The Death Of LIBOR And The Afterlife

This Dentons Client Alert was originally published as an article by Gary Goodman and Alice Yurke in Volume 34, No. 1 (January/February 2020) of the American Bar Association's Probate & Property magazine.

In July 2017, Andrew Bailey, chief executive officer of the UK Financial Conduct Authority (FCA), announced that the FCA would no longer require panel banks to make London Inter-Bank Offered Rate (LIBOR) submissions after the end of 2021. Since the early 1980s, LIBOR and other interbank-offered rates have acted as the reference rates for trillions of dollars in real-estate-secured and other loans, bonds, and securitizations and deposits and derivatives notional. This article provides an overview of LIBOR's historical importance in the financial markets and describes certain challenges in transitioning to a new risk-free rate.

A brief history of LIBOR

LIBOR was developed and launched in the mid-1980s by the British Bankers Association. It is used by the real estate industry as the index rate in many floating rate loans. LIBOR is derived from submissions by panel banks and represents the rate at which those banks could borrow funds in various currencies and tenors from other banks in London. In practice, LIBOR submissions have proven to be subject to manipulation and tampering, as evidenced by the rate-rigging scandal that came to light in 2012. Administration of LIBOR was shifted to the ICE (Intercontinental Exchange) Benchmark Administration (IBA) in 2014.

LIBOR today

LIBOR is currently produced on a daily basis in five currencies: US dollar, Euro, British pound sterling, Japanese yen, and Swiss franc. Sixteen major money center banks are on the panel that contribute rates to USD LIBOR. The banks are based in various jurisdictions and all have operations in London. LIBOR is calculated in various tenors and maturity rates, including overnight, one week, one month, two months, three months, six months, and 12 months. IBA has taken significant steps to improve the production of LIBOR by establishing oversight, surveillance, and validation procedures designed to reduce the possibility of manipulation.

Advantages of LIBOR

LIBOR is forward-looking and is designed to predict a bank's actual cost of funds over a given time period in the future corresponding to the relevant tenor. If LIBOR is accurate, then a bank can reasonably price loans on a forward basis by simply adding a margin reflecting the bank's cost of operations and profit margin, as well as borrower risk. LIBOR as an index also gives the borrower certainty of payment. For example, in a loan with six-month LIBOR as an index, the rate will reset every six months, and the borrower will know its exact cost for the upcoming period. In contrast, if the borrower's rate is based on an overnight index, its borrowing cost is far less certain.

Disadvantages of LIBOR

Panel banks have an understandable reluctance to contribute rates to support LIBOR, given the risk of future liability based on claims of manipulation, notwithstanding improved internal controls and procedures. After the credit crisis, the actual reliance by banks on the interbank lending market for funding operations has declined substantially. As a result, current submissions by panel banks are to a large extent based on “expert judgment: or estimates of the rates the submitting banks would be charged, rather than actual or comparable transactions. LIBOR, therefore, suffers both from reputational concerns and from an absence of robust underlying market data and is disfavored by policy makers.

IOSCO principles

In July 2013, the International Organization of Securities Commissions (IOSCO) issued its Principles for Financial Benchmarks (Principles), following on the LIBOR rate-rigging scandal. The benchmarks discussed in the Principles are prices, estimates, rates, indices, or values that are: (1) made available to users, whether free of charge or for payment; (2) calculated periodically, entirely, or partially by the application of a formula or another method of calculation to, or an assessment of, the value of one or more underlying interests; and (3) used for reference. Reference purposes include one or more of the following: (a) determining the interest payable, or other sums due, under loan agreements or under other financial contracts or instruments; (b) determining the price at which a financial instrument may be bought, sold, traded, or redeemed or the value of a financial instrument; or (c) measuring the performance of a financial instrument. The Principles are designed to address conflicts of interest, promote internal controls, and improve governance and oversight. Principle 6 indicates that benchmark design should consider the “relative size of the underlying market in relation to the volume of trading in the market that references the benchmark.” Principle 7 recommends that a benchmark be “based on prices, rates, indices, or values that have been formed by the competitive forces of supply and demand” and “anchored by observable transactions entered into at arm's length between buyers and sellers in the market.” Principle 8 provides a hierarchy for data inputs, ranking a submitter's own concluded arms-length transactions first and expert judgment last. Policymakers and industry participants in various countries, including the United States, have been working towards the development of new benchmarks that follow the IOSCO principles.

The FCA

The FCA is the regulator that has the power to direct panel banks to continue to submit rates to IBA to help generate LIBOR, inasmuch as the rate submission activity takes place in London. In July 2017, FCA Chief Executive Officer Andrew Bailey asserted that “the absence of active underlying markets raises a serious question about the sustainability of LIBOR benchmarks that are based upon these markets.” 1 This statement prompted the FCA to take the position that panel banks would no longer be compelled or encouraged by the FCA to submit rates in support of LIBOR, effective at the end of 2021.

Notwithstanding recognized improvements in the production of LIBOR, the FCA's determination is based on the absence of an active substantial underlying market in inter-bank unsecured lending (see IOSCO Principle 6). This announcement does not mean that LIBOR will definitely cease to be produced at the end of 2021. Continued LIBOR after 2021, however, would be dependent on the willingness of a sufficient number of panel banks to voluntarily continue to submit bids.

A visualization of financial stability and LIBOR

ARRC implementation plan

In November 2014, the Alternative Reference Rates Committee (ARRC) was convened by the Federal Reserve Board and the Federal Reserve Bank of New York (NY Fed) to consider new US dollar risk-free reference rates. ARRC members include a number of major banks and industry groups, and ARRC obtains input and participation from a broad range of market participants and US regulators. In June 2017, ARRC announced it had selected the secured overnight financing rate (SOFR) as the preferred alternative US dollar risk-free reference rate and as its preferred alternative...

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