What is the problem with LIBOR?
Following a number of scandals involving the setting of LIBOR, the benchmark is seen as lacking credibility. This has been exacerbated by the criminalisation of benchmark manipulation and the introduction of the EU Benchmark Regulation1. The EU Regulation imposes obligations on the administrators, and on the contributors of data into indices used as market benchmarks. This has discouraged banks from inputting into rate based indices because of the compliance burden and the risk of sanctions (LIBOR related manipulations have so far been subject to fines of around US$9 billion ).
While the progress made in strengthening LIBOR has been noted, regulators globally have been pushing for transaction based (as opposed to quote based) rates and there aren’t enough transactions between banks where they lend to each other at the interbank rate to provide a reliable, liquid benchmark. The FSB has stated2 that the change in the structure of wholesale funding markets makes “the identification of and transition planning to RFRs and contract robustness more important”.
Around US$350 trillion of financial contracts reference LIBOR – what should replace it?
The U.S. Alternative Reference Rates Committee announced in June that it had selected a broad overnight U.S. Treasuries repo rate, the Secured Overnight Financing Rate (SOFR), as its recommended alternative for USD LIBOR. However, that would really only work for the U.S. interbank market and is a money market rate. Although SOFR does not yet exist, it is due to start being published around mid-2018.
The UK Bank of England Working Group on Sterling Risk-Free Rates has selected a reformed Sterling Over-Night Index Average (SONIA) as its proposed RFR in the derivatives and money markets. It is also consulting3 the market on the adoption of SONIA in financial markets beyond derivatives, such as the loan and bond markets, including consulting on whether a term RFR may be necessary. There is also an FCA (in its role as the UK’s LIBOR regulator) consultation on the reform of LIBOR, while ICE Benchmark Administration (which currently administers LIBOR) favours an evolutionary approach.
In Europe, in addition to the work on strengthening EONIA, the European Central Bank (ECB) announced in September that it will start providing an overnight unsecured index before 2020. The ECB, the European Securities and Markets Authority, the Financial Services and Markets Authority and the European Commission also together announced a new working group to identify and adopt an alternative RFR for use in financial instruments and contracts in the euro area.
Do we need to make any changes to our documents?
In the absence of a settled alternative rate at this stage, advisers, market participants and trade associations are focusing on keeping up to date with developments, as well as ‘future proofing’ new documents and considering how to deal with legacy transactions.
ISDA is considering the fall-back mechanisms that would apply if an IBOR is discontinued and how to incorporate the required changes into new and existing derivatives contracts. ISDA would likely amend the ISDA 2006 Definitions and publish a protocol to make the process efficient. ISDA protocols are voluntary so regulatory action may be needed to ensure all parties make the necessary changes.
In the loan market, syndicated loan documents typically include fall-back provisions which deal with the temporary unavailability of LIBOR. Amendments to deal with the discontinuance of LIBOR are likely to require all-party consent, unless wording is included to permit amendment, with Majority Lender consent in such circumstances – this is already an option in LMA documents. Legacy bilateral loan documents should be relatively straightforward to amend (albeit operationally burdensome).
In the capital markets, bond instruments often include fall-back provisions to deal with the temporary unavailability of LIBOR, but these provisions are less homogeneous than those in loan documentation and don’t address discontinuance. In addition, some issuers are reportedly including additional risk factors4 in new transactions. Amendments to deal with any discontinuance of LIBOR will not be so easy in respect of capital market instruments and fund interests, etc., as there are multiple holders and changes are usually by way of meetings of those holders or written resolution. Instruments which straddle two or more markets (e.g., a derivative, such as a total return swap, which references a loan or a bond) may also be more difficult to amend.
Any retail customer documentation should theoretically be straightforward to amend, but care will need to be taken to ensure that the relevant institution is seen to explain the change clearly, treat customers fairly and be able to deal with questions and complaints.
Work is ongoing and all parties are being urged to ensure that final decisions are appropriate for all financial markets given the inter-relationship between them. It is vital to ensure that there is an orderly transition from LIBOR to any alternative rate without undue disruption to the financial markets.
- Regulation (EU) 2016/1011, published in 2016 and coming into effect in January 2018.
- “Reforming major interest rate benchmarks – Progress report on implementation of July 2014 FSB recommendations” (10 October 2017).
- BoE white paper – “SONIA as the RFR and approaches to adoption” (June 2017).
- ICMA quarterly report (fourth quarter, 2017).
Client Alert 2017-248
