Libor replacement may not sound like a headline grabber. However, the transition away from Libor is one of the most significant challenges to face financial markets in a generation. Booms and busts that lead to financial crises are largely unpredictable, but this monumental challenge is self-imposed.
What is Libor?
Libor (London Interbank Offered Rate) and other IBORs (Interbank Offered Rates) are, in theory, benchmark interest rates that banks would charge each other for short-term loans. Libor has been used in financial markets since the 1980s and is currently published for five currencies over seven time periods (or ‘tenors’). Libor rates are determined by quotes provided by a panel of banks. For example, a three-month GBP Libor is what benchmark interest rate banks would charge each other to borrow sterling for three months. Libor is easy to use and so is found in a variety of financial products, including loans, derivatives and bonds.
Why Libor is being replaced
On 5 March, the Financial Conduct Authority (FCA) confirmed it would no longer compel panel banks to provide quotes for most Libor rates after 31 December 2021, including GBP Libor. This means that the Libor administrator will not have the information needed to publish the rates from that date.
There are compelling reasons for the FCA’s push to replace Libor. Libor is vulnerable to manipulation, as was discovered in the 2012 Libor rigging scandal. In addition, Libor operates on the assumption that there is a robust unsecured interbank market. However, Libor has become unrepresentative because banks have moved away from funding their activities via the interbank market following the financial crisis.
Enter Sonia
IBORs are being replaced by risk-free rates (RFRs). GBP Libor is being replaced by the Sterling Overnight Index Average (Sonia). Sonia is an interest rate that is already used in certain markets, including retail banking. Sonia is published and administered by the Bank of England and is considered a reliable market standard.
Problems
Simply substituting Libor with Sonia is not straightforward, because of the different ways in which the rates are calculated. Libor is forward looking, with rates set at the start of an interest period. Sonia is backward looking, calculated using transactions from the previous business day on an overnight basis. In addition, RFRs do not contain the risk or time premium that was built into IBORs. This means that swapping Libor for Sonia without making other changes would lead to a different economic outcome for the parties.
Even if IBORs and RFRs were equivalent, amending all of the rates in legacy contracts is a monumental task. For certain products, such as bonds, amending the rates would require noteholders to be notified and agree to the change (known as ‘consent solicitation’). This is burdensome and potentially impossible for certain products due to the number of noteholders.
Solutions
Derivatives
The International Swaps and Derivatives Association (ISDA) represents the derivatives industry. ISDA published standardised IBOR replacement wording that can automatically be incorporated into legacy derivative contracts by a mechanism called a Protocol. New derivatives transactions will incorporate a new set of definitions, that also includes IBOR replacement language.
In order to align the economic outcome, a ‘credit adjustment’ spread is now being published by Bloomberg for derivatives contracts. This is intended to ensure that the parties receive the same amounts as they would have received under the legacy contracts if Libor had not been replaced. The ideal outcome would be for the derivatives, loan and bond markets to agree on the calculation of credit adjustments where needed, to avoid a mismatch.
Loans
Lenders should now either only be offering loan products based on RFRs, or be including contractual arrangements to facilitate Libor replacement. The Loan Market Association, a market-led body representing the syndicated loan market, has published standard fallback wording. For legacy contracts without fallbacks, the parties are likely to be required to individually agree to amend each loan. The loan market does not have the equivalent of an ISDA Protocol.
Bonds
The way forward for the bond market is unclear. Similarly to the loan market, there is no Protocol option. Noteholder consent is needed for changes to documents. With some more complicated products, the noteholders might be unknown or hard to contact. Some issuers may simply choose to unwind the product, rather than go through the process of a consent solicitation to amend the underlying notes.
Long live Sonia
While Sonia may not be the perfect replacement for GBP Libor, the FCA’s clear position on the timeline and the early identification of the replacement rate has put the UK financial markets in a better position than the US or Europe. The next hurdle is to ensure that Sonia (and any necessary credit adjustments) are implemented consistently by the different industry sectors mentioned above. This is important, as derivatives are often used to hedge risks in loans and bonds. A mismatch in the market could lead to serious economic consequences.
It is tempting for market participants to avoid being first movers when adopting a new market standard, to avoid locking in a less favourable approach than the rest of the market. The FCA and Prudential Regulation Authority should act to encourage banks to take a unified and definitive position on Libor replacement and credit adjustments, paving the way for the rest of the industry to follow.
Netanya Clixby is legal counsel at a quantitative finance research firm in London and sits on the Law Society’s LGBT+ Lawyers Division Committee
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