Market participants should review the language in existing loan and derivative contracts relating to the calculation of LIBOR.
On July 27, 2017, UK Financial Conduct Authority (FCA) Chief Executive Andrew Bailey delivered a speech indicating that the London Interbank Offered Rate (LIBOR) will be phased out by the end of 2021. Per Mr. Bailey’s comments, the FCA will continue to support and sustain LIBOR until the end of 2021 and will enable a transition to alternative reference rates that are based firmly on transactions in the market.
Although LIBOR has been linked to past banking scandals, the FCA indicated that ending its use is a result of the lack of meaningful transaction-based data to calculate the benchmark that underpins more than $350 trillion in securities. Consequently, regulators have found that LIBOR no longer reflects actual practices and transactions, making it vulnerable to manipulations. Such manipulations have led to scandals in the banking industry, amounting to $9 billion in fines and convictions of several bankers.
Market participants and regulators have known about the issues surrounding LIBOR and have been working to solve them for the last few years. In the UK, the Bank of England is overseeing the development of sterling risk-free reference rates as a result of the Financial Stability Board’s July 2014 report on interest rate benchmark reform. Additionally, in the same year, the U.S. Financial Stability Oversight Council (FSOC) recommended that U.S. regulators cooperate with foreign regulators to identify alternative interest rate benchmarks anchored in observable transactions and supported by appropriate governance structures. This led the Federal Reserve to convene the Alternative Reference Rates Committee (ARRC) to identify a set of alternative U.S. dollar reference interest rates and to identify an adoption plan with means to facilitate the acceptance and use of these alternative reference rates.
Any transition away from a LIBOR-based reference rate for U.S. dollar denominated lending and derivative transactions will have profound implications for the documentation and negotiation of the transactions and for financial markets around the world. This is true regardless of how the transition is accomplished and the length of time for the transition.
Alternatives to LIBOR
In the UK, the Bank of England proposed replacing the use of LIBOR in contracts with the Sterling Overnight Index Average, or SONIA. Introduced in March 1997, SONIA is a near risk-free alternative derivatives reference rate that reflects bank and building societies’ overnight funding rates in the sterling unsecured market. SONIA, however, is currently under reform by the Bank of England. Once the reform is concluded, the Bank of England will be the benchmark’s administrator, responsible for calculating and publishing the benchmark. Among other things, the applicability of SONIA will be broadened to include overnight unsecured transactions negotiated bilaterally, as well as those arranged via brokers. SONIA is anticipated to move to a new basis by April 2018, and the precise date is expected to be announced at least six months in advance.
On June 22, 2017, ARRC identified a broad Treasuries repo financing rate that, in the committee’s opinion, represents best practice for use in certain new U.S. dollar derivatives and other financial contracts. The new broad Treasuries repo financing rate is linked to the cost of borrowing cash secured against U.S. Treasury securities and is based on about $660 billion in daily transactions. The Federal Reserve Bank of New York has proposed publishing such rate in cooperation with the Office of Financial Research in order to deter its manipulation.
In any case, it is too early to know how the replacement to LIBOR will be chosen, how it will price and how quickly an alternative rate will be accepted in the capital markets, as well as how a transition from LIBOR will be accomplished.
What This Means for Market Participants
Market participants should review the language in existing loan and derivative contracts relating to the calculation of LIBOR to assess whether they provide for a replacement rate or for a specific process for arriving at a substitute benchmark rate when LIBOR is phased out. More information about the transition away from LIBOR is still needed.