The anticipated replacement of the London Interbank Offered Rate (LIBOR) as benchmark interest rates for loans, debt and derivatives will be a dauntingly complex and time-consuming undertaking.
Our US and European LIBOR teams have been deeply involved in this process. Members of our US team have commented repeatedly and participated in meetings of the Alternative Reference Rate Committee (ARRC) convened by the Federal Reserve Bank of New York and in the LIBOR replacement working groups of all the major trade organizations.
Members of our European team have been involved in consultations by the UK and European regulatory authorities, as well as with initiatives undertaken by industry bodies representing asset managers and other financial intermediaries.
— Advise on the implementation of LIBOR’s replacements in the various currencies and markets affected by the transition from LIBOR
— Advise on and assist you with the challenges created by LIBOR transition for your legacy LIBOR assets and liabilities, including how to address credit spread adjustments
— Assist you on your new transactions to ensure that the documentation adopts the latest market-accepted proposals for LIBOR transition mechanics
— Assist and advise you on the implications for your business of adhering, or not adhering, to the ISDA Protocol currently under discussion which will implement amendments to the ISDA Definitions required in order to address the consequences for various existing derivatives products of the transition from LIBOR, as well as general advice on the ISDA amendments for trades going forward
— Prepare you for the litigation and antitrust risks associated with the transition from LIBOR to a successor interest rate
What is LIBOR, and How Does it Work?
LIBOR (sometimes referred to as ICE LIBOR) is a benchmark for short-term interest rates, currently calculated for five currencies (USD, GBP, CHF, EUR and JPY) and seven tenors for each of these currencies. It is intended to be a measure, for each currency and tenor, of the average rate at which leading internationally-active banks are willing to borrow wholesale, unsecured funds in the London interbank market.
The methodologies used to determine LIBOR for a particular currency and tenor are based on submissions made by panel banks to the LIBOR benchmark administrator, ICE Benchmark Administration Limited (IBA), each London business day. The methodologies and panel banks per currency and tenor used are disclosed on IBA’s webpage.
IBA is the “benchmark administrator” for all LIBORs for the purposes of the EU Benchmarks Regulation, and, as a UK-based benchmark administrator, is regulated in the UK by the Financial Conduct Authority (FCA).
LIBOR rates are categorized as a critical benchmark for the purposes of the EU Benchmarks Regulation, and as with all benchmarks used in the financial markets (and pursuant to post-financial crisis legislation such as the EU Benchmarks Regulation), LIBOR for any particular currency or tenor must be demonstrated to be determined using robust methodologies and sufficient and reliable market-based data. The robustness and reliability of LIBOR as a benchmark depends, therefore, on the submissions made by the panel banks, and on an active interbank unsecured lending market.
Why is LIBOR Important?
More than $350 trillion in derivatives and other financial products are tied to LIBOR, including a significant percentage of floating rate notes and floating rate loans denominated in a currency for which LIBOR is quoted. It is particularly prevalent in the USD and GBP syndicated and bilateral loan markets, including commercial real estate loans.
The LIBOR rate determined for a particular currency and tenor can influence the amount of interest you pay on a wide range of financial products, including mortgage loans, credit cards and (in the US) private student loans.
When the transition away from LIBOR to a replacement benchmark interest rate occurs for a particular currency and tenor, you will likely have a significant portfolio of financial assets and hedge products which will require transition.
Why is LIBOR Being Replaced?
LIBOR is predicated on an assumption that there is an interbank unsecured term lending market for the currencies and tenors for which a LIBOR is published.
Regulatory investigations in Europe and the US following the global financial crisis revealed that for some years preceding the financial crisis, as well as during the financial crisis, the volume of transactions in the interbank markets of the relevant currencies had decreased significantly, to the point that the panel banks that contribute to the production of LIBOR were relying on their expert judgment, rather than observable market rates, for some of their submissions, and in many cases were manipulating their submissions to the benchmark administrator and, thus, manipulating LIBOR for certain tenors and currencies.
These investigations led to millions of dollars in fines and undermined public confidence in LIBOR.
Andrew Bailey, the Chief Executive of the FCA (which regulates IBA, the benchmark administrator for LIBOR), announced in a speech in July 2017 that all of the panel banks that contribute to determining LIBOR in the five LIBOR currencies had agreed to continue making their rate submissions to IBA until the end of 2021. Mr. Bailey also said that after 2021, the FCA would no longer compel panel banks to contribute submissions to IBA for the purpose of determining a LIBOR.
As a result, it is anticipated that the panel banks for the various LIBOR currencies will cease making their rate submissions to IBA from the beginning of 2022. The FCA and IBA have also signaled that they may declare that a LIBOR is unrepresentative if even a single panel bank for the relevant currency ceases its submissions for that currency.
A particular LIBOR is unlikely to continue to function as a benchmark interest rate if it ceases to be representative, and market participants in the EU may be prohibited from using it as a benchmark rate if it ceases to comply with the criteria for a critical benchmark under the Benchmarks Regulation.
What is the Timeline?
It is expected that LIBOR may cease to be published or cease to qualify as a critical benchmark starting January 1, 2022.
Although the FCA and other regulators involved in LIBOR transition are working to ensure that the transition to replacement benchmark rates occurs in an orderly fashion, it is possible that a particular LIBOR may be deemed to be unrepresentative before an orderly transition can be achieved, and before January 1, 2022.
Regulators, market participants and ISDA are currently considering the potential consequences of pre-cessation triggers; that is events, such as a determination that a LIBOR is no longer representative, which would trigger a switch to a fallback replacement rate before publication of that LIBOR formally ceased.
What is Replacing LIBOR?
The replacement benchmark rate will differ from currency to currency. The majority of LIBOR replacements will be derived from risk-free overnight rates. Here is a brief summary of these risk-free rates.
USD LIBOR TO BE REPLACED BY SOFR (Secured Overnight Financing Rate)
SOFR was launched as a new interest rate benchmark in April 2018 and is based on the cost of overnight loans, using repurchase agreements secured by US government securities (so looks at a larger section of transactions than is used to derive the Fed Funds rate). SOFR is published by the Federal Reserve Bank of New York.
EUR LIBOR TO BE REPLACED BY €STER (Euro Short-Term Rate)
€STER is based on the wholesale euro unsecured borrowing costs of euro-area banks, and is replacing EONIA (euro overnight index average). The ECB publishes €STER on every TARGET 2 business day by reference to the transaction data reported to it on the previous business day. Note that the current intention is that EURIBOR (which is determined by reference to different methodologies from EUR LIBOR – see below) will continue to be published for various tenors.
GBP LIBOR TO BE REPLACED BY SONIA (Sterling Overnight Index Average)
SONIA has been published since 1997 (albeit the methodology for determining it was revised in 2018) and is administered by the Bank of England. It is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions.
CHF LIBOR TO BE REPLACED BY SARON (Swiss Average Rate Overnight)
SARON was developed in 2009 and represents the average overnight interest rate for secured money market borrowings in Swiss francs; it is based on transactions and quotes posted in the Swiss repo market. It is administered and published by an affiliate of SIX Group Ltd.
JPY LIBOR TO BE REPLACED BY TONA (Tokyo Overnight Average Rate)
TONA is based on unsecured money market rates, and is published and administered by the Bank of Japan.
The London Interbank Offered Rate is only one example of floating interest rate benchmarks based on interbank borrowing markets. The issues which have caused the transition away from LIBOR have affected most of these other interest rate benchmarks, or IBORs. There are proposals to replace the following interest rate benchmark rates with benchmarks based on overnight risk-free rates:
HIBOR - Hong Kong interbank offered rate, applicable to Hong Kong dollars
SIBOR – Singapore interbank offered rate, applicable to Singapore dollars
TIBOR – Tokyo interbank offered rate, applicable to Japanese Yen (with the rate being set in Tokyo rather than (as with JPY LIBOR) London).
The methodologies for determining EURIBOR were revised in 2019, and there is currently no proposal to discontinue publication of EURIBOR rates. EURIBOR is, nonetheless, dependent on the existence of an observable and reliable interbank borrowing market for euros and the published tenors, so it is essential to ensure that adequate fallback mechanisms are included in documentation referencing EURIBOR, should it meet the same fate as other IBORs.
Credit Spread Adjustment
For each LIBOR and other IBOR, one of the most critical, commercial consequences of the transition to a risk-free benchmark rate arises from the fact that LIBOR and other IBORs are unsecured term borrowing rates with an in-built credit spread, whereas risk-free rates (whether secured or unsecured) are overnight rates only and contain a minimal credit spread. The transition of the interest rate applicable to a financial contract from an IBOR to a risk-free rate will require, therefore, a credit spread adjustment.
There have been a number of industry consultations for each IBOR currency on how to address the credit spread adjustment in cash products.
The vast majority of LIBOR exposure lies in derivatives products and ISDA is widely acknowledged as leading work on benchmark reform. Following a request from the Official Sector Steering Group (OSSG) in 2016, ISDA has undertaken work to improve contractual robustness of derivatives contracts that reference LIBOR and other key IBORs. This means updating ISDA documentation to include references to the alternative RFRs instead of the existing family of IBORs.
Current standard ISDA documentation includes references to those IBORs and certain fallbacks. Those fallbacks were however only ever intended to accommodate a temporary cessation of those rates. ISDA’s updates have therefore been focused on including triggers that will switch in-scope derivatives from the current reference rates to the new rates and developing fallbacks with relevant adjustments.
Starting in the summer of 2018, ISDA launched several public consultations most of which focused on identifying the term and credit spread adjustment to convert each of the identified alternative RFRs into rates that would have similar characteristics to the IBORs.
The result of those consultations indicated that the market favored the “compounded setting in arrears rate” for the term adjustment with the “historical median approach” (a five year look-back comparison calculation between the relevant “compounded in arrears” RFR and relevant IBOR) for the credit spread adjustment.
Working groups beyond ISDA have considered this proposal, in the context of addressing the credit spread adjustment required for cash products. One such working group is the ARRC, and on April 8 2020, after having received extensive responses to their own consultation, the ARRC announced that for cash products that reference USD LIBOR, it had agreed on a recommended spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR, a methodology consistent with ISDA’s recommended methodology.
A new ISDA Protocol and supplement to the existing ISDA 2006 Definitions (Supplement), with a new set of ISDA Definitions to follow, will implement the results of ISDA’s consultations, for both existing (via the Protocol) and new trades (via new trades incorporating the Supplement). By adhering to the ISDA Protocol, market participants will agree that their legacy derivative contracts with other adherents will include the amended floating rate option for the relevant IBOR and will therefore include the fallback. As always, adherence to any such protocol will be completely voluntary and will amend contracts only between two adhering parties (i.e. it will not amend contracts between an adhering party and a non-adhering party or between two non-adhering parties).
The launch of the new Supplement and the Protocol was expected to occur during the first half of 2020 but that was delayed in early February 2020 when it was announced that, at the request of the OSSG, ISDA would re-consult on the inclusion of pre-cessation triggers (the original focus of ISDA work was only incorporating so called “permanent” cessation triggers). A pre-cessation fallback for derivatives referenced to LIBOR would be triggered if the FCA, as the supervisor of the benchmark’s administrator, announced that LIBOR is no longer capable of being representative - either immediately or as of a future date - even if it continues to be published (meaning that permanent cessation fallbacks would not be activated).
The point about representativeness is linked to the requirements of the European Benchmarks Regulation. Amongst these requirements, is a clear and unambiguous requirement for not only the administrator, but also for the supervisor of the benchmark administrator, to assess the capability of a critical benchmark to be representative of an underlying market and economic reality. As we note above, in the case of LIBOR, the supervisor is the FCA.
The consultation on the inclusion of pre-cessation triggers ran between 25 February 2020 and 25 March 2020. Results from the consultation indicated that a significant majority of respondents support including pre-cessation and permanent cessation fallbacks without optionality or flexibility in the amended 2006 ISDA Definitions for LIBOR and in a single protocol for including the updated definitions in legacy trades.
Following these results, ISDA announced that it expects to publish the Supplement to incorporate the fallbacks for new trades in late July 2020. The Protocol will simultaneously be launched to allow participants to incorporate the revisions into legacy trades if they choose to do so. There is expected to be a three or four month period before the Supplement takes effect so if the publication occurs during the summer of 2020, both will take effect before the end of 2020.
Throughout the remainder of 2020 and into 2021 it is expected that ISDA will continue its wider LIBOR transition work including in relation to the following areas:
the use of RFRs in non-linear derivatives and cross-currency swaps and supplemental amendments to IBOR fallbacks for these transactions;
continued advocacy to seek to ensure there are no regulatory, tax or accounting impediments to fallbacks or amendments to legacy portfolios; and
continued education on LIBOR
ISDA has published various materials on benchmark reform and transition from LIBOR including the launch of a benchmark reform hub, a link to which can be found below in Useful Links and the resources here are regularly updated with both ISDA material and market materials including from other industry groups.
As you would expect given the extent and complexity of LIBOR transition, there is a wealth of material available on the topic, including specific web pages or websites set up by the ARRC, the Bank of England, the FCA, the ECB, ESMA, ICMA, ISDA, the LSTA, the LMA and other industry bodies. Here are links to some of these websites (some require a subscription).