This guide looks at the challenges caused by transitioning way from LIBOR, the risks that arise, and the potential areas for disputes. It also considers what parties should be doing now to prepare for this historic change.
- LIBOR, the world’s most widely used benchmark interest rate, is likely to be discontinued from the end of 2021.
- LIBOR is referenced in a huge volume of financial and commercial contracts. The discontinuance of LIBOR will affect all financial institutions but also all corporate entities and consumers to a greater or lesser extent.
- LIBOR is likely to be replaced with a “risk free rate” (in the UK, the Sterling Overnight Index Average – “SONIA”).
- LIBOR and risk free rates are not the same – there are likely to be economic “winners” and “losers” from the change.
- The biggest challenge arises in respect of “legacy contracts” i.e. those entered into before the discontinuance of LIBOR was anticipated and that are due to remain in force post discontinuation.
- In relation to “legacy contracts” the contractual counterparties need to consider if and how these will continue to operate once LIBOR is discontinued.
- Regulators are encouraging the market to take active steps now to address these issues and amend contracts where necessary as existing contractual “fall back” mechanisms may not be viable.
- In the absence of agreement, disputes may arise between contractual counterparties that could give rise to litigation on a large scale given the sheer volume of contracts referencing LIBOR.
- Regulators and key market participants are working on a series of measures aimed at mitigating the risks associated with transitioning from LIBOR. However, this remains a work in progress and it is unclear which proposals will be formally implemented prior to the end of 2021.
- It is important that all parties that are exposed to LIBOR take active steps now, and in the lead up to the end of 2021, to consider their own positions and reduce their exposure to disputes arising once LIBOR is no longer available.
What is LIBOR and how is it calculated?
LIBOR is the average interest rate at which major global banks borrow from each other. LIBOR is calculated by reference to five different currencies (USD, EUR, GBP, CHF, JPY) and by reference to seven different maturities: overnight, one week, one month, two months, three months, six months and twelve months. There are therefore 35 different LIBOR rates calculated each business day.
The process for calculating LIBOR rates involves the Intercontinental Exchange (ICE) asking a panel of major global banks how much they would charge other banks for short term loans in different currencies across different terms. The highest and lowest submissions are stripped out and an average rate is calculated from the remaining submissions.
LIBOR is published each business day. Market participants can include a particular type of LIBOR (usually plus a spread) as a benchmark interest rate in their contracts giving certainty as to how interest payments are to be calculated.
Why is LIBOR being discontinued?
LIBOR has been dogged with controversy over recent years. In 2012, the LIBOR scandal broke, uncovering evidence that certain banks had been manipulating their submissions as part of the process for calculating LIBOR with the aim of producing a LIBOR rate that would boost their own profits on financial transactions they were party to. This led to numerous regulatory investigations across the globe and very substantial regulatory fines, civil litigation, and criminal charges against certain individuals.
In the aftermath of the LIBOR scandal, regulators ensured that LIBOR submissions were no longer subject to manipulation. However, at the same time, it became clear that LIBOR was not a sustainable benchmark. Following the financial crisis of 2008, fewer panel banks were able to report actual borrowing rates and those that could were reporting fewer transactions meaning LIBOR calculations have increasingly had to rely on market and transaction data-based expert judgment rather than real data.
In 2017, Andrew Bailey of the UK FCA noted “If an active market does not exist, how can even the best run benchmark measure it?”. The FCA confirmed its intention to ensure that market participants had transitioned away from LIBOR by the end of 2021. This would give the market a period of over four years to adopt alternatives and in the interim period the FCA would require twenty panel banks to continue submitting rates to calculate LIBOR notwithstanding that certain banks felt uncomfortable in submitting rates based on judgments with limited actual borrowing activity against which to validate the figures.
Following the end of 2021, panel banks will no longer be required to make submissions for calculating LIBOR. It is likely that the FCA will (i) announce that some or all LIBOR reference rates will cease, or (ii) determine that they are no longer representative. The FCA and other global regulators are encouraging all market participants to have transitioned away from LIBOR before this happens.
What will replace LIBOR?
Work is ongoing across different jurisdiction to transition to new “risk-free rates”. In the UK the “Working Group on Sterling Risk-Free Reference Rates” (RFRWG) was set up to develop alternative rates to replace GBP LIBOR and to oversee the transition.
The RFRWG recommends the use of SONIA (“Sterling Overnight Index Average”) as the preferred alternative reference rate for sterling transactions.
Below is a summary of the approaches being taken in other jurisdictions:
|Currency ||Reference rate||Proposed alternative rate||Features||Forum|
|USD ||USD LIBOR|| SOFR (Secured Overnight Financing Rate)||Secured,|
|The Alternative Reference Rates Committee|
|EUR||EUR LIBOR Eonia||€STR (Euro Short-Term Rate)||Unsecured,|
|Working Group on Euro Risk-Free Rates|
|CHF|| CHF LIBOR||SARON (Swiss Average Rate Overnight)|| Secured,|
|The National Working Group on Swiss Franc Reference Rates|
|JPY||JPY LIBOR |
|TONAR (Tokyo Overnight Average Rate)||Unsecured,|
| Study Group on Risk-Free Reference Rates|
Is a “risk-free rate” the same as LIBOR?
There is a key difference between LIBOR and the alternative risk-free rates.
LIBOR is forward-looking by reference to estimated interest rates charged across seven different maturities (overnight to twelve months). As a result, LIBOR embeds (i) a credit premium (for the credit risk in lending) and (ii) a liquidity premium (for lending over a period of time). At each tenor, LIBOR acts as a forward-looking rate whereby the interest due at the end of an interest period is known at the beginning of that interest period. Interest periods typically match the tenor of the LIBOR rate chosen – i.e. the 3 month LIBOR rate is used for a 3 month interest period.
In contrast, SONIA is backward-looking as it is based on actual overnight interest rates for unsecured lending of over £25 million and for one business day maturity. SONIA reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. As a risk-free rate it has virtually no credit risk and includes no liquidity premium for lending over a longer term. Accordingly, SONIA tends to be lower than LIBOR as it does not include a credit or liquidity risk premium. Where SONIA is adopted as a replacement for LIBOR it will almost certainly need to be SONIA plus and agreed spread to cater for these differences.
The graph below identifies the credit and liquidity premium different between LIBOR and risk-free rates.
Source: Bank of England
What problems may arise from transitioning to alternative risk-free rates?
The challenges arising from transitioning from LIBOR to an alternative risk-free rate are best looked at in two different circumstances:
- Transitioning in relation to existing “legacy” contracts that reference LIBOR and that will remain in place post-2021.
- Including SONIA as a replacement reference rate in new contracts that might previously have referenced LIBOR.
(i) Legacy contracts
The challenges arising in respect of legacy contracts have the potential to be significant since it is likely to require amendments to existing terms in circumstances where the economic effect of such changes can create “winners” and “losers”. It is these challenges and risks that are discussed in detail in the following sections of this guide.
(ii) New contracts
In relation to new contracts that include a risk-free rate such as SONIA instead of LIBOR, there are also practical considerations.
As noted above, SONIA is an overnight rate only and it is backward-looking rather than the forward-looking LIBOR estimates for term lending (eg 3-month rates). With LIBOR, it is possible for contractual counterparties to know what interest rate will be due over a particular interest period in advance (for example, if the interest period is set at each quarter, 3-month LIBOR can be referenced and the counterparties will know at the start of each 3 month period what 3-month LIBOR is). This is beneficial to the borrower (who knows what they have to pay and can make arrangements in advance to do so) and the lender who knows what they are due to receive. When a contract references a risk-free rate such as SONIA, it is typically only possible to calculate the interest due at the end of the term as SONIA is an overnight rate calculated each day in arrears. This is impractical in (i) giving borrowers and lenders certainty as to the interest payable over the interest period and (ii) compromising a borrower’s ability to effect payment on the usual due date (as the interest payment needs to be calculated at the end of the term).
To try and address the above problems caused by using a backward-looking risk-free rate, work-arounds are being implemented. For example, it is possible to aggregate SONIA rates on a compounded basis over an interest period to give a “term” rate (e.g. 3 months). Bonds typically make use of a ‘lag’ mechanism, in which the interest observation period lags the SONIA rate reference period by 5 London banking days. This means that the final interest payment is known 5 days before it is due to be paid. This mechanism provides market participants with greater certainty of cash flows ahead of interest payment dates.
The market is working on the possibility of calculating a forward-looking SONIA term rate (similar to the forward-looking LIBOR maturities e.g. one week, one month, two months, three months, six months and twelve months). Four administrators (FTSE Russell, ICE Benchmark Administration, Refinitiv and IHS Markit) are working on this. The loan market would benefit from the development of a SONIA term rate as this is likely to be a more straightforward replacement for LIBOR than compounded SONIA. However, this remains a work in progress and there is no certainty as to when this will be developed. The FCA has been keen to stress that market participants should not delay in implementing steps required to transition from LIBOR in the hope that a SONIA term rates will be available.
WHICH MARKETS WILL BE AFFECTED
LIBOR came into widespread use in the 1980s and is now hardwired into the financial system and related commercial contracts.
There are some obvious markets that will be directly affected such as:
- Loan Market
- Derivatives Market
- Bond Market
- Securitisation Market
The table below summarises some of the key products and market participants.
Source: IBOR Global Benchmark Survey 2018 Transition Roadmap
However, the reality is that the change in LIBOR is likely to affect a huge amount of financial contracts as well as commercial contracts which might reference LIBOR in default interest clauses or other payment calculations. The ramifications of the changes are not just for financial institutions but all counterparties to contracts that reference LIBOR (including consumers).
FALL-BACK PROVISIONS IN LEGACY CONTRACTS – FIT FOR PURPOSE?
Some legacy contracts will have contractual terms that anticipate the unavailability of LIBOR and provide for fall-back mechanisms. These contractual terms will have been included to cater for the temporary unavailability of LIBOR. However, they may become relevant following the permanent cessation of LIBOR in the absence of amendments to contracts being agreed.
Some of the typical fall-back provisions that appear in standard form contracts include the following:
A typical Loan Market Association (LMA) loan agreement would include the following waterfall of fall-back options:
- Historic screen rate: the parties can calculate interest based on the last available LIBOR rate for the contractually provided currency and term.
- Reference bank rate: the facility agent is required to poll certain reference banks to prepare its own rate.
- Cost of funds calculation: the lender provides a certified cost of funding for its participation in the loan.
The derivatives market usually involves bi-lateral contracts between parties that are subject to ISDA terms. ISDA contractual fall-backs are more limited than the LMA options above. The fall-back in circumstances where LIBOR is unavailable is usually the “dealer poll” method (i.e. approaching reference banks to obtain a rate).
Bond Market & Securitisation Market
Contracts used in the bond markets and securitization markets will be bespoke to individual transactions. However, typical fall-back provisions that might be appear include:
- Historic screen rate
- Reference bank rate
As can be seen from the above, many standard form contracts within the key markets will have fall-back provisions that may be triggered once LIBOR is discontinued. However, the reality is that these fall-back terms were included to cater for the temporary unavailability of LIBOR rather than its permanent cessation. Reverting to these fall-back provisions post LIBOR discontinuance may not be viable in practice or may be subject to legal challenge.
The RFRWG has made clear that its preferred outcome is that parties re-negotiate existing contracts before fall-back provisions are triggered. For example, in the bond market a number of “consent solicitations” have already taken place. These consent solicitations have typically asked bondholders to agree to replace LIBOR with SONIA compounded daily in arrears over the relevant interest period plus a “fixed spread adjustment” (which is used as a proxy to replicate the bank term credit risk premium and liquidity premium in the forward-looking LIBOR calculation).
However, these amendments require consent and re-negotiation. In circumstances where there are likely to be economic “winners” and “losers” from any change, this gives rise to the potential for disputes.
POTENTIAL DISPUTE AREAS
The New York Fed’s general counsel Michael Held has referred to the end of LIBOR as “a DEFCON 1 litigation event if ever I’ve seen one”.
Whether the fall-out will be quite that dramatic remains to be seen. It certainly has the potential to give rise to significant disputes given the sheer number of contracts that will reference LIBOR in different ways and the unlikelihood that transitions will be agreed consensually between all parties prior to the end of 2021. On the other hand, as explained below, work remains ongoing across different jurisdictions (including as to potential legislative fixes) that may mitigate at least some of the areas for potential disputes. There are 18 months to go before LIBOR is likely to end and so there remains time for market participants to significantly reduce their exposure to litigation risks by taking appropriate action.
Key risk areas
The key risk areas are legacy contracts that were entered into before the termination of LIBOR was envisaged and that will continue post 2021 such that an alternative to LIBOR needs to be adopted so that the contract can function.
(1) Types of contracts
Ultimately, all legacy contracts are at risk but the features of some contracts make them more risky than others. For example, syndicated loans with multiple lenders may create difficulties in securing unanimous consent to amendments (where required). Bond issues will involve seeking consent to amendments from numerous different bondholders. Securitizations involve complex structures with multiple classes of debt and trustees may be nervous amount determining a replacement benchmark. These contracts with multiple parties give rise to the increased risk of consensual amendments not being agreed and disputes as to the operation of legacy contractual terms.
In some cases contracts will be connected across product classes. For example, loan agreements and interest rates swaps. It will be important to ensure that identical changes are made to benchmark rates so that the hedge remains effective. Ensuring consistency across connected contracts presents another key risk area.
(2) Challenges to fall-back provisions
As noted above, some contracts will contain contractual fall-backs that may be triggered once LIBOR ceases to be published. However, all contractual fall-backs are likely to be susceptible to challenge. At a basic level, questions can be asked as to whether provisions designed as a “stop gap” for the temporary unavailability of LIOBR should ever apply in circumstances where LIBOR is discontinued permanently.
Other challenges that might be made to the typical type of fall-back provisions include:
- Historic screen rate: where interest is calculated by reference to the last available LIBOR rate for the contractually provided currency and term, this effectively converts a floating interest rate to a fixed interest rate. This will fundamentally change the bargain that the contracting parties signed up to.
- Reference bank rate: this relies on certain reference banks being prepared to engage in a process of responding to requests for rates. It seems unlikely that third party banks would readily take on such risk in circumstances where LIBOR has been discontinued precisely because there is a lack of a robust market underpinning the submissions that were being made and against a backdrop of years of LIBOR-related litigation. In the event rates are reported, they would be the subject of challenge by reference to a competing market view.
- Discretionary determinations: granting the discretion to the lender (such as a costs of funds calculation) or to a calculation agent or trustee will always be susceptible to challenge in relation to the way such discretion was exercised. Further, administering loans on a costs of funds basis for any significant period of time is likely to be unworkable (as shown when certain LIBOR currencies and tenors were discontinued in 2014).
(3) Heads of claim
- Contractual interpretation:
- Force majeure:
- Mutual mistake:
(4) Types of claim
Some example types of claim include:
- Contractual counterparties: claims between contract counterparties as to how the legacy contract should operate.
- Investor claims: for example, if an investor invested in a floating rate bond and the bond effectively defaults to a fixed rate under the contractual fall-back of historic screen rate.
- Mis-selling claims: for example, where investors allege that they were mis-sold an investment in breach of an advisory duty by an intermediary or even allegations that banks or other financial institutions have assumed an advisory duty when explaining alternative options to LIBOR.
- Issuer liability: the UK has seen an increase in claims based on misstatements in prospectuses. It might be argued that the promotional material did not adequately identify the risk of LIBOR being discontinued.
- Fund managers: where fund managers use LIBOR for performance targets, investors may bring claims alleging that performance has been misrepresented by a change to a new benchmark rate.
In all of the above scenarios, claims will be fact specific and decided on a case by case basis. However, it is reasonable to assume that the English Court will be acutely aware of the risk of setting precedents in respect of contracts referencing LIBOR and this may favour a more conservative approach to deciding such issues to avoid widespread market disruption.
Regulators and market participants are aware of the risks that flow from transitioning from LIBOR and the need to take action well in advance of the end of 2021 deadline. As noted above, the preference of the RFRWG is for contractual counterparties to agree amendments to contracts if possible rather than relying on fall-back terms that were not designed for the permanent cessation of LIBOR.
However, the practical reality is that work around risk mitigation is being undertaken in different ways, in different jurisdictions and markets, and at a different pace. Accordingly, there is no uniform approach and it is by no means certain that all risk mitigation projects will have completed by the end of 2021.
By way of summary of some of the key projects:
1. Legislative fix
One area that has long been a topic of debate since the announcement in 2017 that the markets should transition away from LIBOR by the end of 2021 is whether primary legislation should be introduced to override contractual terms that reference LIBOR e.g. creating a law that replaces references to LIBOR to a risk-free rate. Legislation was introduced in key jurisdictions at the time of the introduction of the Euro currency in 1999 to try and mitigate the impact on commercial contracts.
Unfortunately, limited progress has been made in this area. The UK FCA’s preference has been to encourage the market to find its own solutions on the basis that it cannot guarantee that the UK government will introduce primary legislation. Importantly, the “Tough Legacy Taskforce” set up by the RFRWG issued a paper on 29 May 2020 recommending a legislative fix for all asset classes (derivatives, bonds, loans and mortgages) but stressing that (i) the introduction of legislation was not within its control and (ii) this would be a blunt instrument that could not guarantee economic neutrality for the parties to the contract. In addition, the Taskforce raised the possibility of publishing a “Synthetic LIBOR” (a formula-based LIBOR calculated as a spread over an overnight risk-free rate) for a period of time post 2021, perhaps until primary legislation is enacted.
The above does not take the debate much further forwards. There is currently no draft legislation in the UK and Parliament has important other agenda items as a result of Covid-19 and Brexit. Having primary legislation in place by the end of 2021 is by no means guaranteed and it remains to be seen as to how that would operate including its scope and the impact on contracts across asset classes that are closely linked (e.g. loan agreements and derivative hedging arrangements). However, on 23 June 2020 the UK Government announced that it intends to bring forward legislation to amend the Benchmarks Regulation (BMR) to give the FCA enhanced powers.
As regards the proposal to consider publishing “Synthetic LIBOR”, this is susceptible to challenge on contractual interpretation grounds on the basis that references to LIBOR in legacy contracts should not be taken as referring to a new “Synthetic LIBOR” rate. This could be addressed by the enhanced powers the UK Government plans to give to the FCA, for example, by the FCA allowing replacement of LIBOR with a “Synthetic LIBOR” rate in contracts where it is impossible to amend or renegotiate LIBOR at its end in 2021.
Other countries are also considering legislative fixes which raises the possibility of different approaches being adopted in different jurisdictions. In the US, the Alternative Reference Rates Committee (ARRC) has published a proposal for New York legislation with the aim of transitioning large books of LIBOR referenced contracts to the US risk-free rate (SOFR) alternative. The key terms of the proposals include:
- Any contracts that do not have a fall-back mechanism will transition to the recommended US benchmark replacement.
- The recommended US benchmark replacement will be SOFR plus a spread adjustment selected by US regulators.
- Where a contractual fall-back term confers the right on a party to identify a new reference rate in some way, if that party chooses the recommended US benchmark rate as provided for in the legislation, they will be protected from civil liability.
- Any legacy contracts that have a fall-back mechanism that involves “polling” reference banks for rates will be ignored.
- Parties would be prohibited from backing out or using the LIBOR transition as a breach of contract.
- The legislation will set out defined triggers for transition giving certainty as to when LIBOR is deemed to have discontinued.
- Contracting parties can opt-out of the legislation e.g. if they have contractually agreed some other approach.
If legislation along the above lines is implemented, then it is likely to be effective at mitigating some of the disputes that might otherwise arise in the context of legacy contracts with no or inappropriate fall-back mechanisms. However, regulators are keen to stress that they cannot guarantee that legislation will be implemented on time nor that there will not be economic “winners” and “losers” from the application of the legislation to complex and bespoke contractual arrangements. The only way for parties to have control over the economic impact of transitioning from LIBOR is to reach their own agreements to amend contracts.
2. ISDA amendments
ISDA plans to amend certain of its 2006 ISDA Definitions to include more robust contractual fall-backs that would apply upon the permanent discontinuation of LIBOR. Under the new fall-back provisions, LIBOR would be replaced by SONIA compounded over the relevant period plus a spread adjustment based on the median across a 5 year period of the differences between LIBOR and SONIA compounded. The fall-back would be triggered once the FCA confirms that LIBOR is no longer representative of its underlying market.
3. Other market solutions
- The RFRWG has published a progress report on transitioning from LIBOR in the context of legacy bonds by way of consent solicitation (January 2020). This progress report contained guidance on best practice for pursuing consent solicitation from multiple bondholders.
- As noted above, work is ongoing as to whether SONIA can be used as the basis of a forward-looking term rate (in the same way as LIBOR).
- LIBOR may be published for a period of time after 2021 on a “non-representative” basis i.e. it could be published by ICE without full panel bank involvement. However, the UK FCA have made clear (see FCA letter to ISDA dated 20 January 2020) that if such an arrangement were to happen it would only operate for a matters of months beyond the end of 2021 and it is not a long term alternative to the current LIBOR model.
- As noted above, publication of a “Synthetic LIBOR” (which would see the rate calculated as a spread over an overnight risk-free rate such as SONIA) may be pursued.
- On 25 May 2018, the LMA published a rider with a revised version of the Replacement of Screen Rate clause. The revised version facilitates further flexibility by permitting amendments with a lower consent threshold than may otherwise be required in a wider range of circumstances. It allows amendments to be made to facilitate inclusion of a replacement benchmark which:
- is formally selected as a replacement for LIBOR by the LIBOR administrator or by an appropriate regulator; or
- is otherwise accepted by the relevant markets; or
- is deemed appropriate by the requisite majority of lenders and the obligors
Work in relation to the above (and other mitigation projects) remains ongoing across jurisdictions. It is frustrating that market participants will have to take decisions as to how to transition from LIBOR without knowing if all of the above will be available options by the end of 2021. The message from regulators is clear – market participants should not rely on all of the above (in particular legislative fixes) being implemented in time and regulated firms are responsible for implementing their own transition plans well in advance of the end of 2021.
STEPS TO TAKE
Banks and other regulated entities will already be well advanced in their planning for LIBOR transitioning given the focus of the FCA on the topic. However, there remains much to be done and the transition from LIBOR affects all market participants who are party to contracts that reference LIBOR.
As a minimum, all market participants should be taking action now to conduct an impact assessment as to how the transition from LIBOR will affect their own circumstances. This should include:
- Undertaking a review of all “legacy contracts” to identify the key risk areas with a focus on:
- Identifying a preferred approach to dealing with benchmark rates in relation to new contracts that are entered into in the lead up to the end of 2021 and beyond.
- Considering whether the discontinuation in LIBOR has any wider impact on internal accounting / treasury policies and procedures and IT or reporting systems.