Quick guide to Looming end of LIBOR

With the Bank of England's announcement that it will publish the SONIA compounded index from 3 August 2020, for borrowers, lenders and market participants it is time to act on planning for LIBOR transition.

What is LIBOR transition?

LIBOR (the London Inter-Bank Offered Rate), the long-established benchmark reference rate, which is published for a range of currencies and interest periods and is referenced in a multitude of financial contracts for the purpose of calculating floating interest rates, is set to be discontinued after 31 December 2021.

Its discontinuation is the culmination and result of the LIBOR-rigging scandal which showed that LIBOR could be manipulated and, following a comprehensive review, led the Financial Conduct Authority (FCA) to announce that LIBOR would be discontinued. By discontinuing the rate, the intention of regulators is for the market to move to and adopt a more robust system of “risk free” benchmark rates.

Why is it important?

The impact of the cessation of LIBOR on the financial markets and the contracts that reference it can hardly be overstated. The cessation will affect a vast array of financial instruments including bonds, derivatives, loans, and other investment products and contracts that reference LIBOR.

Most importantly, with the discontinuation of LIBOR there is no automatic or prescribed mechanism to deal with replacing the rate in the contracts that reference it (except in very limited circumstances*) and for the vast majority of contracts and counterparties, it is for the parties to agree suitable replacement rates between themselves and mechanisms to implement them ahead of the discontinuation of the publication of the rate. (*The very limited circumstances relate to “tough legacy contracts” which are those contracts that cannot feasibly be amended to deal with the replacement (e.g. widely-held commercial paper)). In its simplest terms, any existing or new contracts that reference LIBOR and will be in effect after the cessation date will need to be reviewed and to provide for a replacement, fallback rate.

There is risk in the process of transition which needs to be carefully managed. Lack of provision for a replacement rate, the choice of an inappropriate rate or a badly thought-out mechanism for switching to a new rate could lead to unfairness or economic loss, or “winners and losers”, among contractual parties, which brings the potential for litigation. Further, consensus on transition mechanisms, alternative rates and best practices are still work-in-progress. Some commentators have warned that the uncertainties and costs are so great that, in some spheres such as commercial real estate loans, contract counterparties may wish to avoid using floating rates altogether and instead may choose to rely on fixed interest rates.

Points of detail to be aware of

Deadlines

The FCA has set various deadlines including interim milestones for the transition, the most important being:

• 31 December 2021 – The date on which the FCA will no longer require LIBOR panel banks to provide the submissions on which LIBOR is published. Effectively, the cessation date when LIBOR can no longer be relied on.
• 30 September 2020 – Beyond this date, market participants should no longer offer or enter into new LIBOR based products maturing after 31 December 2021 and should have alternative arrangements in place.

“Fallback” language

There are contractual mechanisms that can be drafted into the affected agreements to deal with discontinuation of the rate and the switch to an alternative rate. In relation to loan agreements, for example, the LMA (Loan Market Association) has developed fallback language intended to be a “standard” form and we are seeing this language being adopted increasingly widely by amendment of existing agreements and in relation to new loan agreements.

Alternative Rates

The development of suitable alternative reference rates, termed “risk free rates”, is a work-in-progress and market consensus on which rate to adopt continues to evolve and may differ depending on markets (e.g. derivatives or loans) and geographies. The Bank of England (BofE), for example, recommends the SONIA (Sterling Overnight Index Average) benchmark it administers and publishes as being an appropriate benchmark for sterling products that reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. SONIA is calculated as a backward-looking overnight rate on the basis of methodology published by the BofE.

As a backward-looking overnight rate, SONIA has some fundamentally different characteristics to LIBOR, and the BofE has been keen to stress that SONIA is not a like for like replacement for LIBOR. Whereas LIBOR is a forward-looking term rate published on a projected basis for a range of currencies and terms (e.g. 3 months), SONIA:

• is not projected but looks backwards because the rate is measured on the basis of actual reported transactions and historic transaction data.
• is “compounded in arrear” meaning that it is measured on each day over the relevant interest period to produce a final interest rate at the end of the period.
• is not, under current proposals, published for different terms and involves a different calculation method for establishing interest liabilities over defined interest periods.

We continue to monitor how SONIA will be utilised for forthcoming interest periods as consensus evolves (in order to provide borrowers with certainty of debt service costs, it could be based on counterparties agreeing to apply the ascertained historic rate for the equivalent forthcoming period).

What needs to be done?

The first thing for those affected to bear in mind is that you are not alone – an enormous amount of work is being undertaken throughout the financial markets to manage the transition away from LIBOR and to arrive at consensus and best practice for achieving a smooth transition to replacement “risk free” rates.

In light of the fast approaching deadlines, we would recommend as priorities:

• Recognising the importance of taking action now while there is time left to plan effectively and to assess the best replacement options rather than leaving it to the last minute when it may be too late to negotiate the optimal outcome.
• Putting transition planning on the agenda and defining the next steps towards a transition plan.
• Getting on top of what needs to be done in terms of amending existing contracts and deciding on the position for future contracts maturing after the cessation date.
• Not viewing other priorities (however understandably) as a reason for delay – regulators have made it clear that they do not see Covid-19 and prevailing market conditions as a reason to postpone the December 2021 deadline.

How can we help you?

We would be pleased to help you:

• Assess the impact of transition on your business and how it will affect your contractual arrangements.
• Work through the complexity and manage the transition to appropriate fallbacks and replacement rates.
• Review and assess draft fallback provisions, choose appropriate replacement rates and put into effect the necessary contractual amendments.
• Engage with the relevant counterparties and negotiate the necessary contractual amendments.