We all know of the well-reported scandals from the financial crisis but one of the big conclusions was that the London Interbank Offered Rate (Libor) masterfully manipulated by those manipulating it, had to go. In July 2017, Andrew Bailey of the UK Financial Conduct Authority (FCA) duly announced that after 2021, the financial markets would move away from its reliance on Libor. Libor is not based on actual transactions between banks; rather, it is the heavy-weight lending institutions’ estimations of what they expect to pay if they borrowed from another international interbank market. Hence the invitation to manipulate and the decision to kill off Libor.
However, despite its scandal-tainted reputation, Libor remains at the very heart of the global financial system; it is embedded in everything from mortgages to banks’ regulatory capital with (according to Isda, a trade body) more than $370tn of deals tied to it. Without Libor, an indeterminate number of contracts lose the reference rate that forms the basis of their value. What exactly will replace the interest rate index used in calculating floating/adjustable rates for these loans, bonds and other financial contracts is in itself a mammoth and inevitably complicated exercise. Infact, moving global finance away from Libor could, according to bankers and regulators, be “bigger than Brexit”.
It is well reported that UK regulators would like the market to use a reformed (risk free) benchmark called Sterling Overnight Interbank Average Rate (SONIA). This is a measure of the rate at which interest is paid on sterling short-term wholesale funds. The consultation is ongoing between industry groups and regulators and despite Libor-linked transaction volumes being reported as declining, Libor remains the benchmark for the way institutions borrow and lend money.
While we wait for a definitive decision on an alternative benchmark, borrowers and lenders should undertake their own independent due diligence and identify within their existing loan agreements which references Libor, the following:
- What consent/voting rights are required to change the reference rate? How should this be tackled?
- What are the fall-back provisions for the absence of Libor and are there any trigger events for rate replacements? If there are no fall-back provisions, what are the market disruption/increased costs provisions?
- What exactly are the interest provisions and how are they calculated?
The Loan Market Association (LMA) has published a revised “replacement of screen rate” clause in order to facilitate some flexibility in light of the uncertainty. As a starter for ten, this is helpful but it would be better if it had a broader approach; for example, the market switching to an alternative rate while Libor continues to exist. Like most transactions, one size does not often fit all – risk free rates might just not be appropriate for commercial contracts and any switch to a replacement rate will inevitably lead to figure changes to reflect the spirit of the original commercial deal. We should, therefore, anticipate tailoring industry contracts and drafting bespoke documentation to suit our clients in a post-Libor era.
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