Central banks and regulators continue preparing for the Libor (London Interbank Offered Rate) cessation expected by the end of 2021. Both the Sterling Risk-Free Reference Rates Working Group (RFR WG) convened by the Bank of England (BoE) and the Financial Conduct Authority (FCA) of the United Kingdom, and the Alternative Reference Rate Committee (ARRC) convened by the Federal Reserve Board (Fed) and Federal Reserve Bank of New York (NY Fed), have released announcements and updates on their work aimed at the adoption of reliable reference rates in lieu of Libor.
The global financial services industry has used Libor as a short-term reference rate to price a number of financial contracts, mainly variable rate loans and securities, deposits, borrowings and interest rate hedging transactions. Libor is the most referenced benchmark used for the United States dollar (USD), United Kingdom sterling (GBP), Swiss franc (CHF) and Japanese yen (JPY). Further, the Libor benchmark usage has extended beyond loan products and includes derivatives, discount products, debt securities/commercial paper and even default interest rates.
The manipulation scandals and cases of attempted market manipulation and false reporting of global reference rates uncovered since 2012, "together with the post-crisis decline in liquidity in interbank unsecured funding markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates."1 Uncertainty surrounding the integrity of these reference rates constitutes a potentially serious source of vulnerability and systemic risk for the financial markets.
Considering its systemic importance, the transition away from Libor and to "more robust" reference rates,2 based on actual transactions, is "a significant event" that will affect almost every supervised institution and that they should "closely manage."3
Addressing the Libor transition now will allow financial institutions to mitigate any potential risks in a timely fashion. These risks depend on the variety of on- and off-balance assets of each institution that reference Libor, and include at least the following:
- operational difficulty in quantifying exposure
- fallback language in financial contracts (mismatch between loans and hedging)
- financial valuation and model risk related to reference rate transition
- inadequate risk management processes and controls to support transition
- consumer protection-related risks
- limited ability of third-party service providers to support operational changes
- potential litigation and reputational risk arising from reference rate transition
Recommended Alternative Reference Rates
Both the RFR WG and the ARRC have been working on recommended risk-free rates (RFRs) in preparation for Libor discontinuation. RFR WG's recommended RFR is the Sterling Overnight Index Average (SONIA). ARRC's recommended alternative is the Secured Overnight Financing Rate (SOFR). These are not the only recommended alternatives, as central banks and regulators are still working on benchmarks with all the features previously covered by Libor (e.g., term reference rates).
The BoE began publishing the daily SONIA Compounded Index on Aug. 3, 2020, with data from April 23, 2018, onwards.
The ARRC released conventions related to using SOFR in arrears for syndicated loans on July 22, 2020.
The central banks and regulators of developing countries are also working on designing and implementing reference rates for the domestic markets, but will closely follow the recommendations of both the RFR WG and the ARRC in order to standardize the transition away from Libor for cross-border transactions and Libor-based products offered domestically.
For the Mexico domestic market, Mexico's Central Bank (Banxico) is expected to recommend the use Funding TIIE (TIIE de Fondeo)as conversion reference rate (as of today, only a daily reference rate is available: TIIE de Fondeo a 1 día).
Contractual Arrangements for Existing and New Loan Products
Central banks, regulators and their working groups have urged financial institutions to continue preparing for the transition away from Libor and, in the case of loan products, to begin working with borrowers in the preparation of contractual mechanisms compatible with the industry milestones. The milestones are as follows: all existing Libor-based loan agreements 1) with a maturity date beyond the end of 2021 and 2) all new and refinanced Libor transactions that will be executed after the end of Q3 2020 should contemplate a transition mechanism in order "to facilitate conversion of the contract to a suitable SONIA-based" 4 or other RFR alternative.
Loan Products Subject to Transition Mechanism
All loan products with maturities beyond the end of 2021 and that reference Libor should be considered eligible for transition language, including the following loan products and credit transactions: term loans and revolving credit facilities on a bilateral, club or syndicated basis whether secured or unsecured, and other financing facilities, including commercial mortgages and mortgages on residential properties owned as commercial ventures.
Lenders and other financial institutions should seek legal counsel and work internally to develop clear contractual and trigger provisions for their existing loan products (with maturities beyond 2021) and new loan and refinancing transactions, that reflect a pre-agreed conversion or an agreed process for reference rate renegotiation, from Libor to an available RFR alternative. In any event, the conversion provisions should aim to enter into effect by Dec. 31, 2021.
Lenders should prepare bespoke contractual mechanisms depending on the features of their Libor-based loan products. As discussed, central banks and regulators continue to work on term rates based on their observation of proposed sets of transactions before they are made available, but aiming to meet the Q4 2021 milestone.