By Jennifer Hancock and Simon Finch
The U.K.’s Financial Conduct Authority (FCA) recently announced that the London Interbank Offered Rate (LIBOR) is to be phased out by the end of 2021 and replaced with a more reliable alternative.
LIBOR is a daily benchmark interest rate set at approximately 11:45 a.m. (London time) every morning by a panel of leading banks in the U.K. It is the average rate the banks estimate they’d be able to borrow money from each other in different currencies and over different time periods. In other words, it is the applicable rate for unsecured bank-to-bank borrowing. LIBOR is currently used as a reference to price trillions of dollars of financial contracts around the world, including mortgages, loans, credit cards and complex derivatives contracts.
The intention to replace LIBOR has been applauded by many, including regulators, following an investigation in 2012, which revealed that certain banks in the U.K. were fixing the rate, resulting in billions of dollars in fines to such banks and the conviction of several bankers. Following this industry-wide scandal, the FCA took on interim oversight of LIBOR in 2013 and put Intercontinental Exchange Benchmark Administration (IBA) in charge of administering the rate in 2014. IBA is a U.K. company based in London that is authorized to administer benchmarks and regulated by the FCA.
Aside from LIBOR’s susceptibility to manipulation, the FCA has argued that LIBOR is a problematic benchmark rate because the market supporting LIBOR — that is, the market for unsecured wholesale term lending to banks — is no longer “sufficiently active”. For one currency and lending period in 2016, for example, there were only 15 transactions executed between the panel banks. Accordingly, banks are uncomfortable submitting daily rates based on minimal borrowing activity. If an active market does not exist, then even the best administered benchmark cannot measure it properly. The FCA plans to replace LIBOR by the end of 2021 with a substitute rate that is based firmly on market transactions. In the meantime, while panel banks are being asked to continue to voluntarily set LIBOR daily, they will no longer be compelled to do so by the FCA.
At this time, it is unclear what exactly will replace LIBOR, although a number of groups have been considering alternatives that are significantly tied to active markets and based on actual market transactions. For example, the Bank of England is currently looking into replacing LIBOR in contracts with the Sterling Overnight Index Average (or SONIA), an overnight funding rate in the sterling unsecured market. Switzerland has plans to replace its own key swaps rate, TOIS, with a new benchmark rate by the end of this year. In addition, concerns have been growing in Europe over the Euro Interbank Offered Rate (or Euribor), a Euro-dominated version of LIBOR, as Eurozone banks are pulling out of the relevant rate-setting panels.
Similarly, the U.S. Federal Reserve is in the process of developing a substitute for U.S. dollar LIBOR. This past June, the Alternative Reference Rates Committee, an industry body set up by the U.S. government, recommended that banks start using a new broad Treasuries repurchase (repo) rate linked to the cost of borrowing cash secured against U.S. governmental debt (also known as Treasuries), as a replacement for U.S. dollar LIBOR.
According to the FCA, the benefit of the foregoing alternative benchmarks in comparison to LIBOR is that they are based on actual transaction data from relevant market participants. This, it is argued, will help to alleviate fairness concerns rooted in the fact that daily LIBOR is currently determined by the “expert judgment” of certain banks that sit on the rate-setting panels.
So how will the scheduled demise of LIBOR impact syndicated loan agreements? Certainly there is no easy fix before the market lands on an alternative rate. While the Loan Syndications and Trading Association did meet on July 20, 2017 to discuss the matter, it will likely be some time before there is consensus on the new pricing mechanic and how it should be papered. In the meantime, parties will have to rely upon the fallback definition of LIBOR (assuming that it doesn’t also refer to an underlying benchmark) or the alternate rate provision (which defaults to a floating rate). While these options were always designed as short-term solutions on a narrow scale, they may ultimately be broadly relied on for longer periods of time while the market sorts itself out. Also, we expect that borrowers may ask that any change to a benchmark rate be subject to majority (rather than unanimous) lender approval, such that — if and when the market lands on a solution — amendments can be more readily made.
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