Why SA banks should pay attention to what’s happening in London

Introduction 

Five South African banks face new charges of dollar-rand manipulation, after the Competition Appeal Court dismissed their appeal in February and the Competition Commission issued a new charge sheet last Tuesday.

The case relates to allegations of collusion to fix prices and divide markets in respect of the US$/ZAR currency pair dating back to 2017, when the commission initially made the accusation against 17 banks, now expanded to 28 banks.

Investigations in foreign exchange have been conducted in, for example, the US, UK, Switzerland and Japan since 2013 and substantial fines have been imposed on banks for failing to control business practices in their foreign exchange trading operations.

Earlier, similar allegations of manipulation were made in connection with the determination of the London Interbank Offered Rate (Libor).

This led to drastic amendments to the way in which Libor is calculated and administered and, after further consideration, its imminent demise.

Libor is the average interest rate at which a selection of banks on the London money market are prepared to lend money to one another, and is tied to more than US$350 trillion worth of financial assets. Available in seven maturities (from overnight to 12 months) and in five different currencies, it influences the interest rates of many banks across the world.

Because of the importance of London as an international financial centre, interest rates for many foreign currencies (including US$) are based on Libor, and as a result the planned transition away from Libor has implications for banks across the world, including those in South Africa.

Since the Libor is not guaranteed to be available after 2021, what can African banks expect?

Financial law expert Pieter van Welzen of CMS South Africa explained the effect of the changes in more detail.

What is Libor?

To understand Libor, one has to take a step back and remember that loans can have a fixed or variable interest rate. When the rate is fixed, the interest rate will remain the same during the life of the loan.

In case of a variable interest rate, the interest rate is reset at various intervals, for example every three or six months.

The new interest rate will be based on market conditions and expectations at the time of the reset. For certain currencies, such as the US dollar, this variable interest rate is based on the Libor.

This benchmark reflects an interest rate average calculated from estimates submitted by the leading banks in London for borrowing from other banks for a particular period.

The Libor benchmark is not only used for loans, but also for other financial instruments, such as bonds and derivatives.

Why is the transition away from Libor happening?

In the aftermath of the 2008 financial crisis, it appeared that the banks involved had manipulated the Libor calculation (which was then administered by the British Bankers’ Association) for many years.

As a result, certain changes were made to the administration of the rate and the way it is calculated. However, the regulators believe that Libor continues to have certain defects and that it should therefore be discontinued by the end of 2021.

What is the alternative, new interest rate?

The regulators and industry bodies have proposed a new interest rate benchmark for each currency that now uses the Libor benchmark.

For US dollars, this will be the Secured Overnight Financing Rate (Sofr), which will be calculated and administered by the Federal Reserve of New York.

Sofr reflects overnight transactions in the repurchase market for US treasuries and is therefore based on data from observable transactions rather than on estimated borrowing interest rates.

What are the differences between the Libor and the alternative rate?

There are two main differences between Libor and Sofr.

First, Libor is a forward-looking rate. For example, if a loan provides for a one-month US$ Libor interest rate, it is fixed at the beginning of each month for that month period, based on the US$ Libor for one-month borrowings at that time.

Interest is then paid at the end of the month based on that rate.

Since Sofr is an overnight rate, the actual interest that is payable can be determined only at the end of an interest period.

Therefore, if a loan provides for one-month Sofr, the interest payable at the end of a monthly interest period will be the average of Sofr during that month.

It is therefore backward-looking. A borrower based on Libor knows at the beginning of an interest period how much interest needs to be paid at the end of the interest period.

By contrast, with the inclusion of Sofr as benchmark, the actual amount due is known only at the end of the interest period.

Second, since Libor deals with borrowings between banks, it includes a credit risk element in the interest rate (one of the defects identified by the regulators).

Since Sofr is calculated as an overnight rate with US treasury collateral, the rate is considered risk free. This means that Sofr might potentially provide a lower interest rate.

Although US$ Libor is expected to disappear in 18 months, the regulators and industry bodies are still considering details about the business conventions on how to calculate Sofr and its suitability for certain financial instruments. This is worrying, given the actions that are required to implement the transition.

What are the expected effects on the global market, the SA market and the African markets?

Many international financing transactions in South Africa and other African countries are denominated in US dollars and use US$ Libor as a benchmark rate.

Moving from Libor to Sofr unfortunately does not just involve replacing the US$ Libor reference to Sofr in a loan agreement. The provisions that deal with the calculation of interest will need to be amended too, and the lender might require an additional margin to compensate for the “risk free” character of Sofr.

The fallback provisions typically encountered in loan agreements do not deal with this situation and can therefore not be used. The same applies for bonds, derivatives and other transactions that use US$ Libor as reference rate.

The amendment of loan documentation raises additional questions. For example, who needs to consent to the amendment, the effect on approvals and security and collateral arrangements, and the need to adapt treasury management systems to deal with the backward looking character of Sofr.

The transition from US$ Libor to Sofr is, therefore, potentially a huge operation and various South African financial institutions are already preparing for the transition.

Will only banks be affected?

No, companies and governments with US$ denominated borrowings or derivatives also need to address the transition. To complicate matters, other benchmark rates, such as the Euro Interbank Offered Rate (Euribor) and even the Johannesburg Interbank Average Rate (Jibar), might disappear for similar reasons as Libor.

It is therefore suggested, particularly in connection with long-term financing transactions, that companies consider including provisions in loan documentation that include benchmarks that facilitate the amendment of the documents if and when benchmark changes occur.

Van Welzen is a Dutch and English qualified lawyer at leading corporate law firm CMS South Africa, where he focuses on advising top international financial institutions and investors on financing transactions and financial market regulations.