The final LIBOR settings (for 1-, 3- and 6-month synthetic US dollar LIBOR) will cease to be published by ICE Benchmark Administration Limited (IBA) after their final publication today, 30 September 2024, marking the end of all LIBOR reference rates. In this blog, we look back at how international financial markets have taken on the monumental task of transitioning from LIBOR rates to alternative risk free rates.
LIBOR has been subject to an orderly wind down since July 2017 when Andrew Bailey, then Chief Executive of the UK's Financial Conduct Authority (FCA), announced plans to end the publication of LIBOR rates due to concerns around their reliability, sustainability and integrity.
At the end of 2021, traditional bank panel determined LIBOR settings in sterling, euro, Swiss franc and Japanese yen ceased being published. However, to facilitate transition for legacy contracts, a 'synthetic' form of LIBOR continued to be published for the 1-month, 3-month and 6-month sterling and yen LIBOR settings. The 1-month and 6-month synthetic sterling LIBOR settings ceased at the end of March 2023 and 3-month synthetic sterling LIBOR ceased at the end of March 2024. The synthetic Japanese yen LIBOR settings ceased at the end of 2022.
The US dollar market was given a little longer to transition; the US dollar LIBOR bank panel ended on the 30 June 2023. At that point, the overnight and 12-month US dollar LIBOR settings permanently ceased, and the 1-, 3- and 6-month US dollar LIBOR settings continued to be published in a synthetic form until today.
Development of market standards for new contracts
Since it first became clear in 2017 that the ongoing publication of a LIBOR rate was untenable, authorities and market participants globally have worked hard to ensure an orderly transition from LIBOR to new “risk free rates”.
For the sterling markets, the Sterling Overnight Index Average (SONIA) reference rate was chosen as the preferred alternative to LIBOR. For US dollar markets, the Secured Overnight Financing Rate (SOFR) was chosen as the preferred alternative to LIBOR. Both of these rates are based on active underlying market data and therefore are considered more robust.
There was relatively rapid adoption of risk free rates in the public bond markets. New public issues of floating rate notes referencing sterling LIBOR maturing beyond the end of 2021 had all but ceased by mid-2019. Market practice for new issuances of sterling floating rate notes is now to reference compounded SONIA.
The adoption of risk free rates and agreement on market practice for new loans contracts began slowly but accelerated as the deadline for cessation approached and ultimately has been relatively smooth. There was some initial hesitation in the sterling loans market while parties waited to see if a forward-looking term rate based on Sterling Overnight Index Average (SONIA) or a backward-looking compounded SONIA rate would prevail. The publication of exposure drafts by the LMA in mid-2020 proposing precedent provisions for compounding SONIA helped participants coalesce around a limited number of alternative replacement options. The market standard in the sterling loans market is now to reference compounded SONIA. The extension of dollar LIBOR publication meant that the transition to risk free rates from dollar LIBOR lagged the sterling market. The US dollar market moved to a forward looking benchmark rather than follow the sterling and by January 2022 98% of new US dollar denominated loans had switched to referencing term Secured Overnight Financing Rate (SOFR)[1].
Amending legacy contracts
In addition to the transition to risk-free rates in new transactions, there has also been a need to transition the stock of outstanding legacy transactions, many of which matured beyond the end of 2021, still referencing LIBOR.
For loans this has been a fairly straightforward process given the relatively small number of known parties to each loan. In addition, in 2018 the LMA released standard language to make the process of amending documents to change reference rates easier by making the amendments to the interest rate benchmark a majority lender decision rather than requiring all lenders to agree. In the derivatives market, the multilateral protocol launched by ISDA to incorporate fallbacks from LIBOR to a compounded risk-free rate in the relevant currency plus a fixed credit adjustment spread was widely adopted and greatly simplified the transition.
Bond markets have proved the most challenging to actively transition. For bonds a consent solicitation of the bondholders is required to amend the terms and conditions and consent thresholds to amend existing bond terms are high: often 75% under English law and 100% under New York law.
What about “tough legacy” contracts?
While great progress has been made in the transition to risk free rates, some outstanding “tough legacy” contracts referencing LIBOR remain, where it has not been possible for the parties to amend the terms and change the reference rate to a risk free rate. In these cases, any fallback language set out in the contractual terms will need to be followed. Fallback language pre-dating the 2017 announcement by Andrew Bailey was typically designed to cater for a temporary unavailability of LIBOR, and not its permanent cessation. These fallbacks may result in interest payments being calculated based on a fixed interest rate or the lender’s cost of funds. The resulting outcome may be fundamentally different to that contemplated in the original agreement.
In some jurisdictions legislators have stepped in to bridge the “tough legacy” issue. The United States has enacted federal legislation (the Adjustable Interest Rate (LIBOR) Act (the “LIBOR Act”)) which supersedes similar state laws passed in New York and Alabama. The LIBOR Act allowed the Board of Governors of the Federal Reserve System to select benchmark rates based on SOFR to override contractual references to LIBOR for certain U.S. law governed contracts which: (a) lack any fallback provisions;(b) contain fallback provisions that lead to a replacement rate that is itself based on LIBOR; (c) require polling for interbank rates; or (d) authorise a person to determine a benchmark replacement but such person does not do so by a certain date. However, for many contracts the fallbacks provide for reference to a non-LIBOR base rate so those will not be in scope for this legislation.
Similarly, the EU’s amendments to the EU Benchmarks Regulation allow the European Commission to designate replacement rates in contracts governed by an EU law (and potentially to other contracts to which all parties are located in the EU) and which either do not contain fallbacks or fallbacks are classed as “unsuitable” e.g. where such fallbacks: (a) do not provide a permanent replacement; (b) require third party consent and such consent has been denied; or (c) provide for a replacement benchmark which no longer reflects the market/economic reality that the benchmark in cessation was intended to measure and could adversely impact financial stability. The European Commission has designated replacement risk free rates for CHF LIBOR and EONIA (Swiss Average Rate Overnight (SARON) and Euro Short Term Rate (€STR) respectively) which came into effect in January 2022.
In contrast, the UK government did not introduce contractual override legislation for legacy contracts. Instead, the UK Benchmarks Regulation was amended to give the FCA new powers to require continued publication of LIBOR by the IBA on a non-panel basis for a period of time, known as “synthetic LIBOR”. In addition, the Critical Benchmarks (References and Administrators’ Liability) Act 2021 provided certainty that references to LIBOR in English law governed contracts could be interpreted as references to synthetic LIBOR rates when those replaced panel LIBOR rates. However, this will cease to be relevant once synthetic LIBOR rates have ended, so in English law governed contracts which still reference LIBOR rates, contractual fallbacks will need to be followed.
The FCA has maintained a consistent message that parties to contracts still referencing LIBOR should be taking steps to transition to appropriate, robust reference rates, renegotiating with counterparties where necessary.
A success story?
When Andrew Bailey made his 2017 speech on the end of LIBOR, it seemed almost impossible that the transition could be made without serious market disruption. But this has been a great example of market participants and official sector authorities working together to achieve a smooth and, dare we say it, successful transition.
Whilst risk free rates are seen as more robust than LIBOR rates, regulators continue to keep a watchful eye over interest rate benchmarks. The Federal Reserve Bank of New York last week launched the Reference Rate Use Committee (RRUC), a sponsored group which will continue to convene private market participants to support integrity, efficiency, and resiliency in the use of reference rates across financial markets.
For more information on these developments, please see:
LIBOR replacement: how to protect yourself, Tom Wallis (freshfields.com)
[1] S&P Global: LoanStats February 9, 2022.
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