Andrew Bailey, chief executive of the FCA, announced on 27 July 2017 that the FCA would no longer use its influence or legal powers to persuade or compel LIBOR panel banks to continue making LIBOR submissions after 2021. This announcement has accelerated work already underway to find alternative benchmarks. It has also focused attention on how LIBOR-based finance documents should cater for the possible demise of LIBOR.
Why the need to transition away from LIBOR?
As Andrew Bailey acknowledged in his speech, significant improvements have been made to LIBOR since April 2013. However, the underlying market that LIBOR seeks to measure – the unsecured wholesale interbank lending market – has become significantly less active, leading to questions about the sustainability of the benchmark that seeks to measure it. Panel banks are, according to Mr Bailey, "feeling discomfort" about submitting submissions based on judgements "with so little actual borrowing activity against which to validate those judgements".
However, a planned and orderly transition away from LIBOR is key to avoid significant market disruption. As part of this orderly transition, the FCA announced on 24 November 2017 that it had secured the voluntary agreement of all 20 LIBOR panel banks to continue submitting contributions until the end of 2021. The FCA now expects focus to turn towards developing alternative rates and working towards a transition that can be executed smoothly.
As Andrew Bailey highlighted in his speech, the administrator of LIBOR, ICE Benchmark Administration, and the panel banks may continue to produce LIBOR after 2021 if they want to and are able to do so. The benchmark would, however, no longer be sustained by the FCA persuading or obliging panel banks to continue to make submissions. So its survival after 2021 is not guaranteed.
In addition to developing alternative benchmark rates, market participants will also need to consider existing or new LIBOR-based contracts that may continue beyond the end of 2021. These should have robust fall-back arrangements to allow for a smooth transition if LIBOR were to be discontinued.
Possible alternative benchmark rates
In the UK, the Bank of England's Working Group on Sterling Risk-Free Reference Rates has confirmed the Sterling Overnight Index Average (SONIA) as its preferred alternative benchmark to LIBOR for use in sterling derivatives and other relevant financial contracts.
On 29 November 2017, the Bank of England and the FCA announced that the Working Group would have a new mandate to drive forward a broad-based transition to SONIA over the next four years across sterling bond, loan and derivative markets. The aim is for SONIA to be established as the primary sterling interest rate benchmark by the end of 2021. A priority for the Working Group will be to make recommendations for the development of term SONIA reference rates. SONIA is an overnight rate and does not currently address the forward-looking terms and the credit risk element that LIBOR seeks to reflect.
In the US, the Alternative Reference Rates Committee has recommended the Secured Overnight Financing Rate, a broad measure of overnight Treasury financing transactions, as a robust alternative to US dollar LIBOR.
In the eurozone, a preferred risk-free overnight rate has not yet been identified. However, in September the Financial Services and Markets Authority, the European Securities and Markets Authority and the European Central Bank announced the launch of a new working group tasked with identifying and adopting a risk-free alternative overnight rate for euro-denominated finance transactions.
How does the Benchmarks Regulation (BMR) fit into this?
The BMR applies generally within EU member states from 1 January 2018, with limited provisions applying before this date.
The BMR will impose specific obligations on administrators of, and contributors to, benchmarks, as well as to users of benchmarks. Article 28(2) of the BMR requires a supervised entity that uses a benchmark (which includes LIBOR) to have robust written plans in place setting out what actions will be taken if a benchmark "materially changes or ceases to be provided". Supervised entities must reflect these plans in their contractual relationships with clients.
Supervised entities are, broadly, regulated firms, including credit institutions and investment firms.
The term "use of a benchmark" is defined under the BMR and includes:
- issuing a financial instrument that references an index or a combination of indices;
- determining the amount payable under a "financial instrument" or a "financial contract" (as defined in the BMR) by referencing an index or a combination of indices;
- being a party to a financial contract that references an index or a combination of indices; and
- providing a borrowing rate calculated as a spread or mark-up over an index or a combination of indices that is solely used as a reference in a financial contract.
So a supervised entity may be in scope if it issues a debt security or acts as a calculation agent on a transaction where interest on a financial instrument is calculated by reference to a benchmark. If so, it must ensure the relevant contracts documenting the financial instrument provide for "robust" fall-back plans. (Note that "financial contracts" broadly covers consumer credit and regulated mortgage contracts. So it would not include syndicated and other corporate lending facility agreements.)
Ensuring their compliance with the BMR is another good reason for market participants to think carefully about appropriate fall-back terms in their documents.
Current market changes to finance documents – debt capital markets transactions
For securities maturing after 2021 with floating rate interest rates, it may be appropriate to include a risk factor in offering circulars highlighting the upcoming transition away from LIBOR and other IBOR reference rates. Examples of risks that could be highlighted include:
- any change to the relevant benchmark rate could affect the level of the published rate (including causing it to be lower); and
- the application of the fall-back provisions could result in a fixed rate effectively being applied if the ultimate fall-back is by reference to the rate which last applied when the relevant IBOR reference rate was available.
Any such risk factors should be carefully drafted and tailored to the specific circumstances of the relevant financial instrument.
Amending the terms of capital markets instruments can be difficult because the instruments are often held by a large number of underlying investors. We are seeing the use of the following terms to facilitate future necessary amendments on a discontinuation of a relevant interest rate benchmark:
- In structured finance transactions, negative consent provisions are typically being extended to authorise the trustee to agree amendments relating to the discontinuation of a relevant IBOR reference rate, provided that certain conditions are satisfied. The relevant conditions may include:
- the provision of certificates on behalf of the issuer confirming that the amendments relate to the reference rate's material disruption or discontinuation;
- the alternative reference rate being officially recognised;
- notice of the proposed amendments having been provided to all bondholders; and
- a specific percentage of bondholders not having objected to the proposed amendments within a specified time period.
- Where there is a controlling class of noteholders, the right to consent to amendments relating to the discontinuation or material disruption of IBOR reference rates may be reserved to that controlling class.
- Changes to the calculation of interest rates are often reserved matters or "Basic Terms Modifications" requiring higher quorum and/or voting thresholds. Where this is the case, specific exemptions may be included for amendments relating to the introduction of (widely recognised) alternative reference rates in the event of the relevant IBOR reference rate being discontinued or materially disrupted.
Increasingly, trustees and agents are not wanting to exercise discretion to determine or calculate interest rates in the absence of a screen rate being available or an interest rate failing to be determined. They will be keen to ensure that clear fall-back provisions, which remove any discretion on the part of the trustee or the calculation agent, are included from the outset in the documentation.
Current market changes to finance documents – facility agreements
We are not currently seeing the widespread introduction of new terms into facility agreements to cater for the discontinuation of IBOR reference rates. LMA facility agreements have long contained fall-back interest rate benchmark mechanisms for use if a relevant published IBOR (the so-called "Screen Rate") is no longer available. Such provisions are, however, only ever temporary solutions to the unavailability of the Screen Rate. If an IBOR reference rate were to be discontinued, the LMA's agreements currently leave it to the parties to agree at the time whether to adopt a replacement rate. Since 2014, LMA facility agreements have included an optional clause allowing any such change to be made with the consent of the Majority Lenders and the borrower. Beyond this, there is arguably less need to "future proof" facility agreements at this stage because it is generally relatively easy for the parties to agree to amendments.
Current market changes to finance documents – derivative contracts
We are also not yet seeing significant bespoke amendments to ISDA-based derivative contracts. ISDA has established working groups focusing on:
- developing fall-back rates or mechanisms to use if LIBOR and other IBORs are permanently discontinued;
- amending the ISDA 2006 Definitions to incorporate those fall-back rates or mechanisms; and
- developing plans to enable the amended definitions to apply to legacy transactions, most likely through the use of a protocol mechanism.