It is not just school children that sometimes struggle with plus and minus signs and their implications – the financial markets have been experiencing similar issues recently, in some cases with very painful consequences.
The problem has arisen due to trends in benchmark interest rates (e.g. LIBOR and Euribor). In addition to these rates being a current focus of regulatory interest (see Banking and Finance Update No. 1 / 2014), financial markets are having to get used to the fact that they can turn negative, as has already happened on several occasions.
This new development is highly significant because the interest charged on variable interest-rate loans and bonds is generally based on the following formula:
“Benchmark interest rate + margin = interest rate”. The corresponding clauses are referred to as interest escalation clauses. In practice, this leads to the question: “minus + plus = ?”
This question is not least a legal one, and, as is the case with many legal questions, the answer here is: “It depends”.
A key distinction is between the different financial instruments to which interest rate formulas apply. An OTC derivative (such as an interest rate swap) is entirely different from a loan, and both of them differ from a bond.
The legal situation has traditionally appeared quite clear here:
“An economic entity acting rationally which provides performance to another party is not prepared to pay to do so. A market in which loans are granted with a negative interest rate is therefore inconceivable. In such a situation it would obviously be sensible for the lender to refrain from making the loan and to retain the loan capital.”1
Depending on the exact wording of the interest escalation clause in a given case, however, even the school children mentioned at the start of this article would come to the conclusion that “the interest rate is negative …”.
In the context of the above reference to an “economic entity acting rationally”, this raises the question for lawyers as to whether a negative interest rate (resulting in a lender having to pay interest on the loan it has provided) is impossible even in such cases. Many lawyers believe that requiring a lender to pay interest is not appropriate and was obviously not the intention of the parties to the original loan agreement.
Consequently, the most widely held opinion comes to the conclusion – based on an interpretation of interest escalation clauses – that while the margin can indeed be eroded by a negative benchmark interest rate (depending on the wording of the individual clause), the interest rate cannot be less than “zero”, meaning that in a worst-case scenario the lender receives no remuneration for its loan, but equally does not have to pay anything on top.
OTC derivatives, on the other hand, such as interest rate swaps, are comparatively new financial instruments. Unlike with loan agreements, there is no clear statutory legal principle that can be applied to OTC derivatives. Interest rate and currency swaps are frequently categorised as “agreements sui generis with elements of a purchase agreement and also of an exchange agreement”. As such, there is no clear yardstick to enable the kind of consensus interpretation that is possible in the case of a loan.
Financial market players thus mostly agree with regard to OTC derivatives that the wording of each contract must be interpreted more narrowly than with loans.
This is of particular relevance in the case of interest rate swaps, especially for the party paying the fixed rate.
This party may have entered into an interest rate swap to hedge interest rate risk arising from a variable interest rate loan. For this purpose, it agrees under the swap that it will receive exactly the same variable interest from the counterparty as it is required to pay on the loan. In return, it pays a fixed interest rate to the counterparty. This means that expenditure remains predictable and there is no need to worry about an increase in the interest rate on the loan.
Here again, the interest formula for the variable rate can deliver a negative result, as with a loan. The question arises in such a case as to whether the mathematical outcome is also the legal outcome. If the answer is yes, the fixed-rate party can end up having to pay the (negative) variable rate as well. An “interest-rate hedging instrument” would thus rapidly become an “interest-rate loss instrument”.
The answer here is most definitely “yes”, unlike with a loan. Whether the fixed-rate payer is actually saddled with the extra cost depends on the exact agreement between the parties and the clarity of that agreement.
The framework agreement is an important factor in this regard. OTC derivatives are generally documented using highly standardised templates such as the German Master Agreement for Financial Futures (Deutscher Rahmenvertrag für Finanztermingeschäfte) or the ISDA Master Agreement. It is then up to the parties to apply these standard provisions to their particular transaction, which can involve varying degrees of clarity.
By comparison, the situation with bonds is relatively reassuring with regard to the above issues. Holders of a corporate bond or mortgage bond do not need to worry about having to pay interest to the issuer of the bond or mortgage bond, for example.
This is partly because debt securities involve a unilateral promise of performance (at least under German law). This means that while the bondholder can derive rights from the bond, only the borrower, i.e. the issuer of the bond, owes an obligation under the bond. This applies to all obligations, including the payment of interest.
Nonetheless, the fact remains that the question “minus + plus = ?” is no longer just a theoretical one, given the current interest rate environment. The possibility of negative interest rates on loans will also not necessarily be answered the same way all over the world.
The example of negative benchmark interest rates thus illustrates once again that even longstanding principles can be unexpectedly and dramatically called into question.