates. 

There is a similarity between such interest rate hedging products and more traditional lending arrangements arising from the fact that break costs typically applicable to loan agreements are linked to the cost to the bank of terminating a hedging arrangement the bank has entered into with a third party provider to mitigate its own interest rate risk. Such loans have been referred to as "embedded" or "hidden" swaps.

The FCA's view is that it is not entirely accurate to call such loan agreements "hidden" swaps because they do not have the CFD purpose; their primary purpose is for the customer to borrow and for the bank to lend. The customer is not a party to the hedging arrangement entered into by the bank with the interest rate hedging provider and the break costs arise only when a customer decides to terminate the loan agreement early and it does not operate to change the purpose of such loan agreement as a whole. Such a break cost clause in a loan agreement is, in substance, a liquidated damages clause under which the parties have agreed the basis on which damages will be assessed in the event of default or early termination. The customer may be exposed, under the loan agreement, to liability to pay the break costs incurred by the bank under its hedging arrangements; however that does not change the nature of the loan agreement as for it to be considered as CFD.

The FCA explained that such loan agreements are not "specified investments" under the current regulatory regime and accordingly entering into or terminating them does not constitute a regulated activity under Article 85 RAO. The effect of this is that under the current powers the FCA is unable to establish a redress in respect of any failings to properly disclose break costs in contracts for such loans, and the FCA conduct of business rules do not apply when the bank enters into such a loan agreement or terminates it.

2. Zero LIBOR floor

Zero LIBOR floor language is another recent trend in the loan market. It is included in loan agreements to avoid the potential effect, on the lending arrangements, of negative interest rate benchmarks. A negative LIBOR will reduce the margin payable by a borrower under a loan agreement unless the zero LIBOR floor wording is included.

The LMA (Loan Market Association) recommended definition for LIBOR includes an optional language that if either the applicable screen rate (LIBOR rate administered by ICE Benchmark Administration Limited for the relevant currency and period) or, if the screen rate is unavailable, any other base interest rate determined pursuant to a facility agreement, "is less than zero, LIBOR shall be deemed to be zero."

The question then arises - does zero LIBOR floor wording in a loan agreement constitute an "embedded" swap since a borrower is swapping the negative LIBOR rate for 0%?

Although one might argue that the purpose of the zero LIBOR floor language in a loan agreement is to avoid a loss for the lender by reference to fluctuations in the LIBOR rate which makes it look like a CFD under Article 85 RAO, it seems unlikely that the FCA will consider this as sufficient enough to change the overall objective of such loan agreements which are for the customer to borrow and for the bank to lend. The zero LIBOR floor wording in the definition of LIBOR will most likely be viewed as a mechanism for determining the overall rate of interest under the loan agreement contractually agreed between the parties. Technically, the zero LIBOR floor language means that if the LIBOR rate is negative then the borrower will not be paying the LIBOR rate at all until such time as the LIBOR rate increases above zero. It also protects the lender against a potentially negative margin and what seems like an impossible scenario when the lender will be required to pay the borrower if the overall interest rate itself, under the loan agreement, is negative.

Applying the same analysis as with the "hidden" swaps above, loan agreements with the zero LIBOR floor language are unlikely to be classified as specified investments under the FCA regulatory regime and entering into or terminating such loan agreements will not be subject to the FCA conduct of business rules.

A further question arises as to whether keeping LIBOR at 0% or higher could be considered as fixing it.

We consider that this would be unlikely. During the credit crunch the banks became concerned about lending to each other and the LIBOR rate rose significantly. The fixing LIBOR issue arose because certain banks were attempting to fix LIBOR at a lower rate without notifying their customers in order to show that that bank was in a better position than it actually was.  On the other hand, when two parties contractually agree to avoid the effect of a negative LIBOR in order to preserve the margin under their facility arrangements, the regulators and the court will be reluctant to intervene. 

3. Action plan

We suggest that, whilst the above is the better view broadly in considering the effects of the arrangements described above, when dealing with financial products that seem, in substance to have characteristics similar to a regulated product, it should not be assumed that these are not regulated under the FCA regulatory regime . It is important to consider each financial arrangement or product on a case by case basis taking into account the underlying purpose of such contract.


[1] For the purposes of this article we talk about zero floors in the context of LIBOR but of course this can apply equally to any floating inter-bank offer rate or IBOR.

[2] Letter dated 26 June 2014 from Sean Martin, General Counsel of the Financial Conduct Authority to Andrew Tyrie MP, Chairman of the Treasury Committee.

[3] Legal Opinion submitted by Jonathan Fisher QC, 7 January 2015.