In 2018, the Financial Conduct Authority (FCA) announced that it would no longer require panel banks to support the London Interbank Offered Rate (LIBOR) after the end of 2021. LIBOR is the benchmark rate, used in the worldwide since the 1970s, underpinning loans, bonds and derivative transactions with an estimated cumulative value of over £ 7 trillion. It is also regularly used as a reference rate in contracts for the calculation of default interest.
What is at stake in replacing LIBOR is the volume of transactions and the complexity of the contracts covered. In addition, the securitization, bond, loan and derivative markets offer solutions at different rates. Since its initial announcement, the FCA and other regulators have strongly advised against the continued use of LIBOR and have pressured financial markets to adopt “risk-free” alternative benchmarks for new contracts and existing (or “old”) contracts that reference LIBOR.
Despite the impact of Covid 19, regulators have continued to press for this timeline. As we enter the final year of LIBOR release, the pace and volume of regulatory announcements increases, with the final announcement of the LIBOR end date in various currencies. As regulators in different jurisdictions move at different rates, this shouldn’t be a reason to delay action, as it seems inevitable that LIBOR will come to an end.
The end of LIBOR
On March 5, 2021, the FCA announced that the LIBOR rates published by the ICE Benchmark Administration (IBA) would largely cease on December 31, 2021, with some rates that may continue to be published in a non-representative synthetic form for limited use in some existing contracts. only (see table below). This announcement was supported by coordinated statements from IBA as well as relevant US regulators and industry groups.
“Synthetic LIBOR” rates will only be available for “hardened” contracts expiring after 2021 and particularly difficult to change, for example due to the number of parties involved. The FCA has yet to release a definition of what will constitute a “hardened” contract and continues to press parties to agree to changes to their existing contracts. Synthetic LIBOR will not be available for new loans. A “synthetic LIBOR” rate will not be an exact economic substitute for current LIBOR rates and there will inevitably be economic winners and losers in contracts that switch to synthetic rates, thus creating the risk of litigation. For this reason, the FCA and other regulators continue to advise parties to agree to amendments to existing contracts rather than relying on a synthetic LIBOR solution and / or relying on the proposed security rules.
What does this mean for contracts that have already been changed?
Many contracts have already been amended to include a “pre-termination trigger” which confirms that the LIBOR benchmark referenced in the contract will be converted to an agreed fallback rate. Pre-cease triggers are usually triggered by an announcement by the benchmark administrator or regulator that LIBOR will cease to be published or that LIBOR is no longer representative of the underlying market. . These contracts will roll over at the agreed fallback rate after the appropriate termination date. Importantly for such contracts, the FCA has confirmed that it does not expect LIBOR parameters to become unrepresentative before scheduled termination dates. The position will vary depending on whether contracts have been amended using suggested language provided by the Loan Market Association, or the US Alternative Rate Replacement Committee, or custom drafting.
What if the contract has not been changed?
The pace of work to amend existing contracts will increase significantly in 2021, especially with respect to LIBOR references which will expire on December 31, 2021. Parties should review these contracts and consult with counterparties to agree on an approach to be taken. . As explained above, hoping that a contract will fall under a potential definition of “difficult legacy contract” could put the parties in a worse position than a negotiated amendment at a replacement rate.
And the derivatives?
For derivatives subject either to the ISDA Fallbacks supplement (which, when incorporated, applies to derivative contracts dated after January 25, 2021), or when the contracting parties have subscribed to the ISDA 2020 IBOR Fallbacks protocol, the announcement of the March 5 FCA was a termination event index that sets the date for changing the agreed fallback rate. Contracting parties also use derivatives to hedge interest rate risks in loan contracts, so they should check whether the derivative fallback provisions are consistent with or complementary to those agreed for loan contracts.
What happens if LIBOR is used only as a default rate in a contract?
LIBOR was such an efficient and versatile benchmark rate that it was used much more widely than in purely financial transactions. It is used to calculate default interest rates in many commercial contracts. In such contracts, it is highly unlikely that the risk-free rates offered to replace LIBOR in different currencies are suitable replacements, as they require complex calculations and adjustments to replicate the effect of the prospective LIBOR rate. The parties will have to agree on an appropriate solution, both for existing contracts which refer to LIBOR in the calculation of late interest rates and for new contracts. As with financial contracts, there is no easy or obvious substitute. One possible alternative is to use a relevant central bank interest rate, with a provision for a zero floor to deal with the risk of that rate going negative.