The Replacement of LIBOR Post-2021: A $300 Trillion Question

An Introduction to LIBOR For over forty years, the London Interbank Offered Rate (LIBOR) has been the cornerstone for financial instruments, known as the world’s most widely used interest rate benchmark, reflecting the reference rate at which banks borrow and lend amongst themselves. LIBOR is calculated based on submissions from selected panel banks and is published for a range of tenors in five currencies. It is thereby considered a major benchmark rate which underpins approximately $300 trillion of financial contracts including derivatives, bonds and loans (Bank of England, ‘The Working Group on Sterling Risk-Free Rates’, Nov 2018). Nevertheless, in 2017, the governing body for the regulation of LIBOR, UK’s Financial Conduct Authority (FCA), announced that banks would no longer be compelled to submit data for the purposes of calculating LIBOR from the end of 2021 onwards. In other words, the FCA has announced that LIBOR will be discontinued. The chief executive of the FCA, Andrew Bailey, disclosed that the market that LIBOR sought to measure i.e. unsecured wholesale term lending to banks, was “no longer sufficiently active” for LIBOR to continue as a benchmark (FCA, Speech by Andrew Bailey ‘The Future of LIBOR’, July 2017). As a consequence, a great dilemma has arisen in the financial markets across the world as to how and with what LIBOR will be replaced. Despite its dominant position, LIBOR’s gradual disappearance seemed likely before 2017. Since 2009, the Financial Services Authority (FSA), together with regulators and public authorities in different jurisdictions (including the United States, Canada and the European Union) has been investigating a number of institutions for alleged misconduct relating particularly to LIBOR (The Wheatley Review of LIBOR, 2012). Additionally, the regulatory authorities and the LIBOR administrator, ICE Benchmark Administration (IBA), have introduced varying measures to reform LIBOR. This has been carried out by basing the rate on a transaction-based methodology taking into account a broader range of counterparties and geographies; aiming to ensure that LIBOR is more representative of wholesale funding rates. Notwithstanding these reforms, market inactivity for certain currencies and tenors has made implementation of these measures difficult. Why is LIBOR being Replaced? LIBOR is based on daily submissions of estimated borrowing rates by a panel of banks, as opposed to actual transactions, which signifies that the calculation of LIBOR includes an element of judgement of banks’ credit risk. Following the global financial crisis, confidence in LIBOR has significantly eroded, especially stemming from the high-profile rate-rigging incidents that came to light in 2012, as a consequence of which, the banks themselves became less comfortable with submitting data for the LIBOR calculation (Deutsche Bank, ‘Leaving LIBOR’, Sep 2019). For instance, in June 2012, Barclays was fined $450 million in a settlement with U.S. and British regulatory authorities over rate rigging. In August 2012, a joint investigation of LIBOR resulted in issuance of subpoenas to Royal Bank of Scotland, HSBC Holdings, JP Morgan, Barclays, UBS, Deutsche Bank and Citigroup by the regulatory authorities(Reuters UK, ‘How the LIBOR Scandal Unfolded, Feb 2013). In April 2015, Germany’s Deutsche Bank agreed to the largest single settlement in the LIBOR case, paying $2.5 billion to U.S. and European regulators and entering a guilty plea for its London-based branch (Council on Foreign Relations, ‘Understanding the LIBOR Scandal, October 2016). Since 2015, authorities in both the UK and the United States have brought several criminal charges against individual traders and brokers for their role in manipulating rates, though the success of these prosecutions has been mixed. Despite the LIBOR scandal shaking trust in the financial market, the great volume of transactions referencing LIBOR signifies that the FCA is unwilling to countenance the market disruption that would be caused by an unexpected and unplanned disappearance of LIBOR as a result of any or all of the panel banks simply ceasing their submissions. Consequently, the FCA has sought the voluntary agreement of the current panel banks to continue submitting rates till the end of 2021. The period till the end of 2021 is thereby intended to enable an orderly transition across the market. Risk-free Rates as Alternative Benchmark Rates to LIBOR Starting from the beginning of 2022, the onus is on market participants to (a) develop alternative benchmark rates; and (b) ensure that contracts entered into now which mature after 2021 have sufficiently robust fallbacks to allow a smooth transition if and when the publication of LIBOR ceases (De Nederlandsche Bank, ‘Transition to Alternative Benchmark Rates’, Sep 2019). It is going to be replaced by a system of rates that are more closely tied to the interest rates on actual loans. The starting points for the alternative rates are risk-free rates (RFRs) identified for certain currencies as a part of the Financial Stability Board’s (FSB) interest rate reform initiative. The FSB published a progress report in October 2017 for reforming major interest rate benchmarks (FSB, ‘Reforming Major Interest Rate Benchmarks’, October 2017). Key areas for the FSB include encouraging the identification of alternative RFRs where these have not been identified and the implementation of new fallbacks for key inter-bank offered rates (IBORs) to ensure that contracts are robust and provide a mechanism for calculating a rate if IBOR is permanently discontinued. In 2014, the FSB established five currency subgroups – namely Euro, Sterling, Swiss Franc, U.S. dollar and Japanese Yen – each of which have identified RFRs which could be used as an alternative to the IBORs (Linklaters, ‘Global Interest Rate Reform: An Update’, Dec 2019). For Sterling, the Working Group on Sterling Risk Free Reference Rates selected reformed Sterling Overnight Interbank Average Rate (SONIA) as its recommended RFR in April 2017. SONIA is the main benchmark for overnight unsecured money market transactions in London and denominated in Sterling. SONIA can be compounded to be used in term contracts which tend to be relatively predictable. Referencing alternatives such as SONIA is therefore considered to be the most effective way of avoiding risks related to LIBOR's discontinuation (Bank of England, News Release, ‘SONIA recommended as the sterling near risk-free interest rate benchmark’, April 2017). For U.S. dollars, the Alternative Reference Rates Committee (ARRC) selected a U.S. Treasuries financing rate, known as the Secured Overnight Financing Rate (SOFR), as its recommended RFR in June 2017. This rate is based on overnight lending collateralised by the transfer of U.S treasury securities and will be published by the Federal Reserve Bank of New York. Unlike SONIA, SOFR is a secured rate (New York Fed, ‘Transition from LIBOR’). The national working group on Swiss Franc reference rates recommended Swiss Average Rate Overnight (SARON) as the alternative to Swiss Franc LIBOR in October 2017. SARON is a reference rate based on data from the Swiss Franc repo market. The Study Group on Risk-Free Reference Rates identified Tokyo Overnight Average Rate (TONAR) as the RFR for Japanese Yen in December 2016. TONAR is the uncollateralised overnight call rate calculated and published by the Bank of Japan (International Capital Market Association, ‘The Transition from LIBOR to RFRs’, Jan 2019). In 2017, the European Central Bank (ECB) decided to develop an overnight RFR. This development process resulted in the creation of the Euro Short Term Rate (€STR), a new benchmark rate that has become available since October 2019 (ECB, FAQ on Euro Risk-Free Rates, Oct 2019). However, the potential impact on adopting a new reference rate is financial as well as contractual. LIBOR’s replacement rates, such as SOFR, SONIA and €STR, are calculated quite differently to LIBOR which could result in a change in interest and other payments. While LIBOR is a forward-looking rate published over multiple periods – for example one, three and six months – and fixed at the start of the interest period, SOFR is an overnight, backward-looking RFR that does not include a credit element as they are based on actual transactions. Fixings on RFRs tend to be lower, so the value of variable rate instruments will change, which may prove to be problematic (Deutsche Bank, ‘Leaving LIBOR’, Sep 2019). Conclusion In summation, LIBOR has gradually ceased to be sufficiently representative, both in terms of the methodology for its calculation and by reference to the aggregate value of the transactions on which such calculation is based, of the interest rates for unsecured loans in the financial markets. Although considered to be a bedrock of the financial markets for over 30 years, LIBOR has been under pressure ever since the Wheatley Review and the speech by Andrew Bailey heralded its potential demise. Although alternative (overnight) RFRs to LIBOR are more closely correlated with other money market rates, the value of variable rate instruments will change. How widespread and substantial of a change this will be, is yet to be determined. Interest rate benchmark administrators and regulators around the world have been striving to meet the recommendations of the FSB that benchmark rates be anchored in transactions and objective market data as far as practicable. Whilst the potential discontinuation of LIBOR may be the most high profile consequence to date of this process, it is unlikely to be the last.