The FCA Chief Executive Andrew Bailey announced 0n 27 July 2017 that market participants should not rely on the London Interbank Offered Rate (“LIBOR”) being available long term. The announcement made it clear that the long-standing benchmark used both in the UK and the US is to be replaced.
The speech presented by the FCA’s Chief Executive emphasised that:
- LIBOR is not considered to be sustainable;
- the market should work to transition to alternative rates by the end of 2021; and
- firms should not rely on LIBOR being available after the end of 2021.
In an April 2017 Bank of England press release, its Working Group on Sterling Risk-Free Reference Rates (“the Group”) decided on the Sterling Over-Night Index Average (“SONIA”) as its preferred near risk-free interest rate benchmark for use in sterling derivatives and other financial contracts.
On 29 June 2017, the Working Group published a white paper on potential approaches to a broader adoption in sterling markets of the SONIA benchmark. The white paper closed for feedback on 29 September 2017. The Group’s decision, however, does not create binding obligations for any market participants. Instead, it is intended to act as a signal of market support for SONIA and a platform to promote its broader adoption as an alternative to sterling LIBOR.
The FCA’s announcement, combined with the Group’s white paper, crystallised the idea that LIBOR is coming to the end of its life and introduced the need for market participants to focus their attention on transitional arrangements.
Why the need for reform?
The FCA is concerned that LIBOR is “not only potentially unsustainable,” but it is also “undesirable for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them”.
The reform of interest rate benchmarks has been on the global agenda for the last few years in the wake of the interest rate manipulation scandals. In particular, in 2014 the Financial Stability Board (“FSB”) laid out a reform agenda and, alongside the reform of existing benchmarks (including LIBOR), recommended the development and adoption of alternative near risk-free benchmarks.
Loan market participants, be they traditional bank lenders or direct lending funds which have seen an explosion in activity since the Wheatley review of LIBOR in 2012, have shown no signs of detaching their interest returns from LIBOR.
LIBOR’s administrator, ICE Benchmark Administration Ltd, has said that it intends to continue to produce LIBOR after 2021 because it believes that, in accordance with the Wheatley reforms, it has modified the index into a sustainable, modern part of the financial system. LIBOR’s survival, however, cannot be guaranteed as the FCA has said that it will not compel or persuade LIBOR panel banks to continue to submit quotes after 2021 (and so in practice they may be unlikely to do so).
The Future for LIBOR
It would appear that following the FCA’s speech, LIBOR is now living on borrowed time. Whilst no hard deadline has been set for its actual discontinuation, market participants and their advisors cannot rely on LIBOR being available long term.
It remains to be seen how the markets will address the above issues. It could be expected that LIBOR discontinuance will be addressed on an ad hoc basis in all new facility contracts going forward, at least for longer-dated deals, given the pending adoption of an appropriate market wide fall back or replacement rate provisions.
The FCA acknowledges that the transition to a new rate will take time. 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. There is not yet a consistent market-wide approach.
In the absence of any guidance, it is likely that transactions will continue to be based on LIBOR as documents can be adapted only when market thinking on replacement rates is more developed.