In a speech late last week, Andrew Bailey, the Head of the FCA announced that Libor, the systematically important reference rate used to document and price loans, derivatives and other financial contracts, will be phased out by the end of 2021.
Libor made headlines in the wake of the Global Financial Crisis when it emerged that traders at some banks had been colluding and manipulating these key reference rates as far back as the early 1990s. This led to cumulative fines in excess of $9b for a number of leading global banks. As Libor is the rate at which banks will lend to each other and is therefore an indication as to the health of a bank, Libor was also manipulated by some of the world’s largest banks in 2008/09 to provide a healthier perception of the credit quality of the quoting banks. In the wake of these scandals, regulatory oversight of the Libor benchmark was increased with responsibility moving from the BBA to the FCA. However, in his speech, Mr. Bailey also highlighted an additional issue with Libor- the fact that the market that Libor seeks to measure-unsecured interbank lending- is no longer sufficiently active. He highlighted one example where the currency-tenor combination for which a reference rate is published daily, had only 15 transactions of acceptable size in the whole of 2016. This lack of active underlying markets means that Libor is sustained by the use of “expert judgements” by the panel of banks to form many of their submissions. For regulators and market participants, this raised a serious question about the use of a Libor reference rate that is subjective and a less useful benchmark that it used to be. The clear preference is to have the reference rate that underpins over $350b of contracts to be based on objective transactions rather than subjective quotes.
To ensure a smooth transition to a new benchmark, the FCA decided on a replacement date of the end of 2021; the belief being that this date is far enough away to reduce the risks and costs of a more sudden change but close enough to ensure that serious work on transitioning to a new, more relevant, benchmark will begin. By the end of this period, it is believed that it will no longer be necessary for the FCA to persuade or compel banks to submit rates to Libor, as is currently the case.
As the panel of banks will continue to submit rates during the transition period, there should be minimal impact on companies or individuals with loan or derivative contracts that expire before the end of 2021. However, longer dated legacy contracts should be immediately reviewed for terminology that addresses or contemplates a replacement to Libor or a situation where Libor is unavailable. LMA loan facility agreements do currently include fall-back provisions if published Libor is unavailable but they are only designed to be used temporarily. There are no provisions for a situation where Libor is permanently replaced. For new contracts, we recommend that you proactively address these changes and, in conjunction with your advisers, like Clear Treasury, draw up contracts that amend the definition of Libor or allow for alternative reference rates.
How the transition to the new benchmark is managed and the form it takes has the potential to be highly disruptive for financial markets. A new benchmark that results in a reference rate that consistently prints higher or lower than the legacy Libor rate could have serious repercussions for the valuation of legacy derivatives. A step change in the value of these transactions is feasible in this scenario and could materially impact key financial numbers. It may also lead to some tough negotiations with funders if the new benchmark adversely impacts the return on the loan for your funding partners.
At this stage, detail on the transition is relatively light but the FCA is already working with the industry to promote the use of alternative benchmarks based on actual transaction data, such as the Sterling Overnight Index Average (SONIA) rate, which was selected by the Risk Free Rate Working Group as its preferred benchmark earlier this year. The Bank of England has published a white paper on the adoption of SONIA as the primary benchmark for sterling market. Feedback closes on 29 September after which a working group is expected to publish a summary. However, as SONIA is only an overnight rate, some adjustment to the rate to reflect bank credit risk and a view on central bank policy will need to be factored in. Feel free to get in touch with us directly at Clear Treasury to ensure that you are kept fully updated with updates from the regulators, ISDA, LMA and the market as we move to a replacement for Libor.