Replacing LIBOR - Are you Thinking About This $200 Trillion Dollar Problem With Your Contracts?
Since 1986, the London Interbank Offer Rate (LIBOR) has been used as the reference interest rate for millions of contracts, with a notional outstanding value of more than $200 trillion. Derivative contracts account for the majority, but loans of all types, from syndicated to business and retail, reference what has been termed the “world’s most important number.”
LIBOR’s central function is as the rate that banks charge each other for unsecured lending. Following the highly publicized rate-fixing scandals of 2012 and a decrease in unsecured lending, the UK’s Financial Conduct Authority declared last year, that beyond 2021, it would no longer require or encourage the panel banks to submit the data that enabled LIBOR to be calculated.
What Comes Next?
With so many contracts, financial instruments, and models referencing LIBOR, clearly an alternative or alternatives need to be found in case LIBOR disappears after 2021. To this end, regulators around the world have formed working groups. In the US, this is known as the Alternative Reference Rates Committee (ARRC), whose preferred replacement is the SOFR (Secured Overnight Financing Rate). The corresponding UK group has put forward Reformed SONIA (Sterling Overnight Index Average) and other countries have formed their own variations.
SOFR publication began on April 3, 2018, but currently each of the alternative reference rates only exists as an overnight, rather than a term rate. There are technical differences between the alternative rates and LIBOR and their behavior is also likely to differ, especially in times of financial turbulence.
At the time of writing, there is still much uncertainty regarding whether LIBOR will disappear and, if so, what will replace it and over what precise timelines. The AARC has determined that SOFR will be a replacement rate for swaps, but it is now trying to develop solutions that apply across asset classes.
While 2021 seems far in the distance, certain contractual problems for market participants appear likely, such as how to:
- Contractually deal with different rates for different products and currencies in the future;
- Change valuation methodologies to account for a LIBOR replacement’s different behavior;
- Amend voluminous numbers of existing contracts, if their provisions for the non-existence or replacement of LIBOR are not robust enough (most assume a short-term unavailability);
- Communicate contractual amendments to customers;
- Seek approvals for amendments when necessary from customers; and
- Deal with the lack of term rates, if they don’t become available.
Start Planning Now
It is tempting to hold off acting on the LIBOR transition issue, due to the considerable ongoing uncertainty. However, the scale of the number of contracts affected and the impact of LIBOR disappearing, should that occur, mean that it would be wise to begin thinking about some of the relevant issues now:
- Raise the issue internally if it is not already on peoples’ agendas (legal, risk, operations, contracts, front office);
- Begin to speak to any third parties, such as a Trustee, who might also be affected;
- Start to identify which existing contracts reference LIBOR and will survive beyond 2021;
- Analyze existing contracts and triage them by priority levels;
- Ensure that new contracts have robust language covering reference rates in a variety of scenarios; and
- Start to create plans for communicating with customers and counterparties.
There may be some readers who prefer to take the “Millennium Bug” approach to the issue, ignoring it in the hope that LIBOR’s life extends well beyond 2021. Needless to say, we would not recommend this.
As you navigate your LIBOR transition planning, we encourage you to consider UnitedLex as a strategic partner. Our team of professionals combines the legal knowledge, project management skills, access to proven technology platforms, and cost-effective resources necessary to drive positive business impact throughout your organization. Contact Us for more information.