The FCA recently announced a preference to transition from LIBOR to other rates by 2021 despite significant reforms having been made to LIBOR following the rate-fixing scandal.
LIBOR has been a constant in the UK banking world for 30 years and is the reference rate in many financial contracts.
The FCA has regulated LIBOR and the submission process involving 20 panel banks since April 2013. Since that time significant improvements have been made to LIBOR through its administrator, ICE Benchmark Administration (ICE), including the introduction of an oversight committee to provide independent challenge on how the benchmark operates in order to maintain efficacy and confidence in the rate.
Why is there a need to change?
Andrew Bailey, Chief Executive of the FCA, highlighted that, fundamentally: "The underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active." He was keen to stress that the FCA was not mandating the end of LIBOR, and ICE would be free to continue to publish LIBOR after 2021. However, it is likely that without FCA pressure, panel banks would cease to provide submissions.
In the meantime, the FCA will, if needed, use its formal powers to compel panel banks to continue to provide submissions until 2021 to ensure that the transitional period is smooth and does not disrupt transactions or present undue cost to the market.
What will replace LIBOR?
In April 2017, the Working Group on Sterling Risk-Free Reference Rates which was set up by the Bank of England and which comprises a group of major dealers active in sterling interest rate swap markets announced that its preference was for SONIA (Sterling Overnight Index Average) to take the place of LIBOR.
SONIA is based on actual trades in the UK overnight unsecured lending and borrowing market which is much more active that the long term LIBOR market. As the rate is based on past transactions it also removes risks associated with LIBOR through the reliance on expert judgment by the panel banks when forming their submissions.
What impact does this have on current loan documentation
As noted, no decision has been made on the long term future of LIBOR so it is possible that ICE will continue to publish rates, enabling contracting parties to proceed as before. However there is a risk that without the FCA compelling panel banks to continue with submissions, it will be difficult for ICE to maintain publication of the rate.
Andrew Bailey noted in his speech that some contracts based on LIBOR will continue after 2021 and the potential issues if ICE does not continue. In that regard he was careful to flag that parties should be looking at whether their existing contracts enable changes to the relevant rate and if not, whether variations must be made to the contract by agreement.
This may not be straightforward, for instance if the relationship between the parties has deteriorated during the term of the existing contract. Alternatively, might it be possible to argue as a point of contractual interpretation that the parties always intended the relevant clause to be interpreted as LIBOR or its successor? Further, who pays for the cost of such amendments?
Even if facility documents contain transition provisions which enable the parties to move from LIBOR to a successor rate that may not be the end of the problem. It is obviously unlikely that there will be symmetry in the level of LIBOR and the replacement rate so it is possible that, if for example the replacement rate is lower, then a bank providing term funding to a customer may recover significantly less in respect of interest payments than would have been the case under LIBOR based calculations.
Without agreement on the replacement rate it is difficult to accurately reflect the transition from LIBOR in documentation but parties should ensure they include transition provisions which enable changes in due course.
By way of example, the Loan Market Association standard documentation contains a fall back interest rate benchmark mechanism intended to deal with a temporary unavailability of the applicable LIBOR rate (the "Screen Rate"). In that scenario, while there is a waterfall of alternative Screen Rates which apply they do not provide a permanent solution to the scenario in which the underlying benchmark ceases to exist and the Screen Rates themselves are no longer published. If there is no applicable alternative Screen Rate, the ultimate fall-back interest rate is to use the Lenders' own 'cost of funds', that being the cost to that Lender of funding its participation in the loan from any source it may choose.
This method of calculating the rate of interest however seems impracticable for any significant length of loan because it will be administratively burdensome for parties and may be unpalatable to borrowers.
What should lenders/financial institutions do now to prepare for the change
Andrew Bailey's speech will cause some uncertainty, given that there is no ready reference rate in place to take LIBOR's place albeit SONIA appears the most likely option. Until the replacement is confirmed and accepted by the market, those issuing financial documentation referencing LIBOR (and particularly those documents which will extend beyond 2021) should ensure the amendment provisions allow for the change of reference rate. At the same time, they should consider reviewing their existing arrangements which extend beyond 2021 to confirm whether any remedial action is required.
Aside from the practicalities of amending financial documentation, those relying on these contracts should also consider the practical implications of a potential move to SONIA and whether that will beneficially or adversely affect them.