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This article was published in the August 24, 2017 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG). It is reprinted here with permission.
LIBOR has been referred to as “the world’s most important number,” and $350 trillion in financial products pegged to LIBOR provide strong reason for believing that description to be true. LIBOR, the London Interbank Offered Rate, measures the rate at which banks can borrow from one another on a short-term, unsecured basis. LIBOR is the market standard for pricing financial assets including credit cards, syndicated loans, and swaps and other derivatives.
LIBOR is calculated by asking a panel of banks to estimate the rates at which they could borrow from other banks across five currencies and seven maturities. On July 27, 2017, Andrew Bailey, chief executive of the Financial Conduct Authority (FCA), the UK’s primary financial regulator, announced that the FCA will no longer encourage or compel banks to submit LIBOR quotes after 2021.1 This announcement marks the most concrete step taken by regulators in their efforts to encourage financial market participants to move to transaction-based benchmarks.
What Is Behind the Change?
The primary criticism of LIBOR is that it is based on estimates, and that panel banks are often asked to submit estimates for markets in which they are not active. This gives rise to two difficulties. First, LIBOR may not actually reflect the true cost of borrowing, especially in times of market stress. Second, LIBOR is susceptible to manipulation. For example, as happened in 2012, some panel banks may intentionally report low rates to bolster their profits, demonstrate a low cost of funding, and appear more financially sound.2 Due to its ubiquity and the sheer amount of transactions underpinned by LIBOR, regulators believe that LIBOR may be a source of systemic risk. For these reasons, regulators have encouraged market participants to move away from LIBOR and toward a more robust, transaction-based alternative.
What Will Replace LIBOR?
As an initial matter, it is unlikely that LIBOR will disappear entirely. LIBOR’s administrator is free to continue to solicit quotes after 2021, and indeed the administrator has indicated that it intends to do so.3 The announcement by Bailey, however, signals the end of the FCA’s support of LIBOR, and, without that official approval, it is unlikely that LIBOR will continue unchanged.
A number of potential replacements have been suggested. In June 2017, the Alternative Reference Rates Committee (ARRC), a consortium of U.S. regulators and market participants, announced that it supported a broad Treasuries repurchase financing rate (Broad Repo Rate).4
The Broad Repo Rate will be the rate charged for interbank overnight loans secured by treasuries. The Broad Repo Rate will be published by the New York Fed in conjunction with the Office of Financial Research and take into consideration triparty and select bilateral repurchase transactions. ARRC believes that the Broad Repo Rate provides a robust alternative to LIBOR based on the size of the overnight repo market and its relevance to a large number of financial market participants.5
The Broad Repo Rate is considered more transparent than LIBOR because it reflects actual traded rates. The Broad Repo Rate is an overnight rate, as opposed to LIBOR, which provides longer tenors. The Broad Repo Rate is also a secured rate, whereas LIBOR represents the unsecured cost of borrowing. Although discussions with respect to a new reference rate will continue within the syndicated loan market, the Broad Repo Rate represents the best practice for use in new U.S. dollar derivatives and other financial contracts.
What Does This Mean for Me?
For market participants, the FCA’s announcement signals a change with practical significance. For transactions being entered into between now and 2021, parties should carefully consider the choice of reference rate. Given the uncertainty that remains, it is likely that most financial contracts will continue to reference LIBOR in the short term. However, it is important to incorporate provisions that will allow for a smooth transition from LIBOR to another reference rate in the future. As market discussions evolve and participants settle on new preferred reference rates, those reference rates may be incorporated as back-up rates.
For existing deals maturing after 2021, it is important to scrutinize the documentation to identify what provisions, if any, are included in the event that LIBOR is unavailable. While it is standard practice to include “fall-back” benchmarks in the event that LIBOR is unavailable, these provisions are most commonly intended as temporary fixes. For example, in a syndicated loan transaction, a common fall-back provision requires the agent to solicit quotations from the various lender banks. These stop-gap solutions are often impractical as a permanent solution. Instead, legacy financial contracts should be amended to provide for the flexibility necessary to make future amendments in light of changes to LIBOR. These amendments may take the form of allowing the agent to unilaterally change the reference rate in a commercially reasonable manner and with advance notice, or by requiring the consent of a subset of lenders and the borrower.
Global financial regulators have urged financial market participants to adopt transaction-based benchmarks for a number of years. Recently, the FCA took the most concrete step to date to achieve this goal by announcing that the FCA would no longer encourage banks to submit LIBOR quotes after 2021. As a result, financial market participants need to prepare for potential changes to LIBOR.
For transactions occurring between now and 2021, parties should carefully consider their chosen benchmarks and incorporate the flexibility that will be necessary to achieve long-term solutions. Similarly, existing financial contracts should be scrutinized to determine whether the fall-back reference rates provide practical alternatives. If not, parties should consider how best to ensure a smooth transition away from LIBOR, including by amending their financial contracts.
Pepper Hamilton attorneys have experience in drafting and negotiating commercial contracts. If you have any questions about LIBOR or what the changes to LIBOR mean for you or your business, please contact the attorneys at Pepper Hamilton.
5 ARRC, Interim Report and Consultation, at 17.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.