As announced by the UK Financial Conduct Authority (FCA), Libor shall discontinue to be a benchmark for financial arrangements by the end of December 2021. Countless contracts worth trillions of dollars have binding Libor clauses which extend beyond 2021. Therefore, the transition to incorporate an alternate benchmark will demand considerable effort to assess the impact on firms, amend contracts and update systems. All Libor-based agreements that extend beyond 2021 will likely require certain amendments to accommodate the discontinuation of Libor.
Libor has a critical role in the global markets because it is widely used as a reference rate for financial contracts and as a benchmark to assess funding costs and investment returns for a broad range of financial products. Variations in the ‘spread’ between Libor and other benchmarks indirectly act as a key indicator of changing investor sentiment in the global financial markets. The FCA included measures to make Libor a regulated benchmark and Libor played a vital role in facilitating the use of transactional data by the Financial Stability Board.
The reason for the FCA’s decision to replace Libor was due to the 2012 Libor fraud, where several leading banks participated in manipulating the Libor benchmark interest rates to manipulate the market and boost their own profits. Libor could effectively end before 2021, if, the number of panel banks reporting to Libor which is currently between 11 and 16, fall below the required minimum of four banks. This could result in an immediate change to the reference to calculate interest rates. The replacement of Libor will not only impact the UK, but is expected to have global repercussions being that it is currently the mostly commonly used benchmark for calculating interest rates in the world.
Potential alternatives to Libor
In July 2017, the FCA confirmed that beyond 2021, regulators and market participants will not be able to rely on Libor. Since then, the market has been developing alternate ways, such as the use of risk-free reference rates (RFRs), that will replace the use of Libor. The two principal RFRs currently recommended are the Secured Overnight Financing Rate (SOFR) (for US dollars) and Sterling Overnight Index Average (ONIA)(forsterling).
SOFR is fast becoming the benchmark interest rate for dollar-dominated derivatives and loans. This transition is expected to increase long-term liquidity but also result in substantial short-term trading volatility in derivatives. SOFR relies strictly on transaction data consisting of a daily rate, called an ‘overnight rate’. It is a risk-free rate because it is based on the treasury. SONIA is preferred as the primary interest rate benchmark for sterling markets and is used for overnight funding for trades that occur in off-hours and represents the depth of overnight business in the marketplace.
The key differences between the RFRs and Libor have implications which will affect the way the financial instruments referencing SOFR and SONIA are documented. SOFR and SONIA are based on a measurement of overnight borrowing costs, hence, they are risk free, whereas Libor represents the cost of interbank for a specific period of time, therefore, it takes into account a certain amount of credit and liquidity premium.
Transitioning to a new benchmark rate will be practically difficult and will create issues for the trillions of dollars’ worth of Libor based agreements that are not set to mature until after Libor’s discontinuance (i.e. they go beyond 2021) including the commonly used three-month US dollar Libor. However, the replacement index, once decided upon, can be incorporated into the agreements with the appropriate adjustments. Documentation for these existing agreements will need to be amended by the end of 2021, in order to incorporate the change. As for new financing agreements, institutions are advised to include the appropriate alternative method for how rates will be handled going forward
In a situation where Libor ceases to be temporarily available, loans based on the standard Loan Market Association (LMA) form contain a provision that covers such a situation wherein the lenders cost of funding or a stipulated reference bank rate is used. This fallback however presents further issues as it provides only temporary relief for the situation of Libor unavailability. The FCA will not require reference banks to continue publishing rates as this fallback will be costly in the long run.
To ease the transition of the discontinuation of Libor, the LMA introduced an optional ’Replacement of Screen Rate’ clause which gives parties the flexibility to choose a replacement benchmark following Libor with a majority-lender consent. Pursuant to the introduction of the Replacement of Screen Rate clause, the Asia Pacific Loan Market Association (APLMA) incorporated a modified version of the LMA’s Replacement of Screen Rate clause in its own agreements stating that majority of lenders must approve a change of benchmark, requiring unanimous lender consent if the benchmark would result in a reduction in amount of interest payable.
From January 25 2021, all new derivatives contracts referencing the International Swaps and Derivatives Association (ISDA) definitions will incorporate fallback provisions, which are contained in a new protocol and supplement that ISDA issued on October 23 2020. For derivatives contracts referencing the Libor, the fallback provisions will apply once FCA determines that the Libor rate no longer reflects the underlying market.
Further actions to be taken
Many regulators and financial advisers are in pursuit of obtaining a strategy to implement the anticipated transition. They have also been requesting various firms to prepare for the Libor discontinuance to ensure that the board and senior management of these organisations understand the risks associated and are taking appropriate steps to ensure a proper transition of the RFR by the end of 2021.
It is unlikely that many existing contracts contemplate the cessation of the Libor rates or any circumstance where the Libor rates are not applicable anymore. Failure to amend these provisions will bring complications and significant legal risk. Therefore, it is advisable to insert clauses in various arrangements and agreements to prepare for the resulting effect of the cessation of Libor.
Until there are robust alternatives in place, market participants need to consider, on a case-by-case basis what action to take in relation to current transactions being that there is not yet a consistent market-wide approach. The interests of lenders in the loans market, investors in the debt capital markets and of market participants in derivatives, including interest rate swaps, differ, and so their preferred approach also differs.
In light of the cessation of Libor in less than 10 months, a number of clients including asset management, banks and financial institutions are looking to tackle the implications of the replacement of Libor in their financing arrangements and agreements.
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