Important changes for financial market participants are being proposed in relation to benchmarks, including the possible end of LIBOR and the entry into effect of the Benchmarks Regulation
On 27 July 2017, Andrew Bailey, chief executive of the UK Financial Conduct Authority (FCA), delivered a speech examining important questions about the future of the London Interbank Offered Rate (LIBOR). The speech has been widely reported in the financial press and adds a new chapter to far-reaching changes facing financial market participants in respect of interest rate benchmarks in the coming years.
LIBOR is a quote based interest rate benchmark for various currencies, which is available for several tenors from one week to twelve months. It is based on the interest rates on the unsecured interbank market. LIBOR is among other things widely used as a reference rate in loan and derivatives documentation. In 2012, LIBOR became the subject of increased regulatory scrutiny when it emerged that certain banks had committed offences involving fraud, collusion and manipulation of the rates. Subsequently, significant reforms were implemented, including requirements for panel banks to use actual trades and keep records of substantive submissions.
Nonetheless, insufficient activity in the unsecured (wholesale term lending) interbank market now and in the future has raised a question about the sustainability of the LIBOR benchmarks. In addition, panel banks that submit rates on which LIBOR is based are uncomfortable about providing submissions based on judgments in the absence of borrowing activity against which those judgments can be validated.
Against this background, the Bailey speech indicated that the FCA has spoken to all the current panel banks about agreeing voluntarily to sustain LIBOR until the end of 2021. It is the intention of the FCA that, at the end of this period, it would no longer be necessary for the FCA to persuade, or compel, banks to submit rates to LIBOR. In the meantime, work is being undertaken to plan the transition to alternative reference rates that are based on actual transactions, instead of judgments.
Therefore, market participants should not rely on the availability of LIBOR after 2021. Instead, market participants are encouraged to develop alternative benchmark rates. Legacy contracts, i.e. contracts which have been entered into or are being entered into and which go beyond 2021, must include sufficiently robust fallbacks to effect a smooth replacement of an agreed reference rate should LIBOR be discontinued during the term of the contract.
In terms of documentary implications, it is probable that transactions in the near term will continue to be based on LIBOR. Modification of documentation will only be possible once there has been more progress in market thinking on alternatives to LIBOR. Market participants may consider increasing flexibility to make amendments to interest rate determinations should LIBOR be discontinued, for example by lowering the creditor consent threshold for such amendments. An update in 2014 to the Loan Market Association recommended model forms of investment grade facility agreements enables the incorporation of replacement benchmarks and related market conventions into the agreement with majority lender consent, subject to a "you-snooze-you-lose" clause. Under this clause, the relevant lenders lose their right to participate in the vote if they do not respond within a certain number of days to the request for consent. In structured loan transactions, interrelating products such as interest rate swaps must also be taken into account when making amendments to interest rate determinations. Optional fallbacks are included in the recommended model forms, such as determination of the floating element of the interest rate by reference to the average of the borrowing rates of reference banks in the wholesale markets or each lender's self-certified cost of funds. However, these are unlikely to prove viable alternatives for prolonged periods of time as they are intended for situations in which a specific screen rate is temporarily unavailable.
Closely related to the changes described above are the new EU Benchmarks Regulation (EU) nr. 2016/1011 and the development of a new secured overnight interest rate by the ECB.
The new EU Benchmarks Regulation (EU) nr. 2016/1011 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds introduces a common framework to ensure the accuracy and integrity of benchmarks referenced in financial instruments, financial contracts or investment funds in the European Union. In doing so it aims to contribute to the functioning of the internal market, while achieving a high level of consumer and investor protection. The Benchmarks Regulation entered into effect on 1 January 2018 and includes a two-year transitional period for banks and other supervised entities. Benchmark administrators will become subject to licence and information requirements and benchmark contributors will be subject to extensive rules on input processing and can be compelled to submit interest rates. Although the Benchmarks Regulation has direct effect in the Netherlands, the Dutch legislator has proposed certain legislative amendments which reflect the requirement set out in the Benchmarks Regulation that supervised entities may only use those benchmarks included in the benchmark register maintained by ESMA. The Dutch draft legislation classifies using unregistered benchmarks as an economic offence, which can therefore be prosecuted by the Dutch public prosecutor.
The ECB has decided to develop an unsecured overnight interest rate for the euro based on data already available to the Eurosystem (the collective of the ECB and the national central banks). This interest rate would complement existing benchmark rates produced by the private sector and serve as a backstop reference rate. It will be based entirely on transactions in euro that are reported by banks in accordance with the ECB's money market statistical reporting. The high-level features of this new overnight interest rate will be communicated to market participants in the course of 2018. They will then be invited to provide their feedback on the suggested approach. The ECB envisages preparations for the rate to be finalized before 2020.
It is recommended that market participants review and consider the amendment and waivers provisions in loan agreements being entered into now and extending beyond 2021. It is also recommended that lenders closely review the requirements posed by the Benchmarks Regulation to ensure compliance with its provisions.