COVID-19 - LIBOR transition plans derailed by the pandemic?
In 2017, the UK Financial Conduct Authority (FCA) announced that as of the end of 2021, it will no longer compel or persuade panel banks to make submissions to LIBOR. Once banks are no longer required to contribute submissions, LIBOR will effectively cease to exist.
A series of announcements and statements, as recent as end of April 2020, by the Working Group on Sterling Risk-Free Reference Rates (RFRWG), the Bank of England (BoE) and FCA indicate that the pandemic will cause a shift in the timeline. We investigate.
Why replace LIBOR?
The London Interbank Offered Rate, commonly known as LIBOR, is a globally accepted benchmark interest rate that indicates borrowing costs between banks. LIBOR is administered by the ICE Benchmark Administration, based upon submissions from panel banks. It is the primary benchmark for short term interest rates around the world.
LIBOR was traditionally based upon the rate at which banks could borrow funds in the interbank market. Following the financial crisis in 2008, banks relied to a far lesser extent upon unsecured borrowing in the interbank markets resulting in fewer real transactions upon which to base the LIBOR submissions. Increasingly, the rates submitted by panel banks were based on judgment rather than real market transactions.
Once LIBOR submissions were not entirely reflective of live transactions, the submissions became liable to manipulation. Indeed, panel banks have been found to have manipulated the LIBOR rate for their own financial gain, submitting either inflated or deflated rates to profit from trades or give a false impression of their creditworthiness. Several panel banks were fined by the regulatory authorities of the countries in which they operated and face claims from stakeholders who have incurred damages as a result of this wrongdoing.
Further to the BoE’s announcements, substantial efforts by industry bodies and market participants are being undertaken to work through the issues presented by the end of LIBOR and to replace it with risk-free rates (RFR). RFRs are designed to represent a currency’s baseline interest rate environment rather than the rates available in the interbank lending market.
In April 2017, the RFRWG, as published by the FCA, recommended a reformed version of the Sterling Overnight Index Average (SONIA) benchmark as its preferred RFR for sterling markets. The rate is based on overnight interest rates in wholesale markets.
Timing of the transition
Tushar Morzaria, the Chair of RFRWG commented in the beginning of the year, in a BoE publication, that “2020 would be a pivotal year in the transition journey”, with firms being advised to accelerate their efforts in preparing for the end of LIBOR. Shortly afterwards, the FCA, the RFRWG and the BoE published a set of documents outlining priorities and milestones, together with a 2020 roadmap.
The top five RFRWG priorities focus on:
- ceasing issuance of GBP LIBOR-based cash products by the end of Q3 2020
- taking steps throughout 2020 to enable the use of SONIA compounded in arrears
- taking steps to enable a shift of volumes from GBP LIBOR to SONIA in derivative markets
- establishing a framework to streamline the transition of legacy LIBOR products, to reduce the stock of GBP LIBOR referencing contracts by Q1 2021
- considering and providing market input on issues surrounding tough legacy contracts.
The impact of COVID-19
On 25 March 2020, the RFRWG, the FCA and the BoE issued a joint statement recognising that the COVID-19 pandemic may have an impact upon firms’ preparations for the transition. This was followed by a further statement by the RFRWG at the end of April, advising that the original target of end-Q3 2020 to complete transition away from LIBOR across all new GBP LIBOR-linked loans will not be feasible due to the challenges presented in the current working environment as a result of COVID-19.
The RFRWG recommends, however, that by the end of Q3 2020, lenders should be in a position to offer non-LIBOR-linked products and include clear contractual arrangements in all new and refinanced LIBOR referencing loan products to facilitate conversion to SONIA or other alternatives.
Notwithstanding the difficulty of reaching the interim deadlines due to the current pandemic, the position remains that all new issuance of LIBOR-linked loan products should cease by the end of Q1 2021.
It is difficult to foresee the full implications of LIBOR discontinuation, but it is certain that there will be widespread ramifications. It is inevitable that this major transition will lead to an increase in litigation risk. Indeed, Michael Held, the Executive Vice President of Group Legal of the Federal Reserve Bank of New York identified this in a speech as early as February 2019:
“You can imagine the litigation risk when the reference rate for a 20 -year contract disappears and there’s no clear path to replace it. Now imagine 190 trillion dollars’ worth of those contracts. This is a DEFCON 1 litigation event if I’ve ever seen one”.
With thanks to intern Lida Tsakyraki for her assistance with this blog.