LIBOR’s farewell
A seismic change is taking place in the financial world. At the instigation of the Financial Regulators, the global markets are preparing to transition away from the London Interbank Offered Rate (“LIBOR”) as the leading benchmark for short-term interest rates. This transformation has widespread implications across the global financial spectrum.
In this bulletin we summarise the background, timetable and immediate milestones around the transition away from LIBOR, what this means for corporates and other market participants, and what action they need to take to prepare for life after LIBOR.
What is LIBOR?
Since its inception in 1986, LIBOR has become the world’s most widely-used benchmark for short-term interest rates. Around US $350 trillion in financial products are tied to LIBOR, which serves as the primary indicator for the average interest rate at which leading banks may obtain short-term loans in the London interbank market. LIBOR is quoted in five major currencies: U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF).
Where is LIBOR used?
LIBOR is used in all manner of financial products, ranging from bilateral and syndicated loan facilities, bonds, hedging and derivative products, private placements and securitisations. It is also widely applied in other areas, including calculation of pension liabilities, discount rates applied to valuations, commercial contracts such as joint venture and project agreements, business purchase agreements, leasing and servicing contracts, intra-group loans and accounting and reporting disclosures in financial statements.
What is happening to LIBOR?
LIBOR’s days are numbered: Following the “LIBOR scandal” and a consistent decline in the wholesale interbank lending market, there has been increasing regulatory pressure towards a transition away from LIBOR to alternative reference rates. In July 2017, Andrew Bailey, the head of the UK Financial Conduct Authority (“FCA”) declared that the FCA would not compel or encourage banks to submit rates for the calculation of LIBOR after 2021. Further, he did not discount an earlier decline in the use of LIBOR.
Since then, the Bank of England and FCA have initiated an accelerated process to transition all financial products away from LIBOR and have set up task forces involving financial market stakeholders and professionals to expedite the process and to establish methodologies and processes for this purpose.
As a result, it is expected that LIBOR will cease to exist by the end of 2021, and critical milestones have been set for 2020 to achieve this. For example, the Regulators have encouraged the transition away from LIBOR of all sterling interest rate swaps from March 2020, and expressed the intent that new loans and other cash products issued after Q3 2020 which mature after 2021 will not reference LIBOR. All users of LIBOR need to prepare for this.
What will replace LIBOR? “Risk-free rates”
In response to the Regulators’ concerns, working groups were initially established in each jurisdiction for the affected LIBOR currencies, and each working group recommended a so-called “risk-free rate” (“RFR”) as its proposed alternative benchmark interest rate for LIBOR. In the case of sterling, the preferred risk-free rate is the Sterling Overnight Index Average (“SONIA”) which is proposed to be the primary interest rate in the sterling markets. STERLING OVERNIGHT INDEX AVERAGE was first launched in 1997 and is widely used in the derivatives market. Since April 2018 it has been administered and published by the Bank of England. It is an unsecured overnight rate based on eligible transactions reported to the Bank of England in the sterling money markets. It is considered to be a more robust interest rate benchmark than LIBOR because it is grounded in an active, liquid underlying market. However, STERLING OVERNIGHT INDEX AVERAGE and the other RFRs, which are backward-looking overnight rates, are not a “like-for-like” replacement for LIBOR (which is of course a
forward-looking “term rate”) and transitioning from LIBOR to RFRs is by no means straightforward.
How do RFRs differ from LIBOR and what does this mean for corporates?
RFRs operate very differently to LIBOR. In particular:-
- LIBOR is a forward-looking benchmark which is fixed in advance for a set interest period. This helps a borrower to manage its cashflow as it knows the rate with certainty at the start of the interest period. In contrast, RFRs are backward-looking overnight rates which are calculated daily and published the following business day at specified local times relevant to their currency jurisdiction. Therefore, in simple terms, the interest calculation using RFRs will only be known at the end of each interest period by way of averaging (or, more likely, compounding) each overnight daily rate, and this will clearly impact cashflow management. Although methodologies are being developed to provide a slightly earlier notification of the interest payment amount (typically five Business Days’ notice), for certain borrowers STERLING OVERNIGHT INDEX AVERAGE compounded in arrears may not provide the necessary advance cashflow certainty, and for those borrowers an alternative rate (whether aligned to the Bank of England Base Rate, a fixed rate or a potential “term” STERLING OVERNIGHT INDEX AVERAGE rate) may need to be agreed.
- LIBOR (as a forward-looking rate) factors in a premium for “counterparty credit risk” as well as a “term” premium based on the length of the interest period. RFRs have no built-in credit risk or term premia because they are based on actual lending overnight in the wholesale markets, which is nearly risk-free. This means that RFRs are typically lower than LIBOR and methodologies must be established to “equalise” the economic effect as between counterparties switching existing (“legacy”) contracts from LIBOR to SONIA, by way of a “credit adjustment spread”.
Action Points for Corporates
In relation to existing contracts, transitioning from LIBOR will require amendments to all legacy loans, bonds, hedging, derivatives, commercial and corporate documentation currently referencing LIBOR. In addition, financial counterparties will need to ensure their treasury and back office systems are compatible with the application of compounded STERLING OVERNIGHT INDEX AVERAGEor other alternative rates. While the more commoditised derivatives market can adopt amending protocols under ISDA, the loan and other cash markets require amendment to each individual contract.
Given the breadth of the application of LIBOR and the accelerated milestones intended to significantly reduce the stock of LIBOR-based transactions this year, it is critical that corporates monitor developments, understand how RFRs differ from LIBOR and prepare themselves for the transition. Corporates must therefore:
- Establish where their LIBOR exposures are across all affected currencies.
- Check the terms of contracts which refer to LIBOR . Do they mature after the end of 2021? Do they provide “fallback” provisions setting out what will happen if LIBOR is not available?
- Understand RFRs and what these mean for their business and systems.
- Carry out an impact assessment of existing accounting hedges to gauge potential exposure on transition from LIBOR.
- Consider alternative reference rates (such as a fixed rate, Bank of England Base Rate or potential “term” STERLING OVERNIGHT INDEX AVERAGE rate) compatible with cashflow and calculation needs.
- Where amendments are being made for other reasons to existing contracts, consider including provisions which would make future benchmark-related amendments easier
- Engage with lenders and financial counterparties, professional advisers, regulators and industry groups in order to monitor developments and influence the outcome relevant to their contracts.
How Wedlake Bell can help
Wedlake Bell’s Banking Team is closely monitoring market developments in this area and we have been participating in the Bank of England’s Task Force focusing on transition away from LIBOR for existing cash market contracts. We are actively advising clients on this area across the banking and corporate market spectrum and we would be very pleased to provide guidance, advice or information on the status and implications for transition away from LIBOR insofar as it affects market participants, and how they should best prepare for the cessation of Libor.