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What is LIBOR and why is it important to take note of its disappearance?
The London Interbank Offered Rate (LIBOR) has been the most widely used unsecured wholesale funding rate across the world since 1986. It has been used as a reference rate to price or hedge a host of financial instruments worth around USD 400 trillion across multiple jurisdictions.
In 2017, the UK’s Financial Conduct Authority (FCA) announced that LIBOR panel bank submission will become discretionary post 2021, which means the availability of LIBOR as a benchmark rate becomes completely uncertain. This will have a significant impact on the banking and financial services industry.[1]
What will take its place?
The discontinuance of the London Interbank Offered Rate will necessitate linking loans and derivatives segment to a new benchmark. Central banks around the world have been working to develop a replacement set of benchmarks based on what are called risk-free rates (RFRs)
There is a near consensus that the LIBOR will be replaced by U.S.’s Secured Overnight Financing Rate (SOFR) for all dollar loans, but other benchmarks like the U.K.’s Sterling Overnight Index Average (Sonia), and the Euro Short-Term Rate (ESTR)., are in the race as well.
A McKinsey report estimates that 50% to 75% of banks’ models involve Libor that will need to be redeveloped. Furthermore, almost all systems will require certain remediation and for some banks, more than 80 document types will need to be reviewed for potential “repapering.”[2]
— How does it impact commercial contracts?
Charles Yi, a partner at Arnold & Porter says “Every existing contract that references LIBOR will be impacted by the transition.”
Needless to say, that one of the major difficulties raised by the discontinuance of LIBOR is the sheer number of existing agreements that use LIBOR as an index, posing significant risks:[3]
- There are trillions of dollars’ worth of financial contracts based on LIBOR. Once the rate has been discontinued, as discussed earlier, they will need to be tied to a new benchmark rate, which as has been predicted may have serious consequences.
- These contracts should have ideally had ‘fallback’ clauses specifying what happens when LIBOR is discontinued, however, contracts contingent on LIBOR have continued to be written, many of them extending beyond 2021, without these clauses creating additional challenges.
- The absence of ‘Fallback’ provisions is likely to change the economics of the product, for example effectively converting floating-rate products into fixed-rate products. “As a result, one of the counterparties to a LIBOR contract may suffer material losses while the other receives windfall gains, creating an unacceptable situation.”[1]
The way forward
As regulators like the Financial Conduct Authority in the UK and the New York branch of the Federal Reserve in the US caution banks about the risks associated with LIBOR exposure, it would augur well for general counsel, asset managers, lenders, and everyone in between, to monitor the status of their LIBOR exposure.
A good starting point is to have information about the following key facets of the business that the Federal Reserve or the FCA is expected to ask:
- The volume of contracts reviewed as a percentage of all contract papers.
- Number of contracts affected by LIBOR with respect to the contracts reviewed so far.
- Number of affected contracts re-papered, re-negotiated, or otherwise “fixed”.[5]
A GC or an asset manager must gather all their commercial credit agreements and maintain a record of contracts reviewed, contracts with LIBOR clauses, and how many of those contracts have been fixed. But monitoring thousands of contracts is not an easy task especially when contracts that are tied to LIBOR may not necessarily mention “LIBOR”. Contracts could be using an interest rate term structure that is tied to LIBOR but does not explicitly contain the word “LIBOR” for instance it might have words and phrases like eurodollars, eurocurrency, and base rate, without mentioning “LIBOR”.
To combat these challenges that plague numerous in-house teams, LegalEase Solutions offers hybrid solutions combining the forces of artificial and attorney intelligence to put into operation an all-in-one contract management and analysis system that:
- Searches through a slew of documents in minutes,
- Finds governing law provisions, fallback provisions related to LIBOR and highlights illegality clauses in loan agreements,
- Categorizes syndicated loans and non-syndicated loans,
- Notifies when contracts will expire or terminate, and is
- Quality-checked by subject matter experts to generate fast-paced accurate results.
LegalEase Solutions provides corporate legal departments and law firms innovative support with regulatory compliances. Our team is designed to function as an extension to your legal practice or department, providing you the capabilities and resources to stay up to date with your needs. If you have a project you need a hand with, feel free to reach out to us at contact@legaleasesolutions.com. Our team is happy to assist.
