The Demise of LIBOR
- The reform of major interest benchmark rates commenced some time ago with the Financial Stability Board (FSB) undertaking a fundamental review of major interest rate benchmarks at the request of the G20. The FSB published its "Reforming Major Interest Rate Benchmarks" report in July 2014.
- In July 2017, the UK FCA announced that LIBOR would not be supported after the end of 2021 and panel banks would no longer be compelled to submit rates after that time.
- The FCA announcement was brought about by LIBOR-rigging scandals and an insufficient volume of transactions in the unsecured wholesale bank borrowing market.
- LIBOR will therefore continue until the end of 2021 (although continuing submissions to LIBOR are possible after the conclusion of 2021).
- LIBOR is still evolving under the administration of ICE Benchmark Administration Limited (IBA). IBA published a "Roadmap for ICE LIBOR" in 2016 and more recently introduced the waterfall methodology, which both aim to make LIBOR calculation more transparent and more indicative of the rate offered for interbank deposits.
The Process of Replacing LIBOR
- The FCA has made it clear that market participants must take primary responsibility for the development of, and transition to, an alternative benchmark rate.
- Working groups and committees have been established to identify and develop alternative rates to LIBOR around the globe. By way of example:
- In the United States, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC) in 2014. In 2017 ARRC selected the Secured Overnight Financing Rate (SOFR) as its preferred alternative to U.S. dollar LIBOR.
- In the UK, Working Group on Sterling Risk-Free Rates was established in 2015 to implement the FSB's recommendation to develop alternative risk-free rates (RFRs) for use instead of LIBOR-style reference rates. In April 2017, the Working Group recommended the Sterling Overnight Interbank Average Rate (SONIA) benchmark as their preferred risk-free-rate (RFR).
- In the eurozone, the European Central Bank (ECB), the Financial Services and Markets Authority (FSMA), the European Securities and Markets authority (ESMA) and the European Commission established a working group in September 2017. The Working Group recommended the euro short-term rate (ESTER) as the euro overnight risk-free rate.
- Internationally, a handful of private groups have put together reference rates. Foremost, the Intercontinental Exchange (ICE), the current administrator of LIBOR, has recommended a replacement to USD LIBOR based on primary market funding transactions (e.g., inter-bank deposits, institutional certificates of deposit and commercial paper) and secondary market bond transactions, calling it the “Bank Yield Index.”
The Main Issues in Replacing LIBOR
Many issues arise when considering the transition from LIBOR to an alternative benchmark RFR. These include:
- The methodologies for determining the RFR in different markets is not always the same. For example, SOFR is an overnight borrowing rate which is collateralized by U.S. treasury securities; SONIA is an unsecured rate.
- The methodologies for RFRs continue to be developed and are subject to further change.
- LIBOR is a forward-looking rate (being quoted for different tenors: overnight, one week, one month, two months, three months, six months and twelve months). RFRs are calculated as an overnight borrowing cost on a T+1 basis.
- LIBOR includes an element of bank credit risk whereas RFRs typically do not. RFRs are therefore generally lower than LIBOR. This pricing differential cannot be made up by merely increasing the margin on a given loan (as the credit risk of the borrower has not increased) or by adding a premium to the RFR, and this pricing differential presents a risk to the returns of lenders.
- RFRs are published at different times around the globe according to the time zone of the particular market. By contrast, LIBOR is published at 11:00 am in London across five currencies.
- The implementation of RFRs cannot be undertaken by different markets around the globe in isolation; implementation needs to be considered in tandem across all financial products in all markets.
- A host of contractual and operational issues will arise from the cessation of LIBOR, the most onerous of which will likely result from amending contracts that continue after the 2021 cut-off date.
Next in the Series
In March 2019, the London Loan Market Association (LMA) published a discussion paper “Conventions for Referencing SONIA in New Contracts,” and in April 2019, the Alternative Reference Rates Committee (ARRC) published the document “A User's Guide to SOFR” which highlights progress made in the development of the U.S. dollar risk-free rate SOFR. In our next installment, we will take a deeper dive into the implementation of RFRs as replacements for LIBOR.
(For additional information on this topic, contacts the authors or Daniel Budofsky, Joseph Fastiggi, Michael Reese or Russell DaSilva.)