Facing up to the LIBOR challenge
Opinion 3 minute read

Facing up to the LIBOR challenge

21 November 2019

The transition from LIBOR will cause massive disruption. It is high time the loan market addressed the challenges collectively, says Mark Jones, of TMF Group Capital Markets Services after the LMA Summit.

Following the UK’s Serious Fraud Office decision to close its long-running investigation into the manipulation of the LIBOR (London Interbank Offered Rate) benchmark rate, the banking industry needs, urgently, to get to grips with replacing it. In the seven years since it emerged that certain banks had been involved in fraud, collusion and the manipulation of markets, attempts to succeed LIBOR with a universally accepted risk-free successor have not proved satisfactory.

LIBOR is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It’s widely used as a reference rate in loan and derivatives documentation. It is actively published for five currencies:  US Dollars, Euros, Japanese Yen, Pounds Sterling and Swiss Francs. To replace it universally across this broad array of references requires collaboration by regulators and market participants in each currency sub-market.

Following the 2012 scandal, the Financial Conduct Authority (FCA) attempted to anchor LIBOR submissions and rates to actual transactions to ensure the rate was truly representative of market conditions. Unfortunately, market activity proved insufficient to sustain this. The rates, therefore, had to be set by LIBOR panel banks. It is recognised that this is no longer fit for purpose and the FCA is supporting a transition from LIBOR to other benchmark rates by the end of 2021.

There’s a host of transitional challenges that need addressing before markets can successfully move to a risk-free rate environment. After attending this year’s Loan Market Association (LMA) Summit, my concern is that not enough thought has been given towards the implementation and uptake of potential alternative methods.

In particular, the loan market is far behind in its transition. LIBOR-referencing loans are still common in lending to non-financial institutions. It’s here that a major transition programme needs to be undertaken.

If market players don’t agree a suitable universal solution, the likely fall back is that future loans will be arranged and traded by taking the most recent interest determination date as the basis of the next. In effect, the loans become fixed-rate instruments rather than variable-rate, which  could result in a weaker secondary market with less arbitrage opportunity.

In terms of contracts and other documentary implications, transactions in the short term may well continue to be based on LIBOR while the markets ponder the alternatives.  Remember, transition is about both new business and converting legacy LIBOR contracts.

This is easier in some markets than others. In the derivatives market, some forward-looking UK financial institutions have already closed out their LIBOR-referencing contracts in favour of SONIA (Sterling Overnight Index Average), an unsecured reference rate and an alternative benchmark.

Joining the dots

However, each market (US, UK, Eurozone, Japan and Switzerland) has started developing potential alternative risk-free rates that are backward-looking in their calculation, whereas LIBOR is a forward-looking rate. There are stark contrasts in their approach and not enough planning has gone into standardisation across borders.  In consequence, each region could end up with a specific rate that may not be compatible with others. 

There are encouraging signs. The LMA in Europe and the Loan Sydnications and Trading Association (LSTA) in the US are making some progress on developing new standardised documentation for syndicated loans referencing overnight risk free rates (RFRs).  Delivering this documentation is key to the transition from LIBOR.

Kicking the tyres

The transition also presents a technology challenge for the banks. RFRs are structurally very different to LIBOR and transitioning to these new rates is a demanding and complex process that puts stress on legacy technology systems.

The fintechs are circling. The transition from LIBOR is a once-in-a-generation event, providing an exceptional opportunity to provide new services to banks. This could prompt a market disintermediation effect with fintechs and non-bank operators diversifying their offering by providing calculation services – historically the preserve of banks – to market participants. 

There now needs to be more focus on the shift away from LIBOR. The regulators, the market associations and their members, and the fintechs must drill down into the issues together to find a universally-accepted answer.

Partnering with TMF Group

If you’re putting a deal together in the coming months, you need to give serious thought to the transition from LIBOR. We service bilateral, club and syndicated loans from transaction structuring to placement and distribution of the loan. We can help you to make sure that any new rate considerations are incorporated within your documents. Contact us today to find out more. 

Written by

Mark Jones

Senior Product Manager, Capital Markets Services

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