All good things must end sometime and so the same would appear to be true of LIBOR. On 27 July, the Chief Executive of the UK’s Financial Conduct Authority (“FCA”), Andrew Bailey, delivered a speech on the future of LIBOR and announced plans to identify an alternative reference rate.
LIBOR is commonly used as a basis for determining the applicable interest rate under loan agreements and other financial products. For example, a borrower will often pay floating rate interest on a loan at a specified margin above the applicable LIBOR at a particular time. However the use of LIBOR has been coloured in recent years by rate-rigging scandals and this, together with a lack of readily available market data, has prompted the FCA to commence the search for LIBOR’s replacement.
Here we consider the future of LIBOR and what might be expected to replace it.
- What is LIBOR?
LIBOR is shorthand for the London Interbank Offered Rate. It refers to the rate at which major financial institutions can borrow from each other in the London interbank market over a specified period (typically ranging from overnight periods up to one year).
Since 2013 LIBOR has been administered by ICE Benchmark Administration Limited (“IBA”). IBA requests contributions from a number panel banks. Each panel bank estimates the interest rate they would be charged to borrow money from another bank for a particular period. The average of those rates is then compiled and published daily to produce the applicable benchmark rate at such time.
LIBOR has proven a popular interest rate index for many financial arrangements because it is regularly maintained and updated and there are benchmark rates for several different loan periods.
- So why the change?
Two reasons principally. Firstly, there have been the recent LIBOR rate rigging scandals which have prompted a number of lawsuits (although the FCA has been quick to praise reforms made to improve the governance of LIBOR and to point out that it has no reason to suspect further wrongdoing). Secondly, and perhaps more crucially, the FCA has identified that the market for unsecured wholesale bank borrowing is no longer sufficiently active, with the result that panel banks have relatively little actual data to base their rate submissions on.
- What’s on the horizon?
Nothing immediate it seems. In an attempt to lessen market disruption, the FCA has made clear that any transition away from LIBOR will take time. It has therefore indicated that LIBOR will be sustained until the end of 2021.
What happens after 2021 is up for debate. The intention is that at this time the FCA would no longer require banks to submit to LIBOR, although there is a possibility that LIBOR might continue to be produced even after 2021 (this would be up to IBA and the panel banks). In practice the expectation is that the market will have planned for a transition to an alternative reference rate well before then.
One possibility is that SONIA (the Sterling Overnight Index Average, administered by the Bank of England) might prove to be a popular alternative reference rate. Alternative rates could also be provided by, for example, the U.S. Federal Reserve or the Securities Industry and Financial Markets Association.
- What are the immediate implications?
Fixed rate financial products will of course be unaffected by these changes. We would also expect that loan agreements which use LIBOR but which mature before 2021 will be unaffected.
For new loan agreements which extend beyond 2021, provisions should be included which enable a lender to set the relevant interest rate by reference to a different interest rate measure where LIBOR is no longer available. Fallback provisions of this kind are already included in LMA based loan documentation. Interest rate swaps and other financial products which use LIBOR may also have to be re-visited to the extent the underlying arrangements continue beyond 2021.
More will undoubtedly become clear over the following months.
To read more about the FCA’s announcement in relation to the above, please see this link: https://www.fca.org.uk/news/speeches/the-future-of-libor
Please get in touch if you would like to explore any of the above more fully with us.
Matthew Padian