February 2020 Issue
The rigging of the London Interbank Offered Rate (LIBOR) was a turning point for the financial services sector. The LIBOR scandal saw $10bn of fines handed down and heralded the end of interbank lending as the industry knew it. In its wake, both regulators and banks have begun to demand reference rates that are based on observed market prices rather than ‘expert judgement’.
Accordingly, efforts have begun to pivot away from LIBOR toward newer rates. In 2017, the UK’s Financial Conduct Authority (FCA) announced that from 2021 onward it would no longer pressure banks to contribute rates to the LIBOR, a move which will placate nervous regulators and bankers, though it will have significant implications across the financial services sector and could pose a risk to global financial stability.
LIBOR, the global benchmark interest rate which represents the amount that banks pay to borrow unsecured from each other, underpins around $260 trillion of loans and derivatives, from variable-rate mortgages to interest-rate swaps, according to consulting firm Oliver Wyman. Dollar LIBOR accounts for around $200 trillion, sterling and yen around $30 trillion each and Swiss francs around $5 trillion.
Risks to financial stability
The end of LIBOR poses two significant risks. First, there are trillions of dollars worth of financial contracts based on LIBOR. Once the rate has been discontinued, they must instead be tied to a new benchmark rate, which could have serious consequences. These new contracts should have ‘fallback’ clauses which specify what happens when LIBOR is discontinued. And contracts contingent on LIBOR have continued to be written, many of them extending beyond 2021, which creates additional challenges. ‘Fallback’ provisions in each contract will then determine what happens. However, many of these provisions were designed to cover a temporary unavailability of LIBOR, not its discontinuation and replacement. These provisions also often change the economics of the product, for example effectively converting floating-rate products into fixed-rate products. As a result, one of the counterparties to a LIBOR contract may suffer material losses while the other receives windfall gains, creating an unacceptable situation.
Banks must also assign responsibility internally for the transition and form a committee with senior management oversight. They must review existing contracts to identify exposure to LIBOR and any fallback provisions, mitigate any other potential consequences and educate internal stakeholders to ensure all relevant business implications are dealt with appropriately and in a timely manner. They should also keep abreast of market and regulatory developments.
“Every existing contract that references LIBOR will be impacted by the transition,” notes Charles Yi, a partner at Arnold & Porter. “The impact of the change will depend on the type of contract – for instance, floating-rate notes and securitisations will have certain challenges, like the difficulty with obtaining 100 percent noteholder consent for modification, whereas consumer contracts will face a different set of challenges, including heightened litigation risk.”
“In the loan market, every contract, based on the Loan Market Association (LMA) recommended form, will need amending to give effect to the new rates,” says Jeremy Duffy, a partner at White & Case. “For legacy contracts, discussions will also be needed on whether a spread adjustment is required to bridge the gap between LIBOR and the risk-free rates, which should not be necessary for new contracts, where this can be considered in the initial pricing of the loan. There are concerns that certain documents cannot be amended, because of consent thresholds or otherwise, which risk being frustrated without appropriate fallbacks. The FCA has alluded to the use of a synthetic LIBOR rate in those cases.”
“Though the publication of LIBOR rates will not necessarily end in 2021, various regulatory bodies globally will be throwing their weight behind different rates.”
The second risk relates to the challenges faced once LIBOR has disappeared and the new reference rates are adopted globally, which could cause banks’ assets and liabilities to become disconnected. It is possible that, unlike LIBOR which protects banks against sudden moves in their own borrowing costs, the newly adopted alternatives may not offer the same failsafe. Indeed, it is not simply a case of replacing one rate with another, as there are significant structural differences between LIBOR and Sterling Over Night Index Average (SONIA), for example. The introduction of SONIA could substantially alter expected cash flows and the way they behave as interest rates change. It is vital, therefore, that products are analysed to determine which rate should be used or whether a new rate should be developed for specific product needs.
Opportunities
Though ending LIBOR carries risk, there are also positives. The transition has been welcomed by many in the financial services space, particularly due to the ease with which LIBOR can be manipulated, as demonstrated by the rigging scandal of 2012.
Since the financial crisis and the raft of new regulatory and legislative developments in the financial services sector, the interbank market is no longer as important to the global economy. New banking rules across several jurisdictions have encouraged banks to use other forms of borrowing, meaning fewer transactions rely on an interbank rate.
Following the LIBOR scandal, the Wheatley Review suggested benchmark reforms to prevent a repeat of such incidents. One of the reports’ leading recommendations was that panel bank submissions should be based on transactional data. “In recommending the phase-out of LIBOR, the FCA highlighted that, given the inactivity in the interbank market, panel banks were actually providing rate submissions based on judgement rather than transactional data,” says Mr Duffy. “Interestingly, the Wheatley Review had recommended reform rather than replacement of LIBOR, on the basis that a transition to a new benchmark would pose an unacceptably high risk of financial instability. It is therefore not surprising that the uncertainty around the discontinuation, among other reasons, has made the loan market slow to transition across to alternatives.”
The phasing out of LIBOR has driven the creation of alternative risk-free rates being set up for different currencies globally. In the US, the Federal Reserve System’s Alternative Reference Rates Committee (ARRC) has recommended using the Secured Overnight Financing Rate (SOFR). In the UK, SONIA will be used, though it is a very different benchmark both to LIBOR and other risk-free rates being identified in other jurisdictions. The Euro Short-Term Rate (€STR) will be used for the euro.
The end of LIBOR has been a long time coming, and thus far the process has been relatively successful, according to Andrew Bailey, chief executive of the FCA, who says that good progress has been made across derivatives and the securities markets. Though the publication of LIBOR rates will not necessarily end in 2021, various regulatory bodies globally will be throwing their weight behind different rates.
The levels of preparedness for the end of LIBOR varies from jurisdiction to jurisdiction, however. For example, banks using SONIA and SOFR have made significant progress compared to others. “Looking specifically at the loan market, while there have been instances of the use of SONIA for bilateral loans, as of yet we have not seen its use in syndicated loans,” says Mr Duffy. “This is most likely as a result of the market waiting for a term rate. Given the launch of a term rate is unlikely to be imminent, the LMA recently published exposure drafts of documentation based on a compounded average of SONIA, calculated in arears. Presently, the LMA is seeking market responses on the drafts.”
Despite the progress made so far, the transition away from LIBOR will not be simple. There are a number of differences between LIBOR and SOFR, for example. “LIBOR is essentially the rate at which the panel banks estimate they could borrow from other banks, whereas SOFR is based on US Treasury repo transactions,” says Mr Yi. “LIBOR reflects, according to Fed estimates, a handful of transactions totalling about $500m a day, whereas SOFR is based on about $1 trillion in transactions per day. LIBOR is unsecured whereas SOFR is secured. LIBOR has forward-looking tenors available, whereas forward-looking tenors do not yet exist for SOFR.
“Also, LIBOR has a credit risk premium component, whereas SOFR is a risk-free benchmark,” he continues. “A ‘credit spread adjustment’ may be necessary in a transition from LIBOR to SOFR. LIBOR considers credit risk whereas SOFR does not. During economic downturns, banks’ cost of funds could increase, whereas SOFR and return on SOFR-linked loans may decrease or not increase as much. Some of the potential consequences of this mismatch could include reduction in credit availability and pressure on bank liquidity.”
Improvements required
While contracts must be revamped, there are a number of other areas in which banks need to make improvements. The FCA announced in 2017 that LIBOR would end, so institutions have been given plenty of notice and advice on getting ready. Thankfully, many banks have heeded the call to prepare now for the transition.
“In the US, some firms, especially the bigger ones and the ones that sit on the ARRC, are quite advanced in terms of their planning and preparation for the end of LIBOR, although many questions and issues remain,” says Mr Yi. “On the other hand, many of the smallest firms have not done quite as much work and some are just starting to think about it. Firms should also institute an internal governance process to monitor and manage the transition. Some firms have created working groups and steering committees with reporting lines ultimately to the board of directors. Some of the smaller firms have more streamlined processes.”
There is undoubtedly a concern that too many within the banking industry are failing to take the deadline seriously, however. Going forward, there is a lot of work to be done. As the SEC noted in its statement, “For many market participants, waiting until all open questions have been answered to begin this important work likely could prove to be too late to accomplish the challenging task required.”
If LIBOR continues in some form beyond the end of 2021, there will be ongoing risk that the benchmark might fail the FCA’s representativeness test, for example, if one or more contributing banks leave the panel. In the event that LIBOR becomes unrepresentative, it would be an “irreversible step towards the end of panel bank LIBOR”, according to Edwin Schooling Latter, director of markets and wholesale policy at the FCA.
The transition from LIBOR will be an unprecedented event which will require extraordinary coordination and cooperation across institutions, markets and jurisdictions. It will bring substantial conduct, reputational and legal risks. Accordingly, preparation should already be well underway across the financial services sector.
© Financier Worldwide
BY
Richard Summerfield