In essence, LIBOR is the benchmark rate, published each morning, at which some of the largest banks lend short-term to each other and is set by a self-regulating panel of 20 the world’s largest banks. On the basis of this benchmark, individual banks then price their floating rate products, by charging an amount over LIBOR. Notwithstanding its importance, LIBOR has come under pressure following a speech at Bloomberg’s London headquarters by the CEO of the UK’s Financial Conduct Authority (FCA), Andrew Bailey, on 27 July 2017, wherein Bailey heralded its potential demise and revealed that LIBOR will probably be phased out by 2021. In his speech, Bailey said that LIBOR was unable to fulfill its objective of capturing the cost at which banks borrow from each other since this activity has fallen sharply since the 2008 financial crisis. In short, Bailey noted that “it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them”, since “the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active”.
The phasing out of LIBOR will pose a headache to professionals across the board, especially those dealing with international markets, not least since it will be difficult for transactions to sensibly specify the use of a future alternative reference rate which does not yet exist, thereby making the endeavour of choosing the appropriate reference rate a blind shot. For the near future, transactions will therefore necessarily continue to be based on LIBOR as documentation can only be adapted when a suitable alternative(s) has been identified and agreed to. To this end, in order to pre-empt future changes and amendments to current documentation, it has been suggested that, to the extent allowable by law, in the context of multi-creditor transactions such as syndicated lending or bonds, the provisions dealing with interest rates be worded in a suitably flexible manner so as to facilitate any subsequent future amendment to interest rate determinations as a result of the discontinuation of LIBOR. This flexibility can be achieved by, for example, requiring a lower creditor consent threshold and referring to majority lenders instead of all lenders in the context of lending documentation for syndicated loans having a syndicate of banks acting as lenders and one borrower; and setting a lower threshold for change at a bondholder meeting, rather than a high threshold in the context of bonds or other securities. Even though this flexibility may help to ease the transitional process in the future, it is not an all encompassing solution since other important logistical matters will need to be considered, such as ensuring that borrowers agree to the amendments to the lending documentation together with the majority lenders in syndicated loan transactions. Moreover, in the context of securitisations and in connection with the foregoing, issuers and their advisors will need to ensure that issuers are not left with unhedged mismatches between the asset basis, bond interest basis and other related derivatives following the amendment of transaction documentation to cater for the discontinuation of LIBOR. Accordingly, any amendment to matched LIBOR based floating rates in the transaction documentation of the underlying assets will also require an amendment to the documentation of the issued securities so as to ensure that both issuers and investors are adequately protected.
With a view to plugging the hole that will eventually be created by the discontinuation of LIBOR, the UK authorities, specifically the Risk Free Rate Working Group, has selected a reformed version of the Sterling Overnight Index Average (SONIA), a benchmark introduced in 1997, as a potential replacement for LIBOR. Reformed SONIA, as it is being referred to, will be overseen by the Bank of England (BoE), and the BoE will publish a rate at 9am each morning after collecting information on unsecured overnight lending transactions between banks for sums in excess of £25 million. It is important to note that LIBOR is denominated in five different currencies, namely the Swiss Franc, Euro, Pound Sterling, Japanese Yen and US Dollar (USD LIBOR). In this regard, the authorities in the US have also identified a suitable replacement for USD LIBOR, in fact the US choice of interest rate determination is a broad Treasury repo rate based on market transactions, to be published daily by the Federal Reserve Bank of New York, starting from next year. Unlike the situation for USD LIBOR, where a separate benchmark has been earmarked as a replacement, the other currencies in which LIBOR is denominated will, in all probability, not all have a separate benchmark to replace LIBOR but will be based on a single LIBOR replacement, which, as stated, will probably be SONIA.
Perhaps the main event that triggered the move away from LIBOR was a scandal that broke out in 2008, in the thick of the financial crisis, where some banks were accused of fixing LIBOR in order to save their skin. Although the scandal lead to the imposition of hefty fines, LIBOR’s inherent weakness, of being too subjective, had to be reconsidered, which reconsideration ultimately lead the FCA to impose a deadline on the use of LIBOR. The rationale for the move away from LIBOR was succinctly put by Bailey when he noted that the FCA intends on arriving at a point where “interest rate benchmarks … are based on transactions, not on judgements” with the ultimate purpose of creating fairer markets. Although the vision is noble and one that nobody can argue with, it still has to be seen whether the path leading toward the intended destination has been properly planned or whether it will be made up as we go along – whatever it is, all market participants would be well advised to keep an eye out for future developments in the area since the stakes at risk are high and the potential chaos that may ensue from a badly planned transition will lead to unnecessary costs and worries.
This article was published in the Times of Malta, 21 November 2017.