The expected phase out of LIBOR is creating uncertainty in the markets and in this article we examine what might replace it and the impact on current documentation.
What is LIBOR?
The London Inter-Bank Offer Rate (LIBOR) has traditionally been regarded as one of the most important interest rates in finance. Every day a group of leading banks submit the interest rates at which they can borrow from other financial institutions in five major currencies, the top and bottom rates are discarded and the average is then calculated from the remainder. The resultant figure is intended to reflect the average rate at which banks can obtain unsecured funding in the London Interbank Market for the relevant currency for a specific period at a specific time.
However, in recent years LIBOR has been hit with scandal after scandal in respect of rate manipulations and misconduct and this, combined with the decreasing activity in the interbank lending market, has resulted in the Financial Conduct Authority (FCA) stating that market participants should not rely on LIBOR being available after 2021:
"The underlying market that LIBOR seeks to measure - the market for unsecured wholesale term lending to banks - is no longer sufficiently active." Andrew Bailey (chief executive of the FCA) on 27 July 2017.
Despite there being a large volume of outstanding contracts referencing LIBOR and numerous reforms put in place to try and clean up the rate (following the Wheatley Review (Report) published in September 2012), it seems likely that LIBOR will be phased out.
What happens next?
All 20 banks which submit quotes for LIBOR have promised to support the rate until 2021.
In the interim, the FCA has called upon the market to find an alternate rate to LIBOR. Intercontinental Exchange (ICE), as the administrator of LIBOR, is tasked with the job of managing the transition from LIBOR to a risk-free rate (RFR).
Claire Dawson, chief executive of the Loan Markets Association (LMA) has said that currently there is 'no obvious alternative to LIBOR in the loan market'.
Impact on documentation
With all this uncertainty it is understandable that market participants, including borrowers, lenders and hedging providers, are nervous about the impact the transition away from LIBOR will have on transactions and subsequently documentation.
As no RFR rate has been chosen at the time of writing all that we can currently recommend in respect of drafting is to ensure that:
- for future deals, the appropriate LMA fall-backs for absence of screen rate are incorporated including optional provision allowing for the replacement of an unavailable screen rate with the consent of the borrower group and the majority lenders;
- for existing deals which reference LIBOR, to review their terms to identify what fall-backs are provided for, whether they are sufficient, and whether any amendments to documentation (to bring them in line with the LMA fall-backs, for example) are required. If these fall-backs are not included look out for market disruption/increased costs provisions.
One possible solution put forward for the UK market is the Sterling Overnight Index Average (SONIA), which has been administered by the Bank of England since April 2016.
It has been run by the Bank of England in the derivatives market in an attempt to create a useable RFR not tainted by the LIBOR scandal. It is an unsecured overnight rate which makes it 'backward looking'. This is in contrast to LIBOR which is a 'forward looking' unsecured term rate.
LIBOR is based on submissions from panel banks based on the rate at which they can raise interbank funds at a variety of tenors. SONIA is based on actual overnight transactions between a range of market participants, the key differences are:
- Term - LIBOR is published for seven tenors whereas SONIA is an overnight rate;
- Credit premium - LIBOR includes term bank credit risk whereas SONIA is near risk-free.
The LMA has highlighted that using an overnight compounded rate for longer periods would create uncertainty in the cash markets as it would mean the borrower and lender would not know the rate until the end of the interest period rather than at the start as with LIBOR. In its current form it has been suggested that SONIA on its own cannot be a direct replacement of LIBOR, as it is a benchmark for overnight interest rates only.
In new reforms set to take effect on 23 April 2018 the Bank of England will try to broaden SONIA to include unsecured transactions negotiated bilaterally (in addition to brokered transactions). The reforms will also change the methodology for calculating SONIA. On each London business day, SONIA is measured as the trimmed mean, rounded to four decimal places, of interest rates paid on eligible sterling denominated deposit transactions. The amends will mean that the average will be calculated on a volume weighted basis with any obvious exceptions trimmed from the sample.
Incorporating more transactions into the calculation of SONIA should create a more reliable rate based on real market conditions.
However, the reforms do not deal with the issue of SONIA being a 'backward looking' rate. It has been suggested by Andrew Bailey of the FCA that a new rate could be introduced combining SONIA with a separate bank credit risk measure.
Overall, there is strong support for SONIA as a sterling LIBOR alternative but there are clear challenges including end user demand for term SONIA reference rates and international coordination will be required in order to roll out adoption.
The discontinuation of LIBOR will affect a significant number of transactions and as of yet there appears to be no market consensus on what will replace it (although it looks like SONIA is the most likely alternative). Any changes to a 'backward looking' methodology such as SONIA are likely to cause significant operational disruption for the loan market so there is still plenty of work to be done to create a RFR rate that works with as little disruption as possible.
Until the RFR is chosen the lenders cannot update their documentation. There are a series of screen rate fall-backs within current LMA documentation which seek to create protections if LIBOR (or any other chosen screen rate) is unavailable, but this is just a temporary solution.
The market has three years to decipher a workable LIBOR replacement - whether this is a reformed version of SONIA remains to be seen.