On 27 July 2017, Andrew Bailey, the CEO of the Financial Conduct Authority (FCA), announced in a speech at Bloomberg that LIBOR is to be phased out by 2021. This note considers what might replace LIBOR, and how this announcement affects loan documents on new and existing transactions.
A change of direction – from reform to replacement
The final report of the Wheatley Review of LIBOR, published in 2012 concluded "that there is a clear case in favour of comprehensively reforming LIBOR, rather than replacing the benchmark". The UK government agreed. As part of its implementation of the Wheatley Review's recommendations, LIBOR became a regulated benchmark in 2013 under the supervision of the FCA. The FCA has clearly now decided that the reforms LIBOR has undergone in recent years do not go far enough. Mr Bailey remarked:
"The underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active."
ICE Benchmark Administration, LIBOR's administrator, favours "evolving" LIBOR rather than abolishing it entirely. However, given the FCA's attitude, it seems unlikely that LIBOR will ultimately survive.
What will replace LIBOR?
Mr Bailey made clear in his speech that:
- there has been "wide support" from contributor banks to continue LIBOR until at least the end of 2021; and
- the FCA is willing to use its formal powers to compel them to do this (see LIBOR – FCA consults on additional powers to compel banks to make LIBOR submissions).
The purpose of this is to allow a smooth transition if LIBOR stops being published at the end of 2021.
The most likely candidate to "replace" LIBOR is SONIA (the Sterling Overnight Index Average). SONIA is based on actual trades in the UK overnight unsecured lending and borrowing market. This is a much more active market than the longer term inter-bank lending market that LIBOR is based on. It is administered by the Bank of England and is itself currently undergoing reform. In April 2017 a Working Group on Sterling Risk-Free Reference Rates, set up by the Bank of England, announced that it supported SONIA as its preferred near risk-free interest rate benchmark. Chris Salmon, Bank of England Executive Director for Markets, described this as "the first step on the path towards the adoption of a sterling risk-free rate as an alternative to LIBOR".
However, SONIA on its own cannot be a direct replacement of LIBOR, as it is a benchmark for overnight interest rates only. Mr Bailey suggested that a new rate could be introduced combining SONIA with a separate bank credit risk measure.
How does this affect loan documents?
The recommended forms of facility agreement published by the Loan Market Association (LMA) have long contained fall-back interest rate benchmark mechanisms for use if published LIBOR (called the "Screen Rate" in LMA agreements) ceases to be available. The LMA overhauled these in November 2014 to make them even more robust.
Broadly, they provide that if the Screen Rate is not available (either temporarily or permanently), the parties must either:
- use another recent Screen Rate or Screen Rates (if there are any) to get the nearest available equivalent to what the current Screen Rate would be; or
- create an equivalent to the Screen Rate by asking specified entities (either Reference Banks or individual lenders in the syndicate) the same question about their funding costs that LIBOR contributing banks are or were asked to calculate the Screen Rate.
But these are only ever likely to be temporary solutions to the unavailability of the Screen Rate. The LMA's agreements do not currently provide for any automatic switch to a different public rate if LIBOR is "replaced". This is not an oversight. If the loan markets start to adopt a different benchmark rate in place of LIBOR, that different benchmark will inevitably be generated by asking market participants a different question or set of questions than contributor banks are currently asked to create LIBOR. Different questions are likely to lead to different answers.
So the LMA's agreements currently leave it to the parties to agree at the time whether to adopt any replacement rate, once they know what that replacement rate is. For example if a different rate replaces LIBOR in the market, it might routinely produce lower or higher rates than LIBOR, or what market participants think LIBOR would have been if it had continued. If so, the parties to an existing loan priced against LIBOR may want to change the margin to ensure they get to the same economic position once they start using a new benchmark. Until they agree to adopt a replacement benchmark, they are likely to need to use the inconvenient bespoke fall backs referred to above (i.e. a Reference Bank Rate or cost of funds) once LIBOR is permanently withdrawn.
So while loan documents may start to change to reflect the likely phase out of LIBOR, simply adding a reference to "any rate that replaces the Screen Rate" in new facility agreements may not be a suitable fix. Parties to facility agreements can generally amend them relatively easily. But one would hope the FCA will structure the phase out so to avoid the need to amend loan documentation on a transaction-by-transaction basis. Other finance contracts that use LIBOR, such as those setting the terms of debt securities issued on the capital markets, are likely to be much harder to amend. Obviously, the whole purpose of this development is to encourage market participants to stop using LIBOR on new transactions. But until the market settles on an alternative benchmark, a period of uncertainty beckons.