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The LIBOR Transition: Is IT A Hard Goodbye?

INTRODUCTION

The key benchmark rate underlying various financial contracts worth more than USD 240 trillion, is scheduled to be discontinued from 31 December 2021 for certain currencies and tenors, while complete cessation is scheduled after 30 June 2023. The London Inter-Bank Offered Rate (“LIBOR”) dates to 1960s and has been published daily since 1986. It is determined by polling interbank unsecured wholesale borrowing rates from 20 panel banks in London for various tenors in US Dollars, Sterling, Euro, Swiss Franc and Japanese Yen. However, after the global financial crisis, banks have drifted away from unsecured short-term borrowing. Consequently, importance of LIBOR reduced implying that the underlying market which LIBOR measures is no longer sufficiently active. This has posed questions on the sustainability of LIBOR benchmarks that are based on these markets. Consequently, panel banks used expert judgement for forming their submissions for the determination of LIBOR. Such lack of objectivity was one of the reasons for reported and proven cases of manipulation and false reporting of actual rates at which interbank borrowing took place leading to regulatory intervention and discontinuance of LIBOR as a benchmark rate.

While worldwide regulatory and private efforts are being made to identify a sustainable replacement of LIBOR, there exist various gaps in replicating LIBOR which may cause disruptions in the financial markets. For instance, majority proposed alternative reference rates (“ARRs”) are backward looking, while LIBOR is forward looking. To mitigate shocks in the derivatives markets, the International Swaps and Derivatives Association has published its official fallback protocol derivative trades that reference LIBOR or other Interbank Borrowing Rates as benchmarks. The impact on fixed income markets of this transition is unclear, causing significant uncertainty.

PROPOSED REPLACEMENTS FOR LIBOR

With less than 2 months left for cessation of non-USD LIBOR publications, the effect on ongoing surviving transactions as well as new transactions and the inclusion of an appropriate ARR needs to be assessed.

By way of examples, we have briefly analysed two ARR’s – Bank of England’s replacement for LIBOR, Sterling Overnight Index Average (“SONIA”) and synthetic LIBOR.

SONIA

In April 2017, the Working Group on Sterling Risk-Free Reference Rates recommended SONIA, the unsecured overnight rate as its preferred risk-free rate. We have identified certain key differences between the workability of LIBOR and SONIA, if SONIA is introduced as a LIBOR replacement:

  • SONIA is an overnight rate: While LIBOR provides cost of borrowing for different tenors and is forward looking, SONIA measures cost of overnight borrowing.
  • SONIA does not include credit risk: As SONIA does not include an implicit credit premium, it is therefore, lower than term LIBOR.

Therefore, on transition adjustments need to be made to account for the above differences between LIBOR and SONIA. This adjustment is known as “Credit Adjustment Spread” or “CAS”. The Working Group on Sterling Risk-Free Reference Rates has suggested that CAS for SONIA and LIBOR could be calculated based on the median difference between LIBOR and SONIA over the last 5 years and add this to the SONIA rate for the relevant period.

Synthetic LIBOR

The Financial Conduct Authority has allowed continued publication of 6 Sterling and Japanese Yen LIBOR versions for 12 months from 31 December 2021 using a “synthetic methodology” to ensure orderly wind-down of existing positions. They will, however not be “representative” as defined in the Benchmarks Regulation. The legacy contracts for which its use would be permitted is yet to be finalised. On the legislative front, the UK Government has introduced the Critical Benchmarks (References and Administrators’ Liability’) Bill. This legislation is proposed to address any remaining risks to contractual certainty, or of disputes, in respect of legacy contracts referencing “synthetic” LIBOR rates after end-2021.

IMPLICATIONS OF THE PROPOSED TRANSITION

As no ARR is able to capture both average credit risk and term, we foresee following major implications on cessation of LIBOR:

  • Volatility: Federal Reserve Bank’s proposed LIBOR replacement for U.S. dollar products, the secured overnight financing rate (“SOFR”) is based on actual secured overnight transactions in the treasury repurchase (repo) market. Therefore, ARRs such as SOFR are subject to volatility triggered by stress and irregularities in the repo funding market.
  • Fund transfer pricing (“FTP”): In the transitional arrangements, entities would need to evaluate appropriate FTP processes to allow them to measure cost. LIBOR has inherent interbank credit premium basis unsecured exposure and forward-looking term structure of rates set daily. The transitional arrangements would have to inculcate baseline new pricing and also include within it measures of profitability.
  • Legal contracts: There is possibility of litigation on issues pertaining to interpretation and enforceability of legacy fallback language which only provided for temporary unavailability of LIBOR. As a matter of Indian law, Section 56 of the Indian Contract Act, 1872, provides for discharge of parties from their contractual obligation owing to the occurrence of some supervening event, which renders its performance impossible, like permanent unavailability of LIBOR. As a result, banks in India could recall the facilities extended under such arrangements declaring frustration. There is therefore uncertainty on what rights could then be exercised by borrowers and how such cancellation would take place. Likelihood of litigation is, therefore, high.
  • Uncertainty of borrower: Apart from the above issues, the overnight ARRs are likely to be lower than the LIBOR rates. To balance the value, the replacements would need to be appropriately adjusted. Suggestions include calculation of cost of borrowing at the end of the interest period by compounding backwards. This will cause significant issues as the borrower will not know cost of borrowing at the time of taking debt. In particular such a solution does not work for the trade finance market where margins are set up front.
  • Cost of funds issue: While cost of funds is a commercial concept ascertained by banks basis various objective and subjective factors, the absence of any legislative framework or guidance to provide backing to the calculation of its cost of funds makes it susceptible to challenge. Accordingly, if banks were to adopt an interest spread on their lending book basis cost of funds, proving the same in a court could get very challenging. 

MARKET TRENDS

With the above issues still existing, the financial markets are gearing up at a rapid pace to ensure preparedness for the cessation of LIBOR and to absorb emanating shocks. In April 2021, the New York State adopted Section 18-C of the General Obligations Law, providing fallback on cessation of LIBOR for contracts governed by New York law that utilize LIBOR but lack a replacement benchmark. SOFR is being adopted by large banks in the United States because they have stronger ties to the market for repurchase agreements. However, various small and mid-sized banks are seconding adoption of American interbank offered rate. The index is based on transactions in the overnight loan market on the American Financial Exchange. The Chicago Mercantile Exchange (“CME”) Group adopted CME Term SOFR reference rates for use based on their previously outlined best practices. Since its introduction a little more than three years ago, participation in CME SOFR futures has developed rapidly with more than 600 participants globally trading the product. The Indian regulator, in its discussions on the LIBOR transition has emphasised that SOFR and SONIA constitute a significant share of total floating rate bond issuances. Trading volume in SOFR and SONIA futures has been increasing over the months. In particular, there is significant volume of trading in swaps referencing SONIA.

CONCLUSION

The aim of the efforts being made to make way for orderly wind-down of LIBOR is to reduce disruptions and distortions in the financial markets especially for arrangements which would survive this cessation and reference LIBOR. However, with less than 2 months left, there still appears to be a lack of preparedness. LIBOR elegantly protected banks from the vagaries of risk volatility by increasing and reducing yield with increased and reduced market risk automatically. No solutions currently offered provide such an elegant and automatic adjustment mechanism. The implications will only be visible when transition is forced into effect after 31 December 2021. The impact will especially be enhanced in jurisdictions such as India, where major debt exposure is to US Dollars. Given the possibility of lenders being able to declare frustration and claim restitution, there is urgent need for chief financial officer’s having foreign currency debt exposure evaluate what kind of transitional arrangement would best suit the needs of existing loans and how the transition effects can be minimized.

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For any additional information please contact us at sakate.khaitan@khaitanlegal.com or anisa.bawari@khaitanlegal.com.

Sakate Khaitan

Senior Partner

Sanjeev Singhal

Senior Consultant

Anisa Bawari

Senior Associate

Srishti Dembla

Associate
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