Invented in 1969, by a Greek employee of the London branch of a New York bank named after a German town, in order to price an $80m loan to the then Shah of Iran, the London Interbank Offered Rate (“LIBOR”) has become the “world’s most important number”.
LIBOR is in effect an average of the cost of funds to large global banks operating in London's financial markets or with London-based counterparties.
The majority of the world’s bonds, loans, derivatives and hedging are currently priced by reference to that rate (or a derivative of it).
That number controls the price of circa 350 trillion dollars’ worth of financial instruments today, but it is about to stop existing...
The UK Financial Conduct Authority (the “FCA”) has confirmed that LIBOR will be discontinued by the end of 2021.
More specifically, the FCA has confirmed that it will stop requiring banks to submit the daily rates that are used to calculate LIBOR – in effect killing it as a viable index.
The Problem with LIBOR
It turns out that LIBOR was susceptible to being illicitly manipulated.
The FCA in fact only took over the administration of LIBOR from the British Banking Association in 2014, following the revelation of a series of scandals involving banks “fixing” the rate – this series of scandals also resulted in circa $10bn worth of fines being handed out to those banks.
A more fundamental issue with LIBOR is that in response to a number of the regulatory reforms introduced since the 2008 financial crisis, there has been a significant reduction in the number of interbank short-term loans being made.
The net result being that LIBOR is increasingly reflecting a theoretical rate, rather than the cost of actual trades.
The NY Fed recently estimated only 2 or 3 transactions a day were qualifying to underpin the 6-month LIBOR rate (rather than the dozens, per bank, that it should be based on).
In some markets (though not all) regulatory authorities and ISDA have been actively planning for transition.
These plans have focused on 3 main elements:
- Strengthening those IBORs that will continue post LIBOR (particularly by imposing greater controls and anchoring them to more transactions);
- Identifying alternative “near-risk free rates” (“RFRs”) to be used instead of LIBOR; and
- Improving “contract robustness” to address the risk of discontinuation of any widely used interest rate benchmarks.
Generally, and with regard to LIBOR in particular, the key focus of these efforts has been to prepare market participants for, and actively push them towards, the adoption of RFRs.
For example, since April 2018:
- the Federal Reserve Board has been publishing the Secured Overnight Financing Rate (“SOFR”) as the RFR for the USD; and
- the Bank of England has been publishing the Sterling Overnight Index Average (SONIA) as the RFR for the GBP.
The Can of Worms
Notwithstanding the initiatives in relation to RFRs listed above, there is at present no market consensus as to what will be the replacement rate for LIBOR.
In the interim, there are thousands if not millions of finance documents with maturity dates extending beyond 2021 that refer to LIBOR as the benchmark rate.
As regulators have noted, even now new contracts referencing LIBOR continue to be created.
The foremost challenge for many parties is to deal with the impact of the discontinuation of LIBOR on existing finance documents.
See the table for a snapshot of the other challenges that could potentially be unleashed by LIBOR discontinuation.
Challenges from a documentation perspective include identifying the following:
- whether LIBOR is in fact the benchmark interest rate;
- what are the fallback provisions that apply if LIBOR is discontinued; and/or
- what are the consent provisions governing amendments to the LIBOR provisions?
Getting Consensus on Amendments
The amendment provisions of finance documents will have to be carefully navigated around. The interest rate environment applicable at the time may well disincentivize parties from proposing or agreeing to such changes.
Changes to the terms and conditions of a bond could be exceptionally problematic as they typically require bondholder consent by way of a bondholder meeting.
This process is neither quick nor easy. Formal notice periods and (often) high consent/quorum thresholds are needed to amend terms relating to interest.
In addition, there is the ever-present problem of bondholders who are “asleep” or who choose to “holdout”.
With LIBOR discontinuing, the fallbacks applicable to swaps and bonds may operate differently or may be triggered at different times.
This may result in mismatches on payments, impact expected ROI and affect balance sheets that lose the protections they had expected.
Increased Litigation Risk
Any switch from floating to fixed rates that result in investor losses may expose issuers / arranging bank(s) to litigation risk.
Even if LIBOR is replaced by an alternative floating rate, to the extent that the switch results in a reduction of expected economic benefits since the timing of signing of the documents, the chance of litigation could increase.
Certain market participants have regulatory obligations, e.g. paying due regard to the needs of their clients and communicating information in a way that is clear, fair and not misleading.
These principles will continue to be relevant in the context of introducing new fallback provisions and factoring the lender’s financial position while making any changes to the instrument’s pay-out obligations.
The (Practical) Solutions
Whilst the mathematics behind the new RFRs may be complex, addressing the legal issues involved is not.
At GLS, we believe that simple, scalable, low cost and efficient process planning can help to navigate any documentation issue, however big or small.
We also believe that an issue of this scale is a perfect opportunity to harness technologies such as A.I. and automation to achieve cost and process efficiencies.
Note 1: this is not to say that some contracts will not be problematic. E.g. the contract may not have an automatic fall-back provision AND your counterparty may refuse your preferred RFR.
Note 2: what we are saying is that applying efficient process design and technology to clear your “average contracts” can free up the time and budget capacity needed to properly address those difficult cases.
So in practice a work-plan for this process would look something like:
The Call to Action
In the context of the LIBOR transition optimising the project design and implementation is now a must.
Here are 2 ways GLS can help you:
- Contact Matt Glynn or Nicholas Brocklebank who will talk you through both the A.I. and low-tech solutions for you and design a truly efficient work-plan for you to implement; or
- Book a 30min consult with Pooja Sinha or Rina Lee from GLS's Finance Team who will help you assess the impact of the end of LIBOR on your legal documents.