Background and how the London Interbank Offered Rate ("LIBOR") works
The financial crisis brought considerable changes to the entire financial regulatory environment and the way many financial instruments, especially derivatives, are traded. It also impacted LIBOR. LIBOR is an unsecured interbank rate used in the London lending and borrowing market. In 2012, regulatory investigations began to reveal manipulation of published LIBOR rates. This prompted a regulatory debate on benchmarks and the related regulatory and legal developments.
ICE LIBOR (formerly known as BBA LIBOR) is a benchmark rate produced for five currencies17 with seven maturities quoted for each, ranging from overnight to 12 months, producing 35 rates each business day.18 It is administered by ICE Benchmark Administration ("IBA"), the entity that took over the administration of LIBOR in 2014 (the "Libor Administrator"). There has traditionally been an element of subjectivity in LIBOR. For example, a panel bank may not necessarily have borrowed in the full spectrum of LIBOR maturities, which leaves room to estimate data. Furthermore, if, on a given day, a panel bank has not borrowed in a particular LIBOR currency, it would have to draw upon different data to produce the rate. Since the crisis, interbank lending has reduced considerably and thus has become less liquid.
On 27 July 2017, Andrew Bailey, Chief Executive of the Financial Conduct Authority (the "FCA"), announced that, by the end of 2021, the FCA will not use its legal powers to compel or persuade banks to submit to LIBOR.19 The reason behind this decision is that banks are not comfortable providing submissions to LIBOR where there are only few eligible term borrowing transactions by large banks.20 Mr Bailey described this situation as "potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them".21 This does not necessarily mean that LIBOR will be discontinued. In fact, it is understood that the LIBOR Administrator has indicated its intention to continue producing LIBOR22 although, as mentioned earlier, the FCA will no longer compel any bank to make submissions; as such, there is a material risk that LIBOR will not continue in its current shape.
Given the interconnectivity of the bond and derivatives markets, following industry working groups, it is anticipated that bond markets will be guided by the International Swaps & Derivatives Association, Inc. ("ISDA") guidelines on fallbacks. This will ensure matching cash flows between bonds and derivatives. The pricing of many financial instruments depends on the accuracy and integrity of benchmarks. LIBOR rates have become widely referenced in major interest rate derivatives such as swaps, options and forwards. It is calculated that up to US$500 trillion of swaps rely on market indices. Since LIBOR will not be discontinued, it is unclear how many participants will cease using it. However, following responses from market participants to a questionnaire conducted by ISDA, it would appear that market participants endorse the Sterling Overnight Index Average ("SONIA"), an alternative benchmark to LIBOR.23
Market participants may, therefore, need to rely on alternative benchmark arrangements. The cessation of market-wide usage of LIBOR will obviously affect derivative contracts that rely on LIBOR as well as derivative contracts that rely, for example, on the 2006 ISDA Definitions (the "2006 Definitions") as published by ISDA. The 2006 Definitions provide for a set of definitions that are commonly incorporated into the trading terms for interest rate swap transactions. Other sets of definitions which also reference LIBOR include, but are not limited to, the 2002 ISDA Equity Definitions, 1998 Currency and FX Definitions and the 2005 ISDA Commodity Definitions, each as published by ISDA.
The Benchmark Regulation
The Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 (the "BMR"), which came into force on 30 June 2016, will apply from 1 January 2018. It is a direct consequence of the previous investigations into LIBOR and constitutes the legislative response of the European Union ("EU") to remove any uncertainty regarding the objectivity of LIBOR and other benchmarks. The BMR lays down a new harmonised regulatory framework that imposes conditions on benchmark contributors and administrators. To date, administrators and users of benchmarks have been subject to different rules in different EU Member States. As with all EU regulations, the BMR will have direct effect and will directly impose obligations on persons involved in the provision, contribution and use of benchmarks across the EU. It will not need to be implemented by individual EU Member States.
A "benchmark" is defined under the BMR as:
"Any index by reference to which the amount payable under a financial instrument or a financial contract, or the value of a financial instrument, is determined, or an index that is used to measure the performance of an investment fund with the purpose of tracking the return of such index or of defining the asset allocation of a portfolio or of computing the performance fees".24
An "index" is broadly defined as any figure which is:
(a) published or made available to the public; and
(b) regularly determined entirely or partially by the application of a formula or any other method of calculation, or by an assessment, and on the basis of the value of one or more underlying assets or prices including estimated prices, actual or estimated interest rates, quotes and committed quotes or other values or surveys."
Article 28(2) of the BMR sets out the general framework in the event that a benchmark materially changes or ceases to be provided:
"Supervised entities other than an administrator as referred to in paragraph 1 that use a benchmark shall produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided. Where feasible and appropriate, such plans shall nominate one or several alternative benchmarks that could be referenced to substitute the benchmarks no longer provided, indicating why such benchmarks would be suitable alternatives. The supervised entities shall, upon request, provide the relevant competent authority with those plans and any updates and shall reflect them in the contractual relationship with clients."
The scope of Article 28(2) is limited to establishing the obligation on supervised entities to maintain contingency plans in the event that a benchmark materially changes or ceases to be provided. This obligation falls on supervised entities that use a benchmark. "Use of a benchmark" is defined in Article 3(1)(7) of the BMR in broad terms to include the following situations:
(a) issuance of a financial instrument which references an index or a combination of indices;
(b) determination of the amount payable under a financial instrument or a financial contract by referencing an index or a combination of indices;
(c) being a party to a financial contract which references an index or a combination of indices;
(d) providing a borrowing rate,25 as defined in point (j) of Article 3 of Directive 2008/48/EC, calculated as a spread or mark-up over an index or a combination of indices and that is solely used as a reference in a financial contract to which the creditor is a party; and
(e) measuring the performance of an investment fund through an index or a combination of indices for the purpose of tracking the return of such index or combination of indices, of defining the asset allocation of a portfolio or of computing the performance fees.
As with other pieces of European legislation, a list of Questions & Answers has been published, albeit no questions on Article 28 have been raised to date.26 In respect of subparagraph (b) above, it is not entirely clear what "use of a benchmark" will mean in the context of derivatives. The European and Securities Market Authority ("ESMA") has confirmed that the following will be considered supervised entities using a benchmark:27
(a) a trading venue, where the derivative is the subject for a request for admission to trading on such trading venue or is traded on such trading venue, to the extent terms of such trading venue specified a benchmark;
(b) an investment firm acting in the capacity of a systematic internaliser to the extent the terms of such internaliser specified a benchmark;
(c) a CCP, where the derivatives is cleared by such CCP to the extent the terms of such CCP specified a benchmark; and
(d) each party to a transaction of a derivative where none of (a) to (c) above applies.
Following this clarification there is no doubt that parties to a derivative transaction will be categorised as parties that use a benchmark.
It is important to highlight that Article 28(2) requires that any actions included in the contingency plans contemplate two triggers: (a) if a benchmark changes materially; or (b) if it ceases to be provided. It follows that any BMR-compliant fallback will have to expressly include these two triggers. It will not always be the case that current fallbacks under the different sets of definitions have these two triggers. These plans, which will be triggered by any of these two events, will have to be robust. ISDA has conducted a thorough review of the 2016 Definitions to establish whether the current fallbacks include these two triggers and the result indicates that amendments will be required.
Replacement of LIBOR
In the last few years, regulators, working groups of industry organisations and market participants have discussed how to effect the change from the existing LIBOR to a different benchmark. In particular, the Financial Stability Board (the "FSB") conducted a major review (the "FSB Review") of the major interest rate benchmarks which resulted in a report in which set out its recommendations.28 In its review, the FSB noted that "shifting a material proportion of derivative transactions to a risk-free rate would reduce the incentive to manipulate rates that include bank credit risk and would reduce the risks to bank safety and soundness and to overall financial stability".29
Following its meeting on 7 April 2017, each member firm of a working group set up by the Bank of England (the "BoE") to examine alternatives for LIBOR voted on its preferred near risk-free reference rate ("RFR").30 On 28 April 2017, the BoE proposed31 the replacement of LIBOR with SONIA, whose administrator is the BoE itself. Created in 1997, it reflects overnight funding rates in the Sterling unsecured market. SONIA is an overnight unsecured rate which is currently been reformed by the BoE and which has not yet been published. In principle, it is anticipated that SONIA will move to a new basis by April 2018.32
The BoE is currently working towards the adoption of SONIA as an alternative to Sterling LIBOR and in principle, the adoption strategy will have three strands: (a) development of interest rate derivative products referencing SONIA; (b) seeking feedback on the potential use of SONIA in instruments other than interest rate derivatives; and (c) discussion on the conversion of existing LIBOR contracts to reference SONIA.33
The BoE preferred reformed SONIA to the two available secured overnight rate candidate RFRs – the Sterling Repo Index Rate or Sterling SONET – since their collective assessment was that it best met the selection criteria.34
How is this likely to affect derivative documents?
The challenging question is how existing definitions of LIBOR will operate when the replacement occurs. ISDA has established a working group to lead discussions and propose changes. The BMR acknowledges that the cessation of the administration of a critical benchmark by an administrator could render financial contracts or financial instruments invalid, cause losses to consumers and investors, and impact financial stability.35
LIBOR is included as a benchmark in the 2006 Definitions which also contain fallback provisions to the benchmarks that will cease to continue. However, it is not clear whether a fallback benchmark may meet the criteria recommended by the FSB the Principles for Financial Benchmarks published by IOSCO on 16 April 2013 (the "Principles").36 In particular, Principle 13 thereof requires procedures to be followed if a benchmark is discontinued.
ISDA is currently working on the necessary amendments to certain definitions of the different sets of ISDA definitions, most notably the 2006 Definitions. The strategy has three limbs and will aim to: (a) design fallback mechanisms in the event that LIBOR is permanently discontinued; (b) consider amendments to the 2006 ISDA Definitions to add additional fallbacks; and (c) discuss amendment of legacy contracts. Currently, market participants can rely on the existing fallbacks contained in the 2006 Definitions. For example, the parties can rely on the default fallback for LIBOR which, following a request for quotations by the party acting as calculation agent, will consist of the determination by four major banks of the London interbank market.
In respect of legacy trades, ISDA has warned that "switching the reference rate for existing transactions would likely result in shifts in valuations, which could be disruptive to the market."37 There have been suggestions of a protocol published by ISDA to help firms alter their legacy contracts to incorporate the fallbacks in an efficient way. Separately, in his speech, Mr. Bailey queried "whether the better approach to transition would be to amend contracts to reference an alternative rate, or amend the definition of LIBOR through the fallback protocol to replace the current methodology with alternative reference rates."38 This is a question which is still being considered by the market, particularly ISDA, and which may eventually involve a protocol.
Pursuant to the BMR, it is obvious that market participants will have to select a replacement benchmark and design replacement mechanics that work smoothly. Following the BoE's endorsement and the latest ISDA survey, there seems to be a developing consensus that SONIA will be the replacement benchmark. However, a benchmark in respect of Sterling is only a contractual term and this will be a voluntary process. There is a risk of market fragmentation if a majority of market participants fail to adhere to a universal benchmark rate.