Called variously ‘bigger than Brexit’ or ‘the largest banking challenge you’ve never heard of’, one thing is certain; regulators have specified that the London Interbank Offered Rate (LIBOR) will cease to exist after 2021-end.
LIBOR is estimated to underpin USD340 trillion in financial contracts and has held sway over the interest rates banks charge each other for short-term unsecured loans for decades.
During the 2007-2008 financial crisis, however, LIBOR began to behave in an unexpected manner compared to other market benchmarks. The UK and US regulators and prosecutors scrutinised the benchmark and how it was calculated, ultimately concluding that it was subject to manipulation.
This ‘LIBOR scandal’ sparked calls for deeper reform of the entire LIBOR system as regulators remained concerned that LIBOR was not a reliable benchmark given the relative lack of underlying transactions in the interbank lending market that LIBOR was meant to measure.
The industry now seeks a wholesale move to so-called risk-free rates (RFRs) anchored in actual transactions – with the preferred RFRs for the affected LIBOR currencies already identified by industry working groups.
Where RFRs had previously lacked volume, the industry as a whole is now evolving to offer viable alternatives to the IBORs (interbank offered rates) in a post-LIBOR world, according to the Bank of International Settlements1.
For banks, institutional investors and corporates, however, transition issues loom large, requiring resources in terms of manpower, money and cogent action plans.
The most pressing concern is the migration of legacy LIBOR-linked exposures to the new benchmarks when LIBOR publication ceases after 2021.
Trillions of dollars of legacy contracts will still be outstanding at that time and the results of not constructing adequate fallbacks in LIBOR-referencing contracts is potentially catastrophic.
As 2020 progresses, floating-rate note (FRN) issuers and investors are increasingly being urged to transition away from LIBOR-linked benchmarks towards the use of alternative RFRs in their new contracts – and to ensure their legacy contracts include sufficiently-robust fall-back language. This is to avoid the risk of their FRNs converting to fixed rates in the event of a permanent cessation of LIBOR, with the potential to create losses for the unwary and equally huge windfalls for others.
For John Ho, Standard Chartered’s Head of Legal, Financial Markets, corporates and banks need to realise that the changes will go beyond simply redrafting contracts.
In September 2019, the Alternative Reference Rates Committee (ARRC) released a practical implementation checklist to help market participants transition away from USD LIBOR to using the SOFR. The checklist covers 10 key areas where action is needed in order for impacted firms to prepare for the transition to SOFR. These include governance, communications, risk management, contract remediation, and operational readiness.
When it comes to bank preparation, it’s as much about helping clients as it is about their own impact analysis. According to Dixon-Smith it’s incumbent on banks and their clients to keep the dialogue open and moving.
Worryingly for many banks, contracts that require term rates are still being referenced to LIBOR. At the root of the problem is that while RFRs have a solid past based on actual transactions, they are overnight rates whereas LIBOR is published across a number of maturity periods. Unlike LIBOR, RFRs do not contain an embedded term or credit risk premium.
In contrast, a significant volume of cash products such as loans linked to LIBOR have forward-looking term rates, meaning borrowers have certainty over their future liabilities and can manage cash flows more easily.
While certain currency jurisdictions are working on forward-looking term rates, it is not certain that these will be developed before the end of 2021. According to Ho, global regulators have urged market participants to press on with LIBOR transition without waiting for these term rates to arrive.
Such benchmark reform is sure to create an administrational load as LIBOR’s demise draws near. While there are some that may be hoping benchmark headaches will be regulated out of existence by the time LIBOR is dead and buried, analysts say it’s a misplaced hope.
“I think it’s better to make appropriate proactive plans than to wait and see,” said Ho. “Transition will require mobilisation of significant resources to phase out of LIBOR and no one will want to be left hanging.
“The key message is that people need to start thinking about this, what it means for their organisation and to have a clear plan of action across a range of touchpoints. Firms with LIBOR exposure should fully understand their exposures and risks, seek to reduce reliance on LIBOR and engage in transition efforts.”
Given the degree of risk arising from the continued reliance on LIBOR, market participants should expect increasing regulatory scrutiny of their transition efforts as the end of 2021 approaches.
