by Grant Eldred & Nick Tidmarsh
In 2017 the UK’s Financial Conduct Authority (FCA) announced that after 2021 it would no longer persuade or compel panel banks to submit the rates required to calculate LIBOR (The London Interbank Offered Rate). Although voluntary submissions of rates might keep LIBOR alive a little longer, it seems inevitable that it will then shortly be phased out.
LIBOR is an average rate at which major banks can obtain unsecured funding in the London interbank market in a specified currency for a specified period of time. It is used as a reference interest rate for contracts worldwide which have a value of at least £260 trillion. LIBOR has been a constant within the global financial market since its creation in the 1980s and is said to have now become the “world’s most important number”, fixing terms of contracts ranging from multi-million financial arrangements to residential mortgages.
However, significantly reduced volumes of interbank unsecured term borrowing (the basis for LIBOR) have called into question its ability to continue playing this central role. For example, an interest rate set in 2017 used submissions from banks who based their submission on as few as 15 relevant transactions throughout 2016. Following scandals in 2012, steps were taken to improve the credibility of LIBOR but its fate was sealed when the FCA announced in July 2017 that after 2021 it would no longer request rates from banks to calculate LIBOR.
Working groups convened by regulators in the most used LIBOR currencies have sought to establish Risk Free Rates (RFRs) which could replace LIBOR and the other interbank offered rates on the market (e.g. EURIBOR). The main contenders are:
- The Sterling Overnight Index Average (SONIA) (to replace £ LIBOR): a widely used interest rate benchmark and reference rate for sterling Overnight Indexed Swaps. It has been administered by the Bank of England since April 2016 and was reformed in April 2018.
- The Secured Overnight Financing Rate (SOFR) (to replace US$ LIBOR): a measure of the cost of borrowing cash overnight published by the Federal Reserve Bank of New York.
- ESTER (to replace EURIBOR): an unsecured overnight rate published by the ECB to reflect the wholesale euro overnight borrowing costs of euro area banks.
LIBOR rates may continue to be published after 2021, as banks can still voluntarily submit the data for publication by ICE Benchmark Administration. But after 2021 parties are likely to be unwilling to attach their contracts to a figure based upon limited voluntary submissions by banks.
Adoption of any or all of the above (and, or other) RFRs in place of LIBOR or EURIBOR is far from universally accepted or decided but financial institutions should be reviewing their facilities and policies with these changes in mind – particularly facilities which are likely to extend beyond 2021.
The ramifications for financial firms
Many finance documents will already include terms which provide for a substitute rate in the event that LIBOR/EURIBOR is not published. However, these terms are normally intended to address only a temporary interruption and are unlikely to reflect the longer term arrangements the parties would wish to agree. Some documentation may already provide for suitable alternative rate fixing (e.g. the “replacement of screen rate” clause published by the LMA in May 2018) but this is less likely to be the case for historical bilateral agreements.
An issue may also arise where LIBOR/EURIBOR continues to be published based on voluntary contributions and the substitute rate set out in documentation may not be triggered even if one or all of the parties to a transaction have lost confidence in the rates being published.
A key issue to note about RFRs is that, unlike LIBOR/EURIBOR, they are “backward” not “forward” looking (i.e. what was the rate overnight not, what would it be into the future) and further amendments may be needed to ensure the replacement RFR reflects the economic equivalent of the rate it replaces. It is unlikely to be simply the case of replacing one benchmark rate with another.
Financial firms need to prepare now
Some renegotiation and amendment of documentation to properly effect the parties’ commercial position seems likely in relation to many facilities. It is too early to say with any confidence which RFRs will be adopted and what supplemental terms will be accepted in markets to ensure commercial parity with the previous arrangements is maintained. However, the volume of facilities and products that will be affected will be substantial and, in many cases, amendment terms may need negotiation before being implemented.
Particular consideration will need to be given to any products affecting retail customers since communicating this complicated change to them will carry compliance and reputational risks.
It is not surprising, therefore, that the FCA and PRA wrote to major banks and insurers in the UK in September 2018 regarding their preparations for the transition from LIBOR to RFRs, requiring them to revert with their risk mitigation plans by 14 December 2018. The need to start implementing those means, reviewing historical documentation and referencing RFRs in new facilities was emphasised again by the Director of Markets and Wholesale Policy on 29 January 2019.
The uncertainty surrounding Brexit has masked the certainty of the demise of LIBOR. We are now actively undertaking LIBOR/EURIBOR documentary reviews for clients and would advise others now to be prioritising this issue.
If you have any queries about this article, please contact Grant Eldred, whose details appear below.