Significant efforts are underway to amend and in some cases replace the interbank offered rate (IBOR) for key global currencies. In the UK, the Financial Conduct Authority has issued unequivocal statements imploring parties to consider LIBOR unavailable after 2021. In the EU, the Benchmarks Regulation (BMR) has imposed a hard deadline for administrators of benchmark rates within the EU to register and comply with new rules on benchmark rate setting by 1 January 2020. Existing IBORs will need to be amended to comply with the BMR, and those that are not in compliance by the deadline will be suspended. This could result in serious disruption to markets and contractual arrangements that have not otherwise put in place contingency plans.
What is IBOR?
IBOR represents a financial institution’s borrowing cost for obtaining unsecured funding of a particular currency and term in the interbank lending market. Notable IBORs include LIBOR for GBP, EURIBOR for EUR and STIBOR for SEK. IBORs are a pervasive feature in global finance contracts, from loans and bonds to derivatives (among other things). For example, IBOR often underpins interest rates in commercial lending arrangements and forms the basis for end-of-day values for particular holdings in derivative transactions.
IBOR reform and alternative rates
IBOR reform has been a topic of discussion since reports first emerged of the market manipulation of LIBOR in 2008. Like many IBORs including STIBOR, the rate-setting mechanism for LIBOR relies on submissions from a panel of participating banks of transaction data (if available) or “expert” estimates. The scandal revealed that dealers contributing to the LIBOR rate-setting mechanism were colluding to make submissions that benefitted their trading positions, resulting in dozens of banks paying out total penalties of upwards of 10 billion U.S. Dollars.
The marked decline in the number of interbank transactions has also undermined the reliability of certain IBORs. In some cases, regulators have had to compel banks to continue to submit rates. However, regulatory intervention may be ending for some IBORs: in 2012, the UK’s Financial Conduct Authority announced that it would no longer compel panel banks to submit rates for LIBOR after 2021 and has since actively pushed market participants to identify a replacement rate. Similarly, under the BMR, national authorities only have the power to compel contributions (and only for certain critical benchmarks) for a two-year period.
To address these issues and ensure an orderly transition away from IBORs, regulators have pursued a “multiple-rate approach” which combined reforming and strengthening IBORs for existing contractual arrangements while also pushing private parties to transition away from IBORs and establish alternative reference rates for major currencies in the long-term.
In the EU, the BMR has tightened the controls over how rates are set. The BMR includes sweeping principles for how benchmark administrators, contributors and users within the EU manage conflicts of interest and improve the quality of input data and methodologies used in determining benchmark rates. For example, for interest rate benchmarks, administrators are required to establish independent oversight committees to regularly scrutinise the calculation methodology, input data and wider governance arrangements. All interest rate benchmarks registered with the BMR are also subject to a biennial independent external compliance audit. Entities that produce or control a benchmark, such as the Swedish Banker’s Association in relation to STIBOR, in some cases have had to overhaul their internal procedures to meet these new requirements. The BMR’s compliance requirements also have an extra-territorial impact whereby non-EU benchmarks can only be used in the EU if authorised under the BMR (subject to limited exceptions).
In addition to these IBOR reforms, across all major jurisdictions, working groups were formed to select alternative reference rates. Some of these alternatives include the Secure Overnight Funding Rate (SOFR) for USD, the reformed Sterling Overnight Index Average (SONIA) for GBP, Tokyo Overnight Average (TONA) for JPY and Swiss Average Rate Overnight (SARON) for CHF. These so-called risk-free rates are based on historical data and therefore less susceptible to manipulation compared to the forward-looking IBORs.
Market participants need to be aware of the scale of their exposure to IBORs in their existing contractual arrangements and should start planning how to reduce their reliance on IBORs and transition to new alternative rates as they become more widely adopted.
Some issues for parties to consider include:
- whether their legacy contracts have sufficient fall back language to ensure that a permanent end to an IBOR does not result in contractual disruption and frustration;
- if contractual amendments are required, what consent thresholds are required for such amendments;
- whether new risk factors should be included in offering documents to address the transition from IBOR;
- how to address any pricing gap between IBOR (which includes bank credit risk) and an alternative rate (many of which are so-called risk-free rates) and which contractual party is best suited to absorb the difference;
- how to match the term periods for IBORs (given that some alternative rates only reflect the rate of overnight transactions); and
- the potential impact on accounting standards.
Parties are also advised to monitor guidance issued by the relevant regulators and industry associations such as the Association of Financial Markets in Europe (AFME), Loan Market Association (LMA), and the International Swap and Derivatives Association (ISDA). The Hamilton Banking and Finance team is also available to answer any questions you may have.
Regulation (EU) 2016/1011 of the European Parliament and the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014.