On July 27, the Chief Executive of the UK Financial Conduct Authority (“FCA”) announced that, after the end of 2021, the FCA would no longer use its power to persuade or compel panel banks to submit rate information used to determine the London Interbank Offered Rate, known as “LIBOR.” LIBOR serves as a benchmark rate for hundreds of trillions of dollars of securities, loans and transactions, including over-the-counter and exchange-traded derivatives.[1] The total market of financial instruments based on LIBOR is approximately $350 trillion.
LIBOR, which has been published for over 30 years, is determined for various currencies and designated maturities, or periods. LIBOR is currently determined for a total of 35 rates on each business day: seven maturities (overnight, 1 week, 1 month, 2 months, 3 months, 6 months, 12 months) for each of five currencies (USD, EUR, JPY, GBP and CHF).[2] The current independent administrator of LIBOR, ICE Benchmark Administration Limited (“IBA”), maintains a reference panel of 20 banks with a significant London presence, between 11 and 17 of which submit quotations for each currency upon which the various LIBOR rates are based.[3]
In 2012, allegations of manipulation of LIBOR led to the loss of market trust, individual and class-action lawsuits, criminal prosecutions, billions of dollars in fines and settlements paid by panel banks, an independent review (known as the “Wheatley Review”)[4] and, ultimately, the implementation of several recommendations from that review, including the replacement of the British Bankers Association (“BBA”) as the administrator of the rate by IBA in February 2014.[5] The change in administrator and the implementation of other changes recommended in the Wheatley Review have increased market confidence in connection with the process by which LIBOR is determined. However, market concerns have persisted regarding the reliability of LIBOR due to the decline in interbank borrowing activity since the onset of the financial crisis. As the FCA Chief Executive noted in his recent speech, “[t]he underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active.”[6] In fact, the FCA has been gathering market data from 49 banks and, although its analysis of the data continues, the data indicates that large banks receive few loans or deposits of 12, 6 or 3 month terms from other banks.[7] The thin reference market of actual transactions upon which panel bank submissions may be based has resulted in discomfort on the part of panel banks to make these submissions and has brought into question the sustainability of LIBOR as the dominant market benchmark rate.[8]
Assuming that the relevant banks will continue to voluntarily provide LIBOR submissions until the end of 2021 (or that the FCA compels them to do so),[9] the recent announcement is intended to allow for a transition period during which the various markets using LIBOR will, with minimal market disruption, be able to coordinate and adopt (or develop) alternative rates for new transactions and instruments and arrive at, where necessary, consensus fallback rates for legacy transactions and instruments.
The FCA announcement was not a complete surprise to the market. The Financial Stability Oversight Council recommended in its 2014 Annual Report that U.S. regulators cooperate with market participants and others to identify alternative interest rate benchmarks anchored in observable transactions and develop a plan to accomplish a transition to new benchmarks.[10] In response, the Federal Reserve Bank of New York (“FRBNY”) convened the Alternative Reference Rates Committee (“AARC”) in November 2014, which is comprised of major OTC derivatives market participants and their domestic and international regulators and central banks, to “identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards such as the IOSCO Principles for Financial Benchmarks.”[11] One of the results of this work has been the adoption in June 2017 by AARC of the Broad Treasury Financing Rate (“BTFR”), an alternative benchmark rate for U.S. dollar-denominated transactions and instruments.[12] BTFR represents, generally, where banks and others can fund overnight on a collateralized basis (in other words, the cost of borrowing cash secured by U.S. government debt). This rate would be based on a variety of actual repurchase (or “repo”) transactions between banks, hedge funds, money market funds and others[13] and would be published daily by the FRBNY in coordination with the U.S. Office of Financial Research. It is expected that BTFR will begin to be published by the middle of 2018.[14] On August 24, 2017, the Federal Reserve Board requested public comment on the proposed rate (and certain related rates), which it referred to as the “Secured Overnight Financing Rate (SOFR).[15]
BTFR may yield a more reliable and sustainable rate than LIBOR for use in U.S. dollar-denominated instruments and transactions. However, BTFR solves for a rate that is quite different from LIBOR; the former solves for the cost of overnight repos secured by U.S. Treasuries, whereas the latter solves for unsecured money market borrowing between banks. Among other things, BTFR is an overnight rate that reflects market interest rates, but does not take into account bank credit risk, which is an implicit component of a designated maturity of LIBOR.[16] Therefore, forward spreads to the near risk-free BTFR rate will need to be developed for different tenors (e.g., 1-month, 3-months, 6-months).
The derivatives market may, either as of a designated date or over time, adopt BTFR (or some other rate) to replace LIBOR in new transactions once it begins to be published, although LIBOR and BTFR (or such other rate) may co-exist for at least some period of time. However, dealing with legacy derivatives transactions referencing LIBOR is less straightforward, and presents unique challenges. The 2006 ISDA Definitions (the “Definitions”) could be amended to provide for a specific fallback rate (or procedure) agreed to by market consensus in the case of a permanent LIBOR discontinuance, which could be adopted in legacy contracts using a multilateral industry protocol.[17] However, absent such a broad market conversion (or in the case of transactions for which both parties do not agree to amend their contracts to use the new alternative rate or fallback),[18] upon the discontinuance of LIBOR, the existing transaction documentation would dictate the process to be implemented to arrive at a fallback rate.
The 2006 Definitions provide for a designated fallback process for the LIBOR rate typically referenced in U.S. dollar-denominated swap transactions, USD-LIBOR-BBA.[19] For derivatives incorporating these Definitions, LIBOR is determined with respect to each “Reset Date” as the “rate for deposits in U.S. Dollars for a period of the Designated Maturity [e.g., 1 month, 3 months, 6 months] which appears on the Reuters screen LIBOR01 Page as of 11:00 a.m., London time, on the date that is two London Banking Days preceding that Reset Date.” However, if that rate does not appear on the specified page, then, absent the parties having agreed otherwise in their transaction documentation, the rate for that Reset Date is to be determined as if the parties had specified a different rate, USD-LIBOR-Reference Banks. This fallback rate is, generally, determined by the party specified as the Calculation Agent “on the basis of the rates at which deposits in U.S. Dollars are offered by the Reference Banks [i.e., four major banks in the London interbank market] at approximately 11:00 a.m., London time, on the day that is two London Banking Days preceding the Reset Date to prime banks in the London interbank market for a period of the Designated Maturity commencing on that Reset Date and in a Representative Amount [i.e., an amount that is representative for a single transaction in the relevant market at the relevant time].” Specifically, the Calculation Agent is to ask the principal London office of each Reference Bank to provide a quotation. If at least two quotations are provided, then the rate will be the arithmetic mean of the quotations. However, if fewer than two quotations are provided, then there is a further embedded fallback whereby the rate is to be determined as the arithmetic mean of quotations from “major banks in New York City, selected by the Calculation Agent, at approximately 11:00 a.m. New York City time, on that Reset Date for loans in U.S. Dollars to leading European banks for a period of the Designated Maturity commencing on that Reset Date and in a Representative Amount.”
The Reference Bank method described above may be workable in the case of a limited group of trades, or for a short period of time. However, the permanent discontinuance of LIBOR without any pre-designated replacement rate for the vast majority of legacy transactions would overwhelm the market, as banks (acting in their capacities as Calculation Agents) would need to conduct thousands of dealer polls daily, and would inevitably arrive at different rates resulting in, for example, an end-user with identical 3-month LIBOR trades with two banks having different rate resets on those trades.[20]
The FCA announcement allows for a transition period for the various markets using LIBOR to move away from that benchmark in a thoughtful and calculated way.[21] Substantial groundwork has been laid for replacing LIBOR by regulators and major market participants, with BTFR currently being the likely replacement rate for most U.S. dollar-denominated instruments and transactions. However, uncertainty remains as to how long IBA will receive reference bank submissions (and, therefore, be able to publish rates) for some or all of the currently-published LIBOR rates,[22] whether a longer transition period will be necessary to roll out a replacement rate for new instruments and transactions, and whether (and to what extent) market disruption may occur in connection with legacy instruments and transactions referencing LIBOR.
[1] See Speech by Andrew Bailey, Chief Executive of the FCA, at Bloomberg London (“The future of LIBOR”), available here. The FCA has regulated LIBOR since April 2013, with power to supervise LIBOR panel banks and to enforce against misconduct.
[2] In the past, LIBOR was published for 5 additional currencies (SEK, CAD, DKK, AUD, NZD) and 8 additional maturities (2 weeks, 4 months, 5 months, 7 months, 8 months, 9 months, 10 months and 11 months). These rates were discontinued in several phases from December 2012 to May 2013. In connection with this discontinuance, the International Swaps and Derivatives Association, Inc. (“ISDA”) published a Guidance Note in which it provided the market consensus of its membership for purposes of mitigating market risk and promoting the orderly valuation and settlement of positions by market participants. In this guidance, ISDA noted that market participants with legacy transactions would need to bilaterally agree whether to alter the fallback mechanisms already provided for in their agreements or the related ISDA definitions booklets, and highlighted that such market participants could, inter alia, agree to a substitute rate or terminate the relevant transactions. See ISDA, LIBOR Currency/Maturities Discontinuations – Guidance Note, 25 March 2013.
[3] In connection with the determination of these rates, the relevant panel banks are asked to respond to the following question posed by the administrator: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” The banks provide the lowest perceived rate upon which they could obtain (unsecured) funding in the London interbank money market in the specified currency for the relevant period. Once bank submissions are received, the highest and lowest quartiles are excluded (referred to as “trimming”), and the arithmetic mean of the rates is then taken, with the result rounded to the fifth decimal place. The resulting rates are then published to the market at approximately 11:55 a.m., London time. A total of 20 banks provide submissions for the determination of LIBOR, each for between one and all five currencies (e.g., JPMorgan Chase Bank, N.A. London Branch submits rates for all five currencies, Santander UK plc submits rates only for GBP and EUR, and BNP Paribas SA, London Branch submits rates only for GBP). Individual bank submissions are only published three months after their submission to the administrator to ensure that each bank independently arrives at its own submitted rates and protects against “negative signaling effects” that a particular bank’s submissions might project. For additional information on the determination of ICE LIBOR by IBA, click here.
[4] The Wheatley Review of LIBOR was conducted by Martin Wheatley, the chief executive-designate of the FCA, and was published in September 2012. The Wheatley Review made numerous recommendations to improve the reliability and robustness of LIBOR. The Final Report is available here.
[5] A past Derivatives in Review posting provided additional information on LIBOR Manipulation and Municipal Derivatives, available here.
[6] Bailey Speech.
[7] See id.
[8] See id. (“The absence of active underlying markets raises serious question about the sustainability of the LIBOR benchmarks that are based upon these markets.”).
[9] UK and European legislation gives the FCA the power to compel panel banks to provide submissions for purposes of determining LIBOR.
[10] See Financial Stability Board, Reforming Major Interest Rate Benchmarks, at 2 (July 22, 2014) (“Reforming Benchmarks”), available here.
[11] See Working Group on Alternative Reference Rates, Terms of Reference (Nov. 13, 2014), available here. In July 2013, The Board of the International Organization of Securities Commissions issued a final report in which it stated that “Administrators should encourage Subscribers and other Stakeholders who have financial instruments that reference a Benchmark to take steps to make sure that . . . Contracts or other financial instruments that reference a Benchmark, have robust fall-back provisions in the event of material changes to, or cessation of, the referenced Benchmark.” Principles of Financial Benchmarks, Principle 13 (Transition), at 24 (July 2013), available here .
[12] See The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (June 22, 2017), available here.
[13]As currently contemplated, the following three types of repo transactions would be taken into account in the calculation of BTFR: (i) transaction-level data from a tri-party repo clearing platform; (ii) activity occurring within the Depository Trust and Clearing Corporation’s General Collateral Financing Service; and (iii) trimmed bilateral Treasury repo transactions cleared through the Depository Trust and Clearing Corporation’s Fixed Income Clearing Corporation. As currently contemplated, the rate would not include Federal Reserve Transactions in the repo market. See Federal Reserve Bank of New York, Statement Regarding the Publication of Overnight Treasury Repo Rates (May, 24, 2017), available here.
[14] ARRC contemplates the transition to BTFR to be effected in several stages. Now that BTFR has been selected as the preferred replacement rate for instruments and transactions referencing U.S. dollar LIBOR, a liquid futures market must be developed. On July 26, the Chicago Mercantile Exchange announced that it intends to develop futures and options contracts that will be based on BTFR. See CME Group to Develop Derivatives on Broad Treasuries Repo Financing Rate, available here.
[15] To read the Federal Reserve Board’s press release on this development, click here.
[16] The Financial Stability Board in 2014 highlighted the belief of many regulators and others that “there are certain financial transactions, including many derivatives transactions, that are better suited to reference rates that are closer to risk-free.” Reforming Benchmarks, at 14.
[17] Note that ISDA has established working groups to address issues related to a permanent discontinuance of LIBOR, including (i) suggesting fallbacks, (ii) considering amendments to the 2006 Definitions to add select fallbacks that would apply and (iii) developing a plan to amend affected legacy contracts, possibly through a protocol mechanism.
[18] For example, a derivatives end-user may find that BTFR is an inaccurate substitute to LIBOR as a hedge on underlying obligations, particularly if those obligations do not refer to BTFR, and refuse to adopt BTFR as an alternative rate. Such a mismatch could have tax or accounting implications for market participants as well.
[19] This rate is also sometimes referred to as USD-LIBOR-ICE, since IBA replaced BBA as the administrator for LIBOR. However, ISDA has not formally amended the 2006 Definitions to account for the new administrator, and therefore trade confirmations typically continue to use the USD-LIBOR-BBA designation.
[20] The potential effects of the permanent discontinuance of LIBOR rates is something that ISDA has grappled with in the past. In its 2012 response to the Wheatley Review initial discussion paper, ISDA highlighted the potential impact of the discontinuance of LIBOR and the steps that would be required to make necessary transition arrangements, both for new and legacy transactions. Among other things, ISDA’s response noted the following:
Changes would be required to the standard ISDA documentation to . . . address the consequences of the outright discontinuation of Libor, both in respect of the “back book” of legacy trades and to cover new trades on a going forward basis. The market would need to migrate to a successor rate or rates (pre-existing or otherwise) in respect of each Libor rate that was discontinued . . . . ISDA could publish Supplements to its Definitions to facilitate changes to contracts necessary to reference any newly-published successor rates. To facilitate the use of successors in legacy trades, ISDA would likely publish a Protocol which would have the effect of amending OTC derivatives contracts between adhering parties so as to convert their back book trades to reference the agreed successors. It would be absolutely vital to have clear and long term transition arrangements in place, given that the market will take time to migrate liquidity to new rates. It is important to note that adherence to an ISDA Protocol is entirely voluntary, and market participants will only adhere if they perceive that it is in their interest to do so. For the Protocol to be as effective as possible a significant period of time is required so that as many market participants as possible can participate, and can have the opportunity to do so as they see liquidity migrating to the new rate sources. Without such transition arrangements, the ensuing market disruption could be potentially unmanageable.
Response from the International Swaps and Derivatives Association, Inc. to the Wheatley Review of Libor initial discussion paper, September 7, 2012.
[21] Bailey Speech (“The transition will be less risky and less expensive if it is planned and orderly rather than unexpected and rushed.”) Of course, the potential discontinuance of LIBOR has implications beyond the derivatives markets. Market participants are currently reacting to the FCA’s announcement by, inter alia, beginning to discuss alternative rates and disclosing in connection with LIBOR-based instruments that are expected to be outstanding after 2021 the uncertainty of how relevant rates will be determined and related risks.
[22] Notwithstanding the market traction and support that BTFR (and, outside of the U.S., other possible alterative rates) currently enjoys, it is possible that LIBOR will continue to exist after 2021. See, e.g., Smith, Robert Mackenzie, Replacing Libor: weary swaps market eyes long to-do list, Risk.net (quoting representative of IBA sating that IBA believes that “Libor has a long-term sustainable future”). However, the continued publication of LIBOR “would no longer be sustained through the mechanism of the FCA persuading or obliging panel banks to stay.” Bailey Speech.