The Future of LIBOR
On July 27, 2017, Andrew Bailey, the Chief Executive of the United Kingdom’s Financial Conduct Authority (the “FCA”), gave a speech to Bloomberg London entitled 'The Future of LIBOR' in which he questioned the sustainability of LIBOR as an interest rate reference rate.
LIBOR is a benchmark interest rate used globally for a wide range of financial transactions. It stands for the London Interbank Offered Rate and functions as the first step to calculating interest rates on various loans throughout the world. Presently, LIBOR is calculated for five currencies: U.S. Dollar, Euro, British Pound Sterling, Japanese Yen and Swiss Franc, and seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months.
Questioning the Sustainability of LIBOR
In June 2017, the FCA launched a project to gather and analyze market data from 49 banks in order to gain insight into which of the banks are the most active “actual and potential” participants in unsecured wholesale bank borrowing and related markets. Although the research remains incomplete, one notable trend to emerge is that there are relatively few eligible term borrowing transactions by large banks. This trend demonstrates that (i) activity in these markets is limited and (ii) there is little prospect for these markets becoming substantially more active in the near future. This inactivity raises serious questions about LIBOR’s sustainability and potentially makes the market more vulnerable to manipulation based on judgements rather than the real price of term funding.
In short, Bailey states that, from the perspective of a prudent bank wanting to match interest income and its liabilities, such inactivity makes LIBOR a less useful benchmark than it used to be.
Given the questions regarding the sustainability and desirability of relying on LIBOR in the future, transition work is of central importance to reducing the risk within the applicable financial markets. This transition will take time as transitioning away from LIBOR carries with it the risk of leaving counterparties to and holders of contracts, which rely on LIBOR, without an agreed means of determining those payments.
Panel banks have discussed and have widely supported a voluntary agreement to sustain LIBOR for a four to five year period (i.e. until 2021). This transition period will allow for market participants to plan and negotiate with counterparties and LIBOR users. Discussions are ongoing about how an arrangement would be structured.
The questions remains, what will happen to LIBOR and legacy contracts after 2021?
What will happen to LIBOR remains up to the benchmark’s administrators (ICE Benchmark Administration) and the 20 panel banks that submit contributions to the benchmark. They could continue to produce LIBOR on its current basis if they choose to and were in a position to do so. However, under this plan the benchmark would no longer be sustained through the mechanism of the FCA persuading or obliging panel banks to stay. Due to the inactivity observed in last month’s data analysis, this dynamic seems unlikely and unsustainable.
What will happen to legacy contracts is dependent on the actions of the benchmark’s administrators and the panel banks. It is also dependent on the preparation that users of LIBOR make in either switching contracts from the current basis for LIBOR or in ensuring that their contracts have robust fallbacks in place. Parties to contracts that presently use LIBOR as an interest rate reference rate may want to review their existing contracts to see where and how LIBOR is used and to contemplate what they will do after the end of the five year transition period in 2021.
European Benchmark Regulations require some regulated financial institutions using benchmarks to “produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided.” This could include alternative benchmarks being referenced to substitute interest rate benchmarks that are no longer provided. This model and planning could be useful during the transition period.
Andrew Bailey explains that the transition will be less risky and less expensive if it is planned and orderly rather than unexpected and rushed. In order to avoid perpetuating a financial crisis, planning for this transition must begin now and remain at the forefront of the concerns of current LIBOR users.