Embracing the Future: LIBOR Transition

LIBOR Leftovers

February 09, 2022
  • Investor Services
Financial institutions have had a lot on their plates in bidding farewell to the most popular interest rate benchmark. Sinead McIntosh assesses industry progress in moving away from LIBOR to alternative risk-free rates and the extent to which it will consume the regulatory agenda in 2022.

December 31, 2021 bid a near final farewell to the London Interbank Offered Rate (LIBOR), the most popular refer­ence rate for an array of financial products. Regulators called time on its use for new contracts, with only nine of the ex­isting 35 permutations of LIBOR continuing and those solely for use in legacy contracts yet to be transitioned. This has involved a lot of work for many, from derivatives and loans to debt issuance where consent solicitation has frequently been required.

Launched by the British Bankers’ Association in 1986, initially for three currencies and as a benchmark for pricing floating rate corporate loans, LIBOR grew to become one of the most impor­tant financial constructs in the global economy, with more than US$350 trillion in financial contracts being tied to it. That doesn’t include the tens of billions of dollars of residential. mortgages and consumer loans around the world referencing LIBOR.

Following widening cracks in the authenticity of LIBOR, including incidences of rate manipulation, false reporting, and a decline in liquidity in the interbank funding market, global reforms relating to benchmark rates were undertaken and in March 2021 the U.K. Financial Conduct Authority, and Intercontinental Exchange (ICE) Benchmark Administration (IBA), LIBOR’s administrator, finally announced the definitive end dates for the reference rate.

Transition Risks: Operational, Legal, Political and Conduct

Because LIBOR rates play such a fundamental role in banks’ day-to-day business and importantly in their valuations and risk management, transition away from LIBOR carries significant risks. Banks have been focusing their efforts on transitioning legacy business and internal operational processes and systems capabilities. It has been estimated that banks across the world have spent more than US$10 billion in their transition planning activities and the relevant competent authorities have been keeping an increasingly vigilant eye on their efforts.

U.K. and Europe Accelerate Adoption of Alternative Rates

In the U.K., the FCA states that the Bank of England’s Sterling Overnight Index Average, or SONIA, compounded in arrears, is the preferred alternative rate for derivatives and securities markets. The industry-led Working Group on Sterling Risk-Free Reference Rates opined that the same rate will become the in­dustry standard for the loan markets. Over the course of 2021, there was an accelerated adoption of SONIA across deriva­tives, floating rate notes and securitizations. This consistency of benchmarks across multiple markets has provided market confi­dence and its pervasiveness has become self-reinforcing.

Along with LIBOR cessation, across Europe there have been re­forms and replacements of other national benchmark rates that are in varying degrees of completion.

Banks in Europe continue to see the biggest transition obstacles on the asset side of their business (loans and securities) for a number of reasons. These include legal difficulties in renegotiat­ing existing contracts to implement fallback language for identify­ing a replacement rate if a benchmark (e.g., USD LIBOR) is not available, concerns around litigation and conduct risks, and opera­tional challenges internally. Meanwhile, on the liabilities side, debt issuance is markedly more under control.

This mismatch between asset and liability benchmarks causes a particular headache for collateralized loan obligations (CLOs), which take groups of leveraged loans, package them up and use them to back payments on new debt issuance. CLO managers have been rushing to close transactions ahead of the anticipated rate disparity for existing and new debt and that, combined with very buoyant new CLO volumes (collateralized by plentiful cheap COVID loans), meant there was a large surge in issuance late in 2021.1 CLOs starting from Q1 2022 may be buying loans from late 2021, notes Bloomberg.

U.S. Regulators Focus on Enforcing Transition Plans

In the U.S., there is near universal consensus that derivatives markets and capital markets products should transition to the Secured Overnight Financing Rate (SOFR). The loan markets, however, aren’t quite so clear cut: the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) even stated that they have not endorsed a specific replacement rate; indicating that banks can determine the most appropriate alternative, be that SOFR or another reference rate fitting its funding model and borrower requirements.

Timing for the transition of USD LIBOR is extended due to the sheer number of live legacy contracts. However, the FCA and U.S. regulators jointly stated that financial institutions were “en­couraged” to stop entering new USD LIBOR contracts no later than December 31, 2021, highlighting the safety and soundness risks those institutions would face should they fail to do so. With the ultimate cessation dates of USD LIBOR being set as June 30, 2023, this provides financial institutions with an additional win­dow to work on their transition projects, allowing high volumes of legacy contracts to mature.

With this in mind and safe in the knowledge that SOFR rates have been published by the Federal Reserve Bank of New York since 2018, market participants are not chomping at the bit to switch over. The second half of 2021 saw large U.S. corporate lenders using alternative rates for less than 1% of floating rate loans and 8% of derivatives. U.S. regulators are now laser focused on en­forcing transition plans to ensure compliance with the deadlines.

Asia Navigates Transition Complexity

In Asia the situation is more complex and, with each jurisdiction having different approaches to benchmarks, several countries may end up with multiple rates.

Asian countries must not only adopt changes to the global bench­marks, but refine their own in local markets, notes a Euromoney article.2

The approach is two-fold: adopt global benchmarks such as Dollar and Sterling, and adopt local benchmarks, which regulators have been developing in partnership with the banking industry.

While Sterling transition is well underway, the region is very dollar heavy and many of the swaps, loans and bonds are linked to U.S. Dollar LIBOR.

Asia Pacific jurisdictions are split on whether to take a regulator-led or industry-led approach to benchmark rate transitions, noted S&P Global ratings in an October report. Industry-led approaches can be found in China, India, and Taiwan. Of the other Asia Pacific jurisdictions, the Philippines, India, Singapore, and Thailand have local benchmarks linked to Dollar Libor. In Singapore, the central bank has played an instrumental role in guiding the transition from SOR to SORA.

Then there is a second group: Australia, Hong Kong, New Zealand, and Malaysia which are taking a multi-rate approach, maintaining an existing benchmark while adding a new alternative reference rate.

Industry Appears to Have Coped, but 2022 Will Be A Pivotal Year

While most non-USD LIBORs ceased on December 31, 2021, the FCA requires the benchmark administrator to publish 1, 3 and 6-month Sterling and Yen rates in 2022 for use in select contracts that are difficult to transition, considered “tough legacy” con­tracts. These rates will be set in a modified “synthetic” form and will not be used for any new business.

The significant changes resulting from benchmark reform have been accompanied by new legislation and regulations. U.S. LIBOR legislation expressly includes full safe-harbour and con­tract continuity provisions to provide protection from litigation and associated mis-selling claims. In the U.K. and EU, legislation includes more limited protection via inclusion of contract conti­nuity provisions but not safe-harbor protection from litigation as is currently seen in the U.S.

LIBOR transition impacts a wide range of transactions globally, including securities, loans and derivatives which use LIBOR or any other affected benchmark to determine the interest payable. Firms have undertaken extensive due diligence, both using soft­ware where feasible, and individual contract review where more tailored or bespoke arrangements and documentation exist, to inform remediation strategies and planning.

The approach adopted for amending documentation depends on the type of product as well as client preference. The ISDA Protocol3 assists in handling LIBOR transition, providing agreed alternative replacement rates for certain products with counter-parties that also adhere to the Protocol, but it does not eliminate the complexity entirely; bi-lateral renegotiation is required for con­tracts not covered by the Protocol.

For many financial products, the legal aspects of the transition went smoothly overall, while operationally they were more testing.

Loans were even more problematic. The amendment process was a lot more onerous and labor-intensive in the absence of an ISDA equivalent. Many large banks whose business includes con­sumer through to institutional loans, often backed by swaps, have faced a hugely tough burden to resolve.

Loans documented using standard template documentation were a lighter lift. However, for syndicated lending, where firms were not necessarily in the driving seat, the transition process was more onerous. Certain software proved useful for high volume repeat transactions such as aircraft loans but not applicable where significant redrafting of individual deals was required.

For 2022 and beyond, many financial institutions are focused on so-called “tough legacy” remediation efforts together with build­ing plans for USD transition. For the Asia Pacific markets, where products are in large part USD denominated, these are being re­viewed by banks in conjunction with the USD LIBOR piece. While life after LIBOR appears to be in insight there is still a lot to do for many products that for more than 35 years have been pegged to the popular rate. These leftovers will take a while to consume.

BBH 2022 Regulatory Field Guide

Download the full guide


Related Articles

  • People walking over a world map

    Managing the Present: Securities Settlement

  • Black and white image of a man pulling his hand luggage across a train platform

    Revisiting the Past: PRIIPs, CSDR, and SFDR

https://www.bloomberg.com/news/articles/2021-10-26/sales-in-european-clos-hit-record-thanks-to-buyout-debt-surge
https://www.euromoney.com/article/29bt45w3xv4d4l3yfej9c/capital-markets/asia-races-against-libor-deadlines
3 https://www.isda.org/protocol/isda-2020-ibor-fallbacks-protocol/
https://www.eba.europa.eu/sites/default/documents/files/document_library/Risk%20Analysis%20and%20Data/Risk%20reports%20and%20other%20thematic%20work/1021964/Final%20Thematic%20Note%20on%20benchmark%20rates%20transition%20risks.pdf

Brown Brothers Harriman & Co. (“BBH”) may be used to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2022. All rights reserved. IS-07852-2021-12-23.

As of June 15, 2022 Internet Explorer 11 is not supported by BBH.com.

Important Information for Non-U.S. Residents

You are required to read the following important information, which, in conjunction with the Terms and Conditions, governs your use of this website. Your use of this website and its contents constitute your acceptance of this information and those Terms and Conditions. If you do not agree with this information and the Terms and Conditions, you should immediately cease use of this website. The contents of this website have not been prepared for the benefit of investors outside of the United States. This website is not intended as a solicitation of the purchase or sale of any security or other financial instrument or any investment management services for any investor who resides in a jurisdiction other than the United States1. As a general matter, Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) is not licensed or registered to solicit prospective investors and offer investment advisory services in jurisdictions outside of the United States. The information on this website is not intended to be distributed to, directed at or used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Persons in respect of whom such prohibitions apply must not access the website.  Under certain circumstances, BBH may provide services to investors located outside of the United States in accordance with applicable law. The conditions under which such services may be provided will be analyzed on a case-by-case basis by BBH. BBH will only accept investors from such jurisdictions or countries where it has made a determination that such an arrangement or relationship is permissible under the laws of that jurisdiction or country. The existence of this website is not intended to be a substitute for the type of analysis described above and is not intended as a solicitation of or recommendation to any prospective investor, including those located outside of the United States. Certain BBH products or services may not be available in certain jurisdictions. By choosing to access this website from any location other than the United States, you accept full responsibility for compliance with all local laws. The website contains content that has been obtained from sources that BBH believes to be reliable as of the date presented; however, BBH cannot guarantee the accuracy of such content, assure its completeness, or warrant that such information will not be changed. The content contained herein is current as of the date of issuance and is subject to change without notice. The website’s content does not constitute investment advice and should not be used as the basis for any investment decision. There is no guarantee that any investment objectives, expectations, targets described in this website or the  performance or profitability of any investment will be achieved. You understand that investing in securities and other financial instruments involves risks that may affect the value of the securities and may result in losses, including the potential loss of the principal invested, and you assume and are able to bear all such risks.  In no event shall BBH or any other affiliated party be liable for any direct, incidental, special, consequential, indirect, lost profits, loss of business or data, or punitive damages arising out of your use of this website. By clicking accept, you confirm that you accept  to the above Important Information along with Terms and Conditions.

 
1BBH sponsors UCITS Funds registered in Luxembourg, in certain jurisdictions. For information on those funds, please see bbhluxembourgfunds.com


captcha image

Type in the word seen on the picture

I am a current investor in another jurisdiction