On July 27, 2017, Andrew Bailey, the chief executive of the UK Financial Conduct Authority (FCA), announced in a speech that after 2021 the FCA would no longer use its power to persuade or compel panel banks to submit rate information used to determine LIBOR. Mr. Bailey encouraged the market to develop robust alternative reference rates to replace LIBOR.
This speech marks a turning point in the history of LIBOR. Regulators have been concerned that LIBOR may cease to exist as a financial benchmark, and that such cessation could cause significant disruption to the market. Mr. Bailey’s announcement of an arbitrary deadline has caused market participants to look anew at replacing references to LIBOR in a large number of financial contracts with references to alternative reference rates now being developed, and to reconsider LIBOR fallback language currently contained in existing contracts. Mr. Bailey’s remarks also indicate that the reform of LIBOR, which had been a regulatory goal, is no longer a viable option in the FCA’s view.
Declining activity in the short- term unsecured interbank market
Banks no longer obtain funding through the short-term unsecured interbank market (which has historically served as the basis for LIBOR quotes) to the extent they did previously, and Mr. Bailey stated that this decline in activity made LIBOR unsustainable. For example, for the second quarter of 2017, Ice Benchmark Administration, the current LIBOR administrator (IBA), reported that just over than one-third of the submissions for the US dollar three-month LIBOR were based on actual transactions. The IBA has stated that this market has reduced in size due to several factors: (i) a significant increase in perceived risk of bank counterparty default (credit risk); (ii) regulatory capital charges; (iii) the introduction of liquidity coverage ratios which have modified the demand and supply of wholesale funding, as banks transition to longer maturity funding and more funding sources; and (iv) a significant increase in liquidity available to banks because of the exceptional measures taken by major central banks in response to the financial crisis. See IBA, “Second Position Paper on the Evolution of ICE LIBOR,” 31 July 2015, available here.
This lack of activity has raised regulatory concerns for two main reasons. The first is that the lack of activity in the interbank lending market renders LIBOR susceptible to possible manipulation. The second is the risk that LIBOR will cease to be quoted in the future due to inactivity, which could lead to market disruption on a large scale.
It is estimated that LIBOR is now referred to by an estimated US $350 trillion of outstanding financial contracts. Of this aggregate amount, syndicated loan transactions, where LIBOR was first used, are estimated to be but a small fraction, around US $15 trillion. Regulators have expressed concern with having such a large volume of derivatives contracts refer to prices derived from a thinly-traded, much smaller market.
Reforming financial benchmarks
Since the financial crisis, various regulators have engaged in efforts to reform financial benchmarks, including LIBOR. It has proved difficult to fit the square peg of LIBOR’s traditional quotation process, which fundamentally involves estimates, into the round hole of regulatory benchmark reform efforts, which strongly prefer basing benchmarks on information from actual observed transactions and which disfavor the use of estimates by panel submitters. The shrinking of the interbank lending market has magnified this difficulty.
LIBOR represents an estimate of funding cost for a hypothetical, prospective (or forward-looking) transaction in the relevant currency for a specified maturity. LIBOR was intentionally crafted as an estimate to permit a panel bank to submit a quote for a currency-tenor combination on a given day even if it did not have an actual transaction for such pairing.
Many of the benchmark reform efforts have focused on using actual transactions as a source for reference rates, on the theory that they are less susceptible to manipulation. While the use of “expert judgment” is still permitted for inputs, regulators have given expert judgment a much lower priority than actual, observed transactions. Panel banks face liability for inaccurate or misleading submissions, as well as substantial costs to comply with the LIBOR governance structures that have been implemented since the financial crisis, and have expressed some reluctance to bear this exposure in order to submit expert judgments rather than provide hard information.
The replacement of LIBOR by alternative reference interest rates based on active markets would accomplish the regulatory goals of using reference rates that are more robust and less prone to manipulation. However, these alternative rates (and the markets that would trade in them) are in the early stages of development.
Alternative rates: SOFR and SONIA
In November 2014, the US Federal Reserve Bank convened the Alternative Reference Rates Committee (ARRC), which was tasked with developing a set of alternative reference interest rates based on real transactions from a robust underlying market. On 22 June 2017, the ARRC selected a secured overnight funding rate (SOFR) as its preferred LIBOR alternative.
In March 2015, the Bank of England initiated the Working Group on Sterling Risk-Free Reference Rates to develop alternative Sterling reference rates. In June of this year, the Sterling working group announced its selection of the Sterling Overnight Index Average (SONIA) as its preferred alternative to LIBOR.
Both SOFR and SONIA are intended to be risk-free rates (RFRs), and (unlike LIBOR) do not reflect bank credit risk. To the extent that SOFR and SONIA are used as substitutes for LIBOR, the question may arise in some transactions of determining an appropriate spread to account for the lack of a bank credit risk component.
SOFR and SONIA are also overnight rates, rather than rates that correspond to traditional LIBOR interest periods, and do not reflect any term premium. However, the ARRC stated that one of its goals in selecting SOFR was “to encourage the development of sufficient liquidity in futures and swaps markets referencing the new rate so that trading in these markets can replace a significant portion of current trading in interest rate derivatives referencing all of the USD LIBOR fixings, not simply overnight USD LIBOR.” See ARRC, Frequently Asked Questions, available here.
SONIA is currently quoted. The Federal Reserve Bank of New York announced that it plans to begin publishing SOFR quotes in 2018. See https://www.newyorkfed.org/markets/opolicy/operating_policy_170524a. It remains to be seen whether SOFR and SONIA will be broadly accepted and generate deep liquidity and, if so, on what timeframe.
An RFR has been developed for Yen (the Tokyo Overnight Average Rate, or TONAR), which is an overnight unsecured rate. On 5 October 2017, the National Working Group on Swiss Franc Reference Rates recommended the Swiss Average Rate Overnight (SARON) as the alternative RFR for Swiss Franc LIBOR. SARON is an overnight secured rate.
With respect to the Euro, no formal designation of an RFR by a private sector working group has taken place. However, the Euro Overnight Index Average (EONIA), which has existed since 1999, is an actively used overnight rate. EONIA is an unsecured rate. Market participants and regulators are examining reforms to EONIA as well as considering other rates as alternatives.
Renegotiating legacy agreements
Many contracts now exist that refer to LIBOR and which will remain in effect after 2021. The shift away from using LIBOR as a benchmark will trigger a lengthy and complicated process, since thousands of outstanding agreements will need to be renegotiated. Many legacy debt agreements currently have fallback mechanisms in the event that LIBOR ceases to be quoted or is unavailable. In most cases, these credit agreement fallbacks are intended to address temporary disruptions in the LIBOR market. In the event that LIBOR were to cease permanently, these fallbacks would be cumbersome to administer, unsatisfactory, and/or possibly unworkable.
We are aware of parties negotiating bespoke changes to debt agreements now to allow for an alternative reference rate (once one is identified) to be implemented upon a less than 100% vote of the lenders. No market consensus has yet developed for such changes and understandably, lenders are hesitant to take this approach.
ISDA is currently considering amendments to the 2006 ISDA Definitions to provide for fallbacks to apply in the event of a permanent discontinuation of LIBOR. ISDA has stated that the RFRs are the most appropriate fallbacks for the suite of “inter-bank offer rates” (IBORs) in the corresponding currencies, provided that there is an appropriate transition plan which, among other things, would create liquidity in the rate at tenors relevant to the corresponding IBOR. It is currently contemplated that such new fallbacks would apply to transactions referencing the 2006 ISDA Definitions that are entered into on or after the date of such amendments become effective, but would not apply to transactions entered into prior to that date. ISDA is also considering whether to publish a multilateral protocol pursuant to which parties could agree that for transactions among each other referencing one of the relevant IBORs, the new fallback would apply, regardless of the date of the transaction.
The continuance of LIBOR post-2021?
The 2021 deadline may not allow sufficient time for market participants to address the vast amount of work that lies ahead. The ability of market participants to make a smooth transition will chiefly depend on the development of alternative reference rates, on which work is ongoing on the part of regulators and market participants.
The transition away from LIBOR for existing transactions could also give rise to other unintended legal consequences. For example, if amendments to the fallback rates are treated as material, this could give rise to additional “life-cycle” reporting obligations, as well as potentially bring such existing transactions into scope of applicable derivative regulatory regimes by voiding existing grandfathered protections.
It is possible that LIBOR will continue to be quoted after 2021, a possibility that Mr. Bailey left open in his speech. In fact, the IBA has announced plans to continue to publish LIBOR after 2021. See Samuel Agini, “ICE Benchmark Chief: Libor Is Not Dead,” Financial News, 11 August 2017, available here. Doing so would depend on the willingness of the panel banks to continue to make submissions without FCA compulsion. To the extent that LIBOR continues to be quoted after 2021, it is clear that the process of making LIBOR determinations would need to comply with the new benchmark rules.
Mr. Bailey’s speech was intended to quicken the pace of transition to LIBOR alternatives. Much work will need to be done to effect such a transition. Market participants must begin on such work now, to the extent they have not already done so. Unfortunately, the way forward is not yet entirely clear. We expect that regulators will work to avoid triggering market disruption (which may include extending the 2021 deadline, although there is certainly no guarantee that this will happen), and that the many industry groups currently involved in this process will continue to develop solutions for the many issues that this transition will entail.