Showing the Door to LIBOR

Regulators intend to transition from the London Interbank Offered Rate (LIBOR) to alternative rates by 2021, and counterparties to loan and derivatives contracts should prepare to revisit LIBOR provisions accordingly.

What You Need To Know

• Despite being a benchmark interest rate in contracts aggregating over $350 trillion dollars worldwide, due to some inherent flaws and its susceptibility to manipulation, LIBOR may be phased out by 2021 in favour of alternative rates.
• United States Dollar LIBOR would likely be replaced by the Broad Treasuries Repo Financing Rate and the Sterling LIBOR by the Sterling Overnight Index Average. Neither rate has yet obtained status as LIBOR's official successor.
• Until the fate of LIBOR is known with a higher degree of certainty, it is still premature to begin amending existing LIBOR definitions in finance agreements to substitute potential alternative rates. For the time being, counterparties to affected contracts would be advised to adopt a "wait and see" approach and monitor developments from regulators concerning the future of LIBOR and its alternatives.

Background

LIBOR is the average rate at which banks can obtain unsecured funding in the London interbank market. LIBOR is calculated by averaging the rates submitted by contributing banks in response to the following question: "at what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?" The submissions are then used to publish LIBOR marks for five currencies and seven maturity periods. Since its debut in the 1980s, LIBOR has become one of the most important published rates in the international financial system; it is the reference-rate for approximately $350 trillion worth of contracts globally, and in the United States alone LIBOR is referenced in roughly $4.3 trillion of loan contracts.¹ Now, however, regulators want to phase it out due to a number of inherent flaws.

The first problem with LIBOR is it is susceptible to manipulation. LIBOR is a "polled" rate, meaning it relies on the subjective judgment of individuals acting on behalf of submitting banks to project future market activity. This approach stands in contrast to other reference rates which are based on actual market transactions, which removes or at least mitigates the human forecasting element. In the years following the financial crash, those shortcomings of LIBOR were exposed on the international stage. In 2012, reports emerged that multiple polling banks had been misstating their borrowing costs and submitting false or misleading LIBOR rates. Over the next three years, the implicated banks either settled with regulators or were subject to significant fines (the largest being $2.5 billion imposed on a single bank). In 2015, three traders were jailed for their roles in LIBOR manipulation.²

A second criticism of LIBOR stems from the shrinking size of its source market, being unsecured wholesale term lending transactions between banks. Diminishing activity in the underlying market has resulted in the solicited rate diverging even further from actual transactions. Regulators tracking this market downtrend are now convinced LIBOR needs to be phased out in favour of alternative rates premised on more robust underlying data. To that end, the Financial Conduct Authority has stated that after 2021 it will no longer compel banks to submit LIBOR marks.³

The alternative rate contenders: BTFR and SONIA

In the event of a phase-out, the general consensus is LIBOR would likely be replaced in the United Kingdom by the Sterling Overnight Index Average (SONIA) and in the United States by the Broad Treasuries Repo Financing Rate (BTFR). The former is the rate preferred by the Bank of England to replace sterling LIBOR, and the latter is recommended by the Federal Reserve to replace US LIBOR.⁴ A majority of the members of the International Swaps and Derivatives Association also support the choice of SONIA to replace Sterling LIBOR.⁵

SONIA represents the weighted average rate of unsecured sterling overnight cash transactions over £25 million brokered in London by contributing inter-dealer brokers. BTFR is a benchmark rate based on repurchase (or "repo") transactions collateralized by Treasury securities that settle on a tri-party repo settlement platform.

As such, neither SONIA nor BTFR shares the same fundamental characteristics that have been problematic for LIBOR. While all three rates similarly attempt to measure the near-risk-free lending rate, both SONIA and BTFR differ from LIBOR in the following ways:

• they are based solely on actual transactions (i.e., they are backwards-looking), whereas LIBOR is premised on the "expert opinion" of a panel of banks (i.e., it is forward-looking and relies on forecasts);
• they are overnight rates, whereas LIBOR is published for seven maturities ranging from overnight to 12 months;
• they are limited to one currency (SONIA to sterling and BTFR to U.S. dollars), whereas LIBOR is published for five currencies; and
• historically, they have both been quantitatively lower than LIBOR. As overnight rates, both carry less term risk, and BTFR, being derived from secured transactions, involves less credit risk and therefore a lower risk premium.

The takeaway, in our view, is it is unlikely that either SONIA or BTFR will be universally accepted as the de facto "successor rate" to LIBOR by the services that publish LIBOR—the alternative rates simply differ from LIBOR in too many fundamental respects.

For Canadian based transactions, agreements using a Canadian Dollar Offered Rate (CDOR) interest rate basis will remain unaffected. With attributes similar to SONIA and BTFR, CDOR is derived from the high volume Canadian inter-bank market for banker’s acceptances using observed and real-time transactions.

Reports of LIBOR's demise may be overstated

Even if SONIA and BTFR gain traction in the market, it does not necessarily mean LIBOR will disappear altogether. Although the Financial Conduct Authority will not compel banks to submit LIBOR quotes after 2021, the ICE Benchmark Association (IBA), which publishes LIBOR, has presented a dissenting view expressing confidence that LIBOR will have a place in the future.⁶

Beyond merely predicting the survival of LIBOR, the IBA is currently reforming LIBOR by increasingly basing the rate on transactions rather than abstract forecasts, by improving oversight of submitting banks, and by revising its methodology to include loans by corporations in the underlying data. These changes are intended to make LIBOR harder to manipulate and to buttress the market underpinning LIBOR data. Given the volume of debt and derivatives tied to LIBOR, it is possible and perhaps likely that banks will continue to submit LIBOR marks for a published rate long after 2021, even without the patronage of the Financial Conduct Authority.

Amending LIBOR fallback provisions

After 2021, the fate of contracts referencing LIBOR will depend on how fallback provisions in those contracts are drafted and interpreted. Most contracts define LIBOR with reference to a published screen rate such as Reuters or Bloomberg. If the applicable LIBOR screen rate page is no longer available, contractual fallback provisions generally provide that a successor screen rate will be used. A subset of those fallback provisions will go further and articulate a mechanism or procedure to determine another suitable benchmark interest rate if no successor rate is ascertainable (which may likely be the case, given that, BTFR and SONIA differ fundamentally from LIBOR). For example, fallback provisions may direct the agent lender to solicit quotes from reference banks to determine a market interbank lending rate, or be drafted to provide that the fallback rate will be the rate determined by the relevant agent lender, in its sole discretion or with reference to the rate at which deposits are offered by or to the agent in the London interbank market.

Even the more comprehensive fallback provisions may nonetheless prove to be ambiguous or otherwise unsatisfactory for counterparties wishing to avoid uncertainty due to a potential LIBOR phase-out. However, it is likely still too early to pre-emptively amend existing agreements or draft new agreements deeming one of the alternative benchmark rates (i.e., SONIA or BTFR) to automatically replace LIBOR should it cease to be published. Caution should be exercised when including one of these fallback benchmarks, as there are no guarantees either rate will become the next widely adopted risk-free reference rate.

Moreover, as outlined above, both SONIA and BTFR will likely be quantitatively lower than LIBOR, and lenders and hedge providers will not want existing interest rates to decline merely due to a technical drafting switch to a different benchmark rate. Rather, counterparties will want to ensure that both new and existing contracts contain fallback language that avoids changing the economics of the existing deal (e.g., by increasing financing costs for the borrower or lowering the rate of return for the bank). To achieve that result, counterparties may wish to provide for a net-neutral formula that ensures a smooth transition away from LIBOR without affecting the economics of the contract. Again, it is likely too early to advise on the specifics of such a conversion mechanism.

In the short-term, counterparties may do well by simply adopting a "wait and see" approach and keeping an eye on developments from the IBA, Federal Reserve, and Bank of England with respect to the future of alternative rates and the fate of LIBOR. Counterparties should also consider revising their existing contracts to confirm they contain workable LIBOR fallback language. Finally, counterparties to new contracts with multiple parties (e.g., syndicated loan contracts and bond indentures) should consider drafting-in flexible amendment provisions requiring something less than unanimous consent (and ideally the consent of a sole specified agent) in order to quickly amend contracts when the heir apparent to LIBOR does eventually emerge. Should a clear replacement rate fail to emerge as the 2021 milestone approaches, counterparties to existing contracts might consider amending affected finance contracts by drafting in simplified mechanics for designating an agreed replacement rate, whatever it may be.

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¹ ICE Benchmark Administration, Summary of ICE LIBOR Evolution , online at: https://www.theice.com/publicdocs/LIBOR_evo_summary.pdf. The Loan Syndications and Trading Association, "LIBOR: A Process, Not a Problem (II)" (news release published on August 24, 2017), online at: www.lsta.org.

² For a timeline of the LIBOR scandal see New York Times, "Tracking the Libor Scandal" (timeline last updated on March 23, 2016), online at: https://www.nytimes.com/interactive/2015/04/23/business/dealbook/db-libor-timeline.html?mcubz=1.

³ Andrew Bailey, The Future of LIBOR (speech of the FCA given at Bloomberg London on 27 July 2017).

⁴ SONIA is the rate recommended by the Working Group on Sterling Risk-Free Reference Rates, which was set up by the Bank of England to recommend a LIBOR alternative (see The Working Group on Sterling Risk-Free Reference Rates, SONIA as the RFR and approaches to adoption (June 2017)), and BTFR is recommended by the Alternate Reference Rates Committee, which was set by the Federal Reserve to find a LIBOR alternative (see Alternate Reference Rates Committee, The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (22 June 2017)). Other countries are developing replacements for LIBOR for other currencies, with Japan picking the uncollateralized overnight call rate (TONAR) and Switzerland picking the overnight secured benchmark rate SARON.

⁵ International Swaps and Derivatives Association, ISDA response to the Bank of England Working Group on Sterling Risk-Free Reference Rates White Paper: SONIA as the RFR and approaches to adoption (Report published by the International Swaps and Derivatives Association) at 1.

⁶ "A crucial interest-rate benchmark faces a murky future," The Economist (3 August 2017). The President of the IBA was quoted as saying he was "very confident ... that LIBOR will be here for a long, long time to come."