Financial markets around the world rely on the existence of transparent, reliable and liquid benchmark rates as a fundamental input to credit financing transactions. Recently, there has been much conjecture about the benchmark rate setting process. Globally, much has been said about the manipulation of the London Inter Bank Offer Rate (LIBOR). Locally, many of our biggest banks have come under scrutiny in respect of the Bank Bill Swap Rate (BBSW).
As a result of the negative stigmas associated with these rates and a deeper issue with the markets that underpin the rate setting process, there is a clear sense that support for the continued publication of LIBOR is on the decline.
The demise of LIBOR
In July 2017, the Financial Conduct Authority (UK) (FCA), the primary authority driving the promotion and publication of LIBOR, indicated that it would not require panel banks to submit LIBOR rates past 2021. While there has been no express denunciation of LIBOR, the FCA has effectively withdrawn its support for its publication, making it clear that LIBOR has no future as a global benchmark rate.
The drivers behind the change are said to be the lack of interbank borrowing and dwindling wholesale transaction volumes. This has left the rate reliant on the use of ‘expert judgement’ as opposed to actual transaction data. Of course, the general public will be much more familiar with the problems many banks have faced over allegations of LIBOR (and BBSW) manipulation which has caused a number of banks both reputational and financial harm.
Similar questions have been asked in Australia with respect to the liquidity and transparency of the BBSW. While no one is calling for its removal there has been robust discussion about the process by which the BBSW is calculated. The RBA had mooted that it would support a move away from the somewhat rigid National Best Bid and Offer (NBBO) rate calculation method to the broader Volume Weighted Average Price method. The control and regulation of the BBSW has recently shifted from the Australian Financial Markets Association (AFMA) to the ASX with the ASX publishing updated guidelines in July this year with respect to how it will administer the BBSW. The NBBO method still prevails.
The key question for financiers, borrowers and other parties who rely on LIBOR as the lynch pin of their transactions is what would replace LIBOR and how would it affect existing financing arrangements? The answers to these questions are not simple and the markets and authorities are yet to properly come to grips with how a shift away from LIBOR might actually transpire.
The preliminary response – risk free rates
Regulators and authorities around the world have been considering how a transition away from LIBOR would occur. The US Federal Reserve established the Alternative Reference Rates Committee (ARRC) to consider the best alternative to LIBOR and have put forward the secured overnight funding rate (SOFR) as its preferred alternative. The Federal Reserve Bank of New York will begin publishing the SOFR in 2018. The International Swaps and Derivatives Association announced it would embark on a comprehensive global analysis with a view to producing a global roadmap for benchmark rate transition. The Bank of England has made submissions on its views as to what a replacement LIBOR would look like and, together with the FCA, established a working group to devise an alternative risk free rate approach. This group has now selected the Sterling Overnight Index Average (SONIA) as its preferred alternative. The Bank of England will take over the calculation and publication of SONIA on 23 April 2018. In other jurisdictions, working groups are similarly developing overnight average rate indices for their currencies. The benefit of the various proposed rates is they are intended to be risk free rates and should not reflect bank credit risk.
The Australian regulators and authorities have taken a watching brief on the transition away from LIBOR whilst also engaging in some reform with respect to the BBSW. As for how to deal with the demise of LIBOR for foreign currency transactions, the Australian markets will be largely guided by the work of the international bodies and associations. The Asia Pacific Loan Market Association is likely to follow and implement any guidance from the LMA, while the RBA would likely follow the developments of the Bank of England and US Federal Reserve.
The Loan Market Association (LMA) has recently issued guidance on the approach to a LIBOR free market from a transaction documentation perspective. The LMA has updated its user guide to include an additional fall back within the definition of the ‘Relevant Benchmark Rates’. The effect of this response is a layered fall-back provision which would be triggered in the event a benchmark rate such as LIBOR is discontinued. The eventual result, having exhausted all other fall-backs, is that the applicable rate would be determined by the seller. However, this may prove difficult, particularly taking into account that in structured finance transactions it is critical that the various interrelated products all reference the same rate at all times.
The great unknown and dealing with the past
The nature of cross-border financing transactions means any solution to the discontinuance of LIBOR will not be simple. Financing parties rely on benchmark rates such as LIBOR to underpin long-term financing arrangements (be they corporate loans, bond issues or other debt financing transactions) over five different currencies. Many of these transactions are collateralised by products which also rely on LIBOR with many of the applicable rates hedged (through fixed and floating components) at some level. It’s important that lending syndicates, borrower groups and each subsequent counter-party can rely on an established benchmark rate which supports the initial transaction as well as any derivative of that transaction. That is, a rate which can be consistently and effectively applied by a multiplicity of parties across a broad range of transactions over varying terms.
It’s not clear whether the proposed overnight rates will be acceptable to underpin transactions with longer term interest periods, although the ARRC is hopeful that, with sufficient liquidity in Futures and Swap markets, these rates can be used for all interest periods.
Legacy transactions which are drafted in terms that do not contemplate a LIBOR-free market will need to be amended to ensure a smooth transition. Each transaction document will need to be amended to reflect the discontinuance of LIBOR with those amendments to be agreed as between the borrower group and lender syndicate. International syndicates with a variety of financiers may have a difficult time agreeing on what the proper alternative rate should look like and how it should operate.
Any amendments would need to be properly carried through each collateral transaction and each derivative transaction to ensure the risk profile of the financing is unaffected. The practicalities of implementing any such change to long-term sophisticated financing arrangements are likely to be burdensome on all parties involved.
The Australian impact
An Australian borrower, lender or counterparty involved in financing transactions which use LIBOR as the benchmark rate will face the sorts of challenges contemplated above. Australian regulators are yet to publish any official guidance outlining their views on the proposed phasing out of LIBOR and the possible impacts it may have on Australian markets.
Watch this space
LIBOR has been the backbone of credit transactions across financial markets over recent times however, the growing mistrust of the institutions that are involved in setting the rate and the declining transactional volumes which support it have resulted in a loss of support for LIBOR. We shall monitor how participants respond to a LIBOR-free market, how borrowers, financiers, counterparties and their advisors will overcome the challenges facing existing financing arrangements and what role regulators and authorities will have in any transition process.