Since the announcement on July 27, 2017 by the UK Financial Conduct Authority (the FCA) that the LIBOR rate would be phased out after 2021, much has been written about the complications of switching over from LIBOR to an alternative rate. It is reported that LIBOR is tied to over $350 trillion in derivatives, corporate bonds, and other financial products (such as adjustable rate mortgages). Although efforts to strengthen LIBOR have been ongoing, there are simply not enough underlying transactions upon which a LIBOR quote can be reliably based, according to FCA Chief Executive Andrew Bailey.
Killing off LIBOR inevitably raises questions about how a transition to a replacement rate would work. For GBP LIBOR, the Sterling Overnight Index Average, or SONIA, has been put forth as a replacement. One might question whether SONIA is a perfect fit for replacing a LIBOR instrument, as SONIA is solely an overnight rate, while LIBOR has a range of tenors from overnight to 12 months.
In the United States, the Alternative Reference Rates Committee recommended the "Secured Overnight Financing Rate" (SOFR) as a replacement for USD LIBOR. Again, there would be transitional issues, as LIBOR is forward-looking and unsecured, and has a range of tenors, while the replacement rate is an overnight, secured, and backward-looking rate.1
How would this all affect existing structured products and floating rate notes based on LIBOR? As opposed to derivatives contracts negotiated between two parties, who could agree to amend the documentation to switch to a new rate, beneficial interests in corporate bonds are held by many parties. Under a standard indenture, changing the interest rate would require the consent of all of the holders; i.e., a consent solicitation, a costly exercise. Absent an industry-wide agreed replacement rate for LIBOR, it's hard to imagine bond holders, being 100% in agreement on replacing the existing LIBOR rate without a sweetener.
What options do issuers have for future issuances of LIBOR-linked notes with maturities of longer than four years? Some options, all of which would be built into the documentation and would take effect upon a defined LIBOR "termination," are:
- Agreeing on a replacement rate;
- Agreeing to adopt a rate considered by the International Swaps and Derivatives Association, Inc. (ISDA) to be a LIBOR replacement; or
- Defaulting to calculation agent discretion in picking a replacement rate.
Issuers will also have to agree on what constitutes a termination of LIBOR. In a recent ISDA presentation, four possibilities were put forward as IBOR terminations, each of which would trigger the use in derivatives contracts of revised fallback provisions using a replacement rate:
The insolvency of the relevant IBOR administrator (and there is no successor administrator);
A public statement by the relevant IBOR administrator that it will cease publishing the relevant IBOR permanently or indefinitely (and there is no successor administrator that will continue publication of the relevant IBOR);
A public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR has been permanently or indefinitely discontinued; or
A statement by the supervisor for the relevant IBOR administrator that the relevant IBOR may no longer be used.2
Although LIBOR rates may still be published by ICE Benchmark Administration, there is no guarantee either that there will be sufficient transactions for the submitting panel banks to report, or that the number of panel banks would not fall below the current number (17 for USD LIBOR). The FCA recently announced that it would use its "compulsion powers" to force banks to contribute to setting the LIBOR rate "only where it would be appropriate to ensure market integrity or consumer protection."3 In addition to the proposed ISDA termination events listed above, issuers may want to define LIBOR as being terminated if, for example, despite the FCA's compulsion efforts, there were only six submitting panel banks.