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.