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August 11, 2017

The End of LIBOR? A Q&A of the Central Issues


The London Interbank Offered Rate (LIBOR), is a fundamental reference rate in numerous contracts, both in the financial markets and in commercial contracts. Interest rate swaps, syndicated loans, certain bond rates, and even domestic residential mortgages are frequently pegged to LIBOR, and yet it currently seems under attack. Undermined by a raft of litigation and regulatory fines in relation to its alleged manipulation, the rate has become largely based on judgment due to lack of real transaction data. On 20th July this year, the US Alternative Reference Rates Committee (ARCC) announced that it had identified a broad Treasuries repo financing rate as its preferred alternative reference rate to LIBOR. A week later, on 27th July, Andrew Bailey, the chief executive of the UK's Financial Conduct Authority (FCA) gave a speech in which he questioned the sustainability of the London Interbank Offered Rate (LIBOR).

This Advisory explores the reasons why this decision on LIBOR has been made and the future of an alternative interest rate benchmark.

Why is LIBOR under threat

LIBOR was introduced by the British Bankers' Association in the 1980s as a means of ensuring uniformity of settlement rates across a new breed of financial markets instruments which were developing at the time. It was also a time when there was a significant volume of interbank lending, a market which has seen a massive drop in volumes since the global financial crisis. Consequently, LIBOR has become a largely hypothetical rate since it is often based on judgment rather than real transaction data. In addition, the number of parties submitting LIBOR rates has diminished, causing a reduction in the liquidity of LIBOR.

Even more damage has been done to LIBOR's reputation as a result of certain financial institutions having been found to have been manipulating the rate (with manipulation obviously being much easier when that rate is largely based on judgment rather than hard transaction data). The subsequent global investigations by regulators and criminal investigators into the fraudulent manipulation of the rate, and the ensuing litigation and regulatory fines at the multiple million dollar level, have been widely publicised and hugely damaging to LIBOR's standing.

So is the end of LIBOR imminent?

Not at all. In his speech, Andrew Bailey said that the FCA had agreed with the LIBOR panel banks to continue submitting LIBOR until the end of 2021, so we have four years to go before the banks are allowed to cease providing a LIBOR rate. Steps have already been taken to strengthen LIBOR, including a new governance process. The ARCC's focus has really been on the derivatives market rather than the loan market. So we will continue to see LIBOR in the loan and bond markets for some time to come.

What will replace LIBOR as a reference rate?

There is no single obvious successor to LIBOR as a global reference rate. As we have discussed above, the ARCC has focused on the broad Treasuries repo financing rate, which is the rate of overnight loans having US government debt as their underlying collateral. The Treasuries repo financing rate is calculated on the basis of real transaction data drawn from a large volume of deals in a large and liquid market. However, it is not a complete substitute for LIBOR, because while LIBOR represents the rate at which banks are willing to lend to each other on an unsecured basis for a fixed, medium term period of time, the Treasuries repo refinancing rate represents the cost of secured financing at an overnight rate. Other suggested successor rates include, in the US, the Prime rate and the federal funds rate; while in the UK there has been a focus on SONIA (Sterling Over Night Index Average), which is the weighted average rate of all unsecured overnight sterling transactions brokered in London by the Wholesale Markets Brokers' Association member banks. Again, SONIA is based on real transaction data, and has the advantage of being an unsecured lending rate, but it is also an overnight rate rather than a term rate.

It may well be the case that different markets adopt different reference rates, so that there is no single global successor to LIBOR. And indeed while the derivatives markets seem to be leaning towards the Treasuries repo financing rate, it is difficult to see that, for example, a UK residential mortgage lender will wish to see its rates tied to a US treasury rate.

Why is the FCA taking four years to change LIBOR?

The FCA's intention in committing to require the panel banks to calculate LIBOR for another four years is to allow an orderly transition in the market. The phasing out of LIBOR is a long term project, and it will be critical to both the banks and the regulators to minimise any market disruption during the process. It is also a process at which we are really only at the very beginning, so there are many unknowns: What might a successor rate be? How might it be implemented? What will happen with legacy arrangements? The key point though is that we are not expecting the gradual phasing out of LIBOR to have any dramatic or market disruptive impact on the markets.

What does that mean for the LIBOR interest rate in my documentation?

The FCA has committed to require panel banks to submit LIBOR until the end of 2021, so there will be a LIBOR calculation available until then. After that, how LIBOR is calculated will be a function of the definitions in the underlying documentation, and what (if anything) those definitions say about the fallback position when LIBOR cannot be calculated. Accordingly, in preparation for 2021, it is important to consider a thorough contract review and to assess whether the existing fallback LIBOR definitions are appropriate and whether any revisions are required to those provisions going forwards now that we know that LIBOR may be being phased out.

© 2017 Arnold & Porter Kaye Scholer LLP. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.