LIBOR is the global interest rate that has so far been crucial for managing financial risk. With an estimated $350 trillion global outstanding loans and trading contracts based on LIBOR, looking at the current status of the transitioning process is paramount for financial services.

Most loan agreements have LIBOR embedded in the contracts. Furthermore, financial services use LIBOR-based derivatives as a strategy to hedge or counteract their exposures to interest rates elsewhere.

But, the abuse of the calculating methods for interbank borrowing rates has led to major disruption. It is for this reason that regulators are keen to develop a new rate that can prevent banks from manipulating the rating figures.

Whilst COVID-19 has caused negative effects to the global banking industry, regulators have made it clear that there will be no change in the timetable for banks to achieve the completion of the LIBOR transition. During the spike of the LIBOR rates in March and April 2020, the inter-bank transactions dried up and the submissions of LIBOR reflected the effect of the credit component of LIBOR. This has made it more expensive to borrow on a LIBOR rate rather than using the Risk-Free Rates (RFRs).

Most global banks still have concerns over hedging risks and litigation after the shift away from LIBOR. Bankers are also facing problems with educating their clients about the transition and preparing themselves for the legal battles with clients following the introduction of the new benchmarks. Moody’s also stated that the transitions often carry the “basis risk”, which could lead to the incoming and outgoing cash flows to diverge.

Given the rising concerns, global market regulators have taken further actions to help banks with their problems of transitioning out. Bank of England (BoE) is expected to allow banks to develop new rates that match their sterling funding and lending costs. The UK regulators also strongly insist banks on the faster removal of LIBOR referencing across bonds, loans, mortgages, and derivatives.

The banks and lending institutions in the United States are also preparing for the transition from LIBOR. At that point, all dollar-denominated loans, derivatives and debt will reference a new rate—the Secured Overnight Funding Rate, or SOFR—which is a median of rates that market participants pay to borrow cash on an overnight basis, using Treasurys as collateral. It’s worth noting that other countries are introducing their own local-currency-denominated alternative reference rates for short-term lending, but SOFR is expected to supplant USD LIBOR as the dominant global benchmark rate.

The transition out of LIBOR will impact markets of the UK, US, Japan, Switzerland, and the European Union as the LIBOR rates are published in the currencies of those countries. Even so, the impact also exceeds beyond those countries due to the prevalence of finance in US dollars, which leads to potential exposure to US$ LIBOR.

Additionally, as LIBOR rates are input to several other benchmarks, such as the SOR for Singapore, the relevant regulators of those benchmark rates must pay attention to the need for appropriate changes to their calculations when transitioning out of LIBOR. The global financial industry must prepare themselves for the transitioning out of LIBOR.

It is crucial for financial institutions around the world to develop clear plans for transition, including key milestones and deadlines, to ensure the delivery by the end of 2021. The plans should include details of communicating with clients, rigorous risk assessment of various aspects of transitioning, and the LIBOR training programs for the stakeholders. This preparation will need to include assessing all current borrower loan documents, drafting new loan documents referencing the inevitable change, and preparing systems to handle the new RFR.

As funders are settling on the RFRs that they intend to use after transitioning out of LIBOR, it is expected RFRs funding will become more prevalent in the upcoming period. Thus, commercial lenders and borrowers will need to pay close attention to the LIBOR language used in future loan transactions.

FLI advises clients on corporate portfolio management and strategy, with a key focus on global roll-outs and investments. With over 17,000 lawyers worldwide in over 100+ jurisdictions, FLI benefits its clients by providing access to local industry and jurisdictional experts. If you would like to discuss how this may relate to your outside counsel requirements or to explore how FLI may render assistance to your firm both domestically or in cross-border matters, please feel free to get in touch with Daniel Casares-Lauritsen at dcasares@first-law.com

References:

https://www.ft.com/content/812b50c8-7561-11e9-be7d-6d846537acab https://www.ft.com/content/f54baa08-6ce6-11e9-80c7-60ee53e6681d https://www.ft.com/content/161fcb96-39cb-11e9-b72b-2c7f526ca5d0 https://www.lexology.com/library/detail.aspx?g=94c0c430-28a8-4099-8c31-db0f336feab6