LIBOR replacement: how to protect yourself

The LIBOR style of benchmark rate is scheduled for replacement.

Without action you may have to pay more, or may receive less, than you expected under any financing arrangement or contract that references LIBOR and has a term that extends past 2021.

If you may be affected, discuss your exposure and potential solutions with your normal Freshfields contact or send an email enquiry.

What is happening?

The Financial Conduct Authority (FCA) has announced that it will not compel banks to provide submissions for the calculation of LIBOR past 2021. The FCA has firmly messaged that borrowers, lenders and other market participants all need to prepare for the discontinuation of LIBOR.

This decision has been repeatedly reaffirmed by the FCA, as there are identified weaknesses in LIBOR that make its manipulation more likely. These include that the unsecured inter-bank term borrowing market that LIBOR measures has significantly declined since the benchmark was introduced in the 1980s. This means that submissions to LIBOR are increasingly reliant on expert judgement rather than transaction data.

The preferred replacement to LIBOR is a set of liquid near risk-free rates (RFRs). These are different depending on the currency referenced:

All of the proposed RFRs are backward looking overnight rates, while LIBOR uses term rates that look forward across an agreed tenor, such as a month or a quarter. While work is currently underway by different working groups to create term RFRs these are not yet being widely used by market participants. An update is expected later this year for a term SONIA rate, and a term SOFR rate.

This trend also affects EURIBOR and EONIA, with the ECB having announced the launch of a private sector working group on euro RFRs in September 2017. ESTER has also been selected by them as the preferred euro RFR, although a timetable for replacement is not set as it is for LIBOR. Although this note just refers to LIBOR, most of the same points may apply to EURIBOR and EONIA.

Why should I care?

The selected RFRs produce different interest rates in comparison to their LIBOR comparable, so even with a straight switch your interest payments will be different (especially without an accompanying margin adjustment). Not switching may also create unintended results, for example by triggering fallback provisions.

Floating rate loans could become fixed rate if they fall back to use the last available LIBOR screen rate available, or could become based on each lender’s self-determined cost of funds rather than the more objective screen rate. This could be the case even if RFRs are being widely adopted by other market participants.

Additionally, if your exposure to LIBOR based financing is hedged, this may become mismatched. ISDA is looking at implementing a more automatic switch for LIBOR derivatives so that they will reference the relevant replacement RFR past 2021.

It is also possible that a transition to RFRs may also require adjustments to your month-end or quarter-end processes, operations and systems.

How do I protect myself?

• Take stock of your LIBOR/EURIBOR exposure and start your planning early.
• Ahead of market adoption of RFRs, be aware of the likely need for future loan amendments or bond consent solicitation processes to implement the relevant RFR once the market has adjusted.
• If you are entering into new syndicated loan agreements, consider including a lower consent threshold to implement a switch to an RFR, as changing the benchmark rate would normally be an all lender decision.
• Stay in touch with Freshfields to keep up to date with further developments.