Mayank Tripathi analysis the significance of the LIBOR transition.
LIBOR stands for the London Interbank Offered Rate and is the average rate at which banks are willing to borrow unsecured funds from each other. This rate is calculated by the ICE Benchmark Administration and is based on submissions from a panel of select banks. LIBOR is the most relied upon benchmark for short-term interest rates and banks use the LIBOR as the base interest rate for various commercial and corporate loans. It is estimated the LIBOR underpins $300 trillion worth of financial instruments and any changes in LIBOR directly affect interest payments made by borrowers across the world.
In 2012, Barclays, UBS, Deutsche, RBS were among a group of banks that were investigated by regulatory bodies in the UK, US and Europe for colluding to manipulate LIBOR between 2005 – 2008. It was revealed that Barclays bank had artificially lowered LIBOR submissions during the financial crisis. This would give the market the impression that Barclays had good credit quality, could raise adequate funds, and would have no issues returning borrowed money – while this may not necessarily have been the case. Barclays admitted to the misconduct and UK and US authorities imposed fines totalling £290 million. This is separate to any amounts it had to pay out in class action civil lawsuits. LIBOR’s susceptibility to manipulation could be one of the reasons why the rate is now being phased out. Some critics of the LIBOR transition have argued that the transition from the rate is merely a knee-jerk reaction to the scandal.
However, as Davide Barzilai, head of law firm Norton Rose Fulbright’s global LIBOR transition team speaking at a Legal Cheek event notes, “the writing has been on the wall for a long time”. In 2017, five years after the scandal, the Financial Conduct Authority (FCA), which is responsible for regulating the functioning of the UK’s financial sector has received a voluntary agreement with the panel banks to cease submissions after the 2021. This gives banks sufficient time to explore and start using other risk-free alternative rates. Davide notes that continued use of LIBOR was “unsafe to markets and unfair to customers”.
Furthermore, the way banks fund themselves has changed since 2008 – with a decrease in reliance on unsecured funds, which form the underlying market for LIBOR. Since the underlying market itself is rarely used, the rate is not set based on actual transactions but expert opinion. This makes the use of LIBOR unsustainable.
Thus, the scandal, in conjunction with the fundamental change in the way banks operate are the two key reasons why LIBOR is no longer going to be considered a viable option for the market.
One of the key concerns about the end in the use of LIBOR is what about contracts that have used it as their base rate. Consider a mortgage which states that the base rate is pegged to LIBOR, but LIBOR ceases to exist. While some contracts may have “fall back” rates/clauses, in the event this was not agreed by the parties when entering the contract, at what rate will the borrower be liable to pay interest?
Such a scenario could lead to a disorderly and volatile market during the transition period. Hannah Meakin, a Partner in Norton Rose Fulbright’s financial services regulation team, considers that most contracts will have to be changed but “this may not bring the same economic results and this could lead to a lot of litigation in the future”. As a result, regulators are working with a variety of stakeholders to examine the impact of transition initially, and further down the line.
The Working Group on Sterling Risk Free Rates was established in 2015 to advise on alternatives to the use of LIBOR and in 2017, it recommended the Sterling Overnight Indexed Average (SONIA) benchmark. SONIA was selected for a variety of reasons but most importantly, it was based on a highly liquid and active underlying market rather than submissions from a bank panel. The average value of transactions underpinning SONIA since 2018 is £45 billion per day. This feature also makes it less susceptible to bank manipulation.
Furthermore, SONIA has closely mirrored the Bank Rate set by the Bank of England. This is important because in March 2020, when the BoE lowered the Bank Rate, borrowers would have directly benefited from having to pay lower interest if these payments were tied to the Bank Rate or SONIA. LIBOR rates on the other hand had risen.
By Mayank Tripathi.