LIBOR no more: practical guidance on how to prepare for the phase-out of LIBOR
May 2019 | SPECIAL REPORT: BUSINESS STRATEGY & OPERATIONS
Financier Worldwide Magazine
May 2019 Issue
First, it was the LIBOR scandal. Then, negative LIBOR. But soon, it will be LIBOR, no more. Followers of the financial press may well feel that LIBOR is never out of the news. LIBOR could be phased out by the end of 2021 as part of a broader move away from interbank offered rates (IBORs) globally. Other IBORs, such as EURIBOR, are likely to suffer the same fate.
This discontinuance of IBORs will have implications for all businesses that have agreements referencing IBORs. Few organisations will be unaffected by this change. While the financial services industry is beginning to tackle the issue head-on, corporates are thought to be less well prepared at present, notwithstanding that many corporates have agreements that reference LIBOR and other IBORs, including loans, bonds, derivatives and intercompany loans, as well as ordinary commercial agreements that specify, for example, an interest rate for late payment based on LIBOR plus a spread. This article explores the reasons for and effects of this phase-out, before setting out practical steps a business can take to prepare for its potential impacts.
What are IBORs, why are they being replaced and by what?
IBORs are interest rate benchmarks that are based on the rate at which banks are able to obtain unsecured funding in the interbank market for a specified currency and time period. They have traditionally been calculated from submissions made by panels of banks, although under recent reforms some of them (including LIBOR) are now based in part on actual transaction data.
On 27 July 2017, the chief executive of the UK Financial Conduct Authority (FCA) announced that LIBOR panel banks will no longer be compelled by the FCA to submit rate quotations from the end of 2021 onwards. A year later, coordinated announcements by the FCA chief executive and US regulators stated in no uncertain terms that market participants needed to prepare for the end of LIBOR in 2021. The phase-out was necessary, according to the regulators, due to a reduction in the volume of interbank lending activity, leading to concern that LIBOR is thereby potentially more vulnerable to manipulation and less likely to be a truly representative reference rate.
From a European perspective, EURIBOR does not currently comply with the requirements of the European Benchmark Regulation (BMR). A reform process is currently underway to amend its methodology to include transaction data in order to make it compliant by the deadline of 1 January 2020 (which, at the date of writing, appeared likely to be extended until the end of 2021). The success of this reform is not guaranteed, and it is likely that EURIBOR might equally cease to be published, as the new methodology will be based in part on submissions by panel banks that may not wish to continue to provide quotations.
If not IBORs, then what?
Various national working groups that have been established to answer this question have designated certain overnight risk-free reference rates (RFRs) as their preferred successor to IBORs. Examples include a modified version of the Sterling Overnight Index Average (SONIA), based on overnight unsecured deposits, for sterling, the Secured Overnight Financing Rate (SOFR), based on overnight secured transactions, for US dollars, and a new Euro Short-term Rate (ESTER) for euros.
These RFRs are, however, not a panacea to the phase-out. RFRs differ materially from IBORs in ways that may be challenging for users. IBORs are forward-looking and available for multiple tenors (e.g., one week and three months). RFRs are backwards-looking and available on an overnight basis only. There is at present no widely accepted method of converting pure overnight rates into term rates. There are also concerns that RFRs do not reflect the banking sector credit risk inherent in IBORs, so margins above IBORs will not easily be convertible into RFR margins.
What are the implications of this phase-out for businesses?
While it is possible to use overnight rates to produce a retrospective term rate at the end of a period, this has a significant disadvantage because borrowers would not know the amount of an interest payment at the start of a period, making it harder for corporate treasurers to plan. Working groups sponsored by central banks and industry groups, such as the International Swaps and Derivatives Association (ISDA), continue to consider how to make RFRs workable replacements for IBORs, but much remains to be done.
Even if RFRs were the perfect solution, they will not automatically be ported across into existing agreements. An amendment process for underlying contracts will be required, which may be lengthy with non-negligible transaction costs and could have accounting and tax implications. Organisations will need to carefully plan and manage this process.
Yet for most businesses, leaving current agreements referencing IBORs unchanged would not be a prudent course. Some agreements, particularly financial agreements, provide for so-called ‘fallbacks’, which set the interest rate when IBORs are unavailable. All but the most recent of these clauses were drafted with temporary rather than permanent discontinuation in mind. As a result, applying contractual fallbacks may cause outcomes that make no economic sense or materially alter the expected contractual terms. As an example, floating rate notes might become fixed-rate (at the last available LIBOR) and interest rates under loan documentation might be calculated, based on the cost of funds of each individual lender.
Businesses will also be subject to basis risk, where the application of different fallbacks in connected products – e.g., a floating rate loan and a derivative hedging the floating exposure – produces mismatched outcomes. This risk is heightened in complex financial products such as securitisations or structured products.
Contracts without any fallback, which is often the case in commercial contracts, are potentially even more problematic. The enforceability of the entire agreement may be subject to challenge by counterparties seeking to avoid contractual obligations. The basis for any such challenge and the likelihood of success will depend on the governing law.
While the steps that each organisation should take to deal with these issues will depend on the nature of its business and exposure, we set out some high-level guidance below.
What steps can businesses take to prepare?
The first step for any organisation will be to identify and organise appropriate resources. This will include identifying responsible individuals or teams to manage any required implementation and retaining external advisers. Given that risk mitigation steps may have tax and accounting consequences, organisations would be well-advised to obtain input from their internal and external tax and accounting teams from the outset.
Businesses will need to identify and risk assess their existing exposure to IBORs. All relevant products, contracts and processes (such as transfer pricing or asset valuation) should be reviewed to identify where IBORs are used. A risk assessment should be conducted to identify the scale of potential exposures under those arrangements and to identify high-risk areas (in particular, areas where applications of fallbacks will result in unintended or mismatched outcomes or where there are no fallbacks) in order to prioritise the implementation phase.
Armed with the information from the diligence process, organisations can then identify and execute a risk mitigation strategy for affected arrangements. The first step is to assess how each contract or process can be amended and the likely timeline. Certain instruments will have longer lead times than others. Structured products, loans with covenants and widely held bonds may require more time than bilateral credit facilities, for example. Relevant tax, accounting and regulatory teams should be consulted as required to analyse the potential impact of any amendments. Having considered the above and conducted any necessary cost-benefit analysis based on the size of the exposure and the costs of the change, discussions can then be started with counterparties in relation to execution.
Organisations should educate teams about the terms of fallback provisions in future contracts that are entered into before, but will endure beyond, the phase-out date. An internal policy providing guidance on fallback provisions that should be included in such contracts is an important step in standardising an organisation-wide approach. This policy should be communicated to teams dealing with agreements containing reference rates as part of a broader education programme about the transition. It is important that these policies not be static – they should be updated as matters progress.
Members of the implementation team should keep themselves informed of key developments. One method of doing so is keeping track of how the working groups and industry groups (e.g., ISDA and the ACT) are dealing with these issues. Teams may wish to shape market solutions by participating in any consultation processes held by such bodies.
Throughout the process, thought should also be given to the non-contractual uses of IBORs and the operational and process impact of the phase-out. For example, IBORs may be used for accounting purposes (e.g., for discounting provisions and calculating fair value for certain derivatives) and for internal reporting or analysis (e.g., measuring investment returns). Systems and processes that are currently based around term IBORs may require upgrades in order to deal with RFRs that are backwards looking and overnight-only, where amounts payable as interest are only known shortly before the payment date.
Andrew Bernstein and Sui-Jim Ho are partners, and Adam Machray is an associate, at Cleary Gottlieb Steen & Hamilton LLP. Mr Bernstein can be contacted on +33 1 40 74 68 00 or by email: firstname.lastname@example.org. Mr Ho can be contacted on +44 (0)207 614 2284 or by email: email@example.com. Mr Machray can be contacted on +44 (0)207 614 2282 or by email: firstname.lastname@example.org.
© Financier Worldwide
Andrew Bernstein, Sui-Jim Ho and Adam Machray
Cleary Gottlieb Steen & Hamilton LLP