What Just Happened?
From 11 May this year liquidity providers in the sterling non-linear derivative market are being encouraged by the Bank of England and the Financial Conduct Authority (FCA) to adopt new quoting conventions for inter-dealer trading based on SONIA instead of LIBOR[1]. This is to help facilitate the ongoing shift away from LIBOR.
What Does This Mean?
LIBOR is the London Interbank Offer Rate; this is a central interest rate against which the interest rates of other financial products are set. These products include loans, derivatives, bonds, trades and working capital. There are 5 different currency that use LIBOR (USD, GBP, EUR, CHR and JPY) all of which will be switching to Risk Free Rates (RFRs) by the end of 2021 except for US dollar LIBOR that will transition away from LIBOR by mid-2023[2].
In the UK LIBOR is being replaced with Sterling Overnight Index Average (SONIA). The Prudential Regulation Authority (PRA) and FCA have set out milestones based on those set by the Working Group on Sterling Risk-Free Reference Rates (the Working Group) that firms are expected to meet[3]. This is to ensure firms transition away from LIBOR in a timely manner.
LIBOR is being decommissioned because it is no longer a reliable method to measure the cost to borrow due to it being a forward predicting rate[4], so it is effectively just an estimate and isn’t based on a live market. Secondly, LIBOR is very susceptible to manipulation due to how it is calculated. In the past this has led to corporations taking advantage of this by choosing favourable rates for themselves or colluding with other banks to set more favourable rates[5]. This creates an unfair market with unrealistic capital prices. RFRs will be more reliable and less easy to manipulate because they are “backward-looking” rates meaning they based on transactions that have already happened in the market[6].
How Does This Impact the Legal Sector?
Lawyers will have to review and interpret any contracts that include terms that involve LIBOR to ensure a smooth transition to RFRs. This is a very important process since there are trillions of dollars’ worth of financial contracts that rely on LIBOR[7], so there is a lot at stake if the contracts aren’t amended on time. As part of this process, they will be able to use Artificial Intelligence (AI) tools to find contracts that include LIBOR terms. However, AI is likely to have limitations since it probably cannot distinguish between clauses that stipulate what would happen if LIBOR were to be decommissioned and those that don’t.
Since decommissioning LIBOR has been a topic for a while, last year recommended fallback language was published by the Alternative Reference rates Committee (ARRC), International Swaps and Derivatives Association (ISDA)[8] and some other institutions. The language was provided to be used for contracts that either had no fallback provision addressing a cessation of LIBOR or the fallback was to the last LIBOR fixing or dealer poll[9]. The fallback would provide security for liability and litigation to parties that have contractual discretion to choose a replacement for LIBOR.
Overall, the transition away from LIBOR to RFRs will likely provide greater stability within the financial sector. This is due to RFRs being more controlled with less risk of manipulation or of the rates plummeting, as well as the rates being a more truthful representation of the market.
Written by Isabella Hunter
Assessing Firms
#Dorsey&WhitneyEuropeLLP #Dentons #DLAPiper #Axiom #NortonRoseFullbright #PaulHastingsLLP #Dechert #Linklaters #WombleBondDickinson #Holland&Knight
References
[1] Bank of England ‘Transition from LIBOR to risk-free rates’ <https://www.bankofengland.co.uk/markets/transition-to-sterling-risk-free-rates-from-libor> page last updated 28 April 2021
[2] HSBC ‘IBOR reforms’ <https://www.gbm.hsbc.com/financial-regulation/ibor#:~:text=On%2024%20February%202021%2C%20the,non%2Dlinear%20derivatives%20that%20expire> page last updated 16 March 2021
[3] IBID (1)
[4] IBID (2)
[5] Miranda Marquit, ‘What is Libor and Why is it Being Abandoned?’ (Forbes Advisor, 16 December 2020) < https://www.forbes.com/advisor/investing/what-is-libor/ > accessed 5 May 2021
[6] IBID (2)
[7] Chirag Domadia, ‘The Discontinuation of LIBOR – The Top Five Things Investment Managers Should Consider’ (Dorsey & Whitney LLP, 17 October 2019) <https://www.dorsey.com/newsresources/publications/client-alerts/2019/10/the-discontinuation-of-libor> accessed 5 May 2021
[8] ISDA ‘ISDA 2020 IBOR Fallbacks Protocol’ (23 October 2020) <https://www.isda.org/protocol/isda-2020-ibor-fallbacks-protocol/>
[9] J.P. Morgan ‘Leaving LIBOR: A Landmark Transition’ <https://www.jpmorgan.com/solutions/cib/markets/leaving-libor> page last updated 6 April 2021
Disclaimer: This article (and any information accessed through links in this article) is provided for information purposes only and does not constitute legal advice.