From the late 1960s, the LIBOR became the benchmark used for pricing floating rate loans and subsequently, it became the basis of interest rate derivative transactions. The uses of LIBOR have continued development and it is now the benchmark to which the global financial markets default. An estimate suggests that currently there are $350 trillion of transactions using LIBOR as its benchmark.
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For decades, the financial world placed its trust in the LIBOR as a reference interest rate for a wide range of financial instruments across the globe. LIBOR was aimed to represent the average interest rate that a panel of leading banks in London would charge each other for a loan.
However, the trust in LIBOR started fading as scandals eroded, one after another, over the past five years. In 2012, a plot was unveiled by some banks to manipulate LIBOR for profit by regulators in the United States and Europe. Nearly 12 banks were fined and had to pay penalties to the tune of $10 billion in 2016.
The UK's Financial Conduct Authority (FCA) has now called for an end to LIBOR as a benchmark. It is supposed to discontinue by the end of 2021. As LIBOR moves, so do the interest payments for the $350 trillion in financial securities.
Whilst it is too early to be definitive at this stage as to where things will end, the phasing out of LIBOR will undoubtedly have a significant impact across the global financial markets.
The Syndicated Loan Saga
What will happen to the syndicated loans which have been priced using LIBOR, post-LIBOR?
While the FCA has allowed the banks to voluntarily publish LIBOR rates for additional 4 years for a smooth transition, there is still no clarity on how these will be transitioned post the 2021 deadline.
In the event that the parties are unable to agree on the amendments to the transaction documents to reflect the amendments to the benchmark:
- If LIBOR continues to be published (as is currently being suggested by InterContinental Exchange, the entity currently responsible for the administration of LIBOR), those transactions can continue "as is", or
- In the case where LIBOR is no longer published, the parties may ultimately end up in court. One or other of the parties may be arguing that alternative benchmarks or methods of calculating interest should be used. Depending on how the claims are framed, the court may be invited to apply principles of contractual construction to determine what the parties intended by the words actually used in their contract.
- Alternatively, the court might be asked to imply a term into the contract to give it business efficacy or perhaps even to rectify it on the basis that it contained a mistake. Much will depend on the wording actually used in the contract and the context in which it appears as well as the commercial context. The outcome of such claims can be notoriously difficult to predict as the rules relating to them are complex and allow a judge considerable leeway.
Bonds and their documentation
Changing the applicable benchmark where there is no provision for it in the terms and conditions of the bonds will require an amendment to be made to the underlying documentation.
Risk factors have already started to appear in bond prospectuses related to uncertainty and changes around the calculation, or even availability, of benchmarks. It is likely that these will need to be amended to explicitly deal with the phasing out of LIBOR. Market consensus over how to approach the issue in transactions going forward is likely to be reached relatively quickly but existing transactions will need to be reviewed on an individual basis to ascertain what, if any, amendments are required, and how those amendments will need to be implemented.
What lies ahead?
The real impact of the phasing out of LIBOR will only become apparent when it becomes clear whether or not LIBOR will continue to be published after the end of 2021. If LIBOR is still published, then existing transactions can continue by reference to LIBOR without needing amendment, whilst new transactions can be written by reference to the replacement benchmark. On the other hand it would be costly accruing to the administrative burden due to the amendments which will be required to the underlying documentation.
The financial services industry along with the regulators across the globe are focused on efforts to choose and transition to alternative risk-free rates (RFR). In a highly uncertain environment, individual financial institutions must assess and plan for the potential impact of a transition away from LIBOR on their products, infrastructures, and customers. A broad range of financial instruments involving trillions in USD worldwide use LIBOR. Hence, the decommissioning of LIBOR will significantly impact most of the functions and businesses of financial institutions.
Some commentators are suggesting that in the wider financial market the replacement (sterling) benchmark will be SONIA - a sterling overnight interest rate - as it is the most comprehensive sterling alternative benchmark currently.