End of LIBOR in UK: Impact on Loan Documents and Swaps
On July 27, 2017, the chief executive of the United Kingdom’s key financial regulator (the Financial Conduct Authority, or FCA) announced that the FCA would phase out the London interbank offered rate (LIBOR) by 2021. In his remarks, FCA CEO Andrew Bailey’s stated that “the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks - is no longer sufficiently active.” The lack of liquidity in these markets has rendered LIBOR unreliable, susceptible to manipulation and, ultimately, unsustainable.
Because LIBOR is a reference rate in trillions of dollars’ worth of swaps, loans, and other transactions, market participants are rightfully concerned about how the transition away from one of the world’s most important benchmarks will play out.
As an initial matter, federal regulators and industry groups are focused (and have been focused for some time) on determining “risk-free” replacement rates for LIBOR. In the United States, the Alternative Reference Rates Committee (ARRC), a public-private initiative spearheaded by the Federal Reserve Bank of New York, recently recommended using the Broad Treasuring Financing Rate (BTFR), which is based on the cost of overnight loans that use U.S. Treasuries as collateral, in place of USD LIBOR. BTFR will begin being published in early 2018. Additionally, the United Kingdom’s SONIA, Europe’s EONIA, Switzerland’s SARON, and Japan’s TONAR have all been proposed as LIBOR alternatives.
As lenders and other market participants await formal guidance regarding replacement benchmarks, transition timelines and market solutions to the massive shift away from LIBOR, there are a number of steps they can take to prepare for this major disruption. First and foremost, legal, documentation, and compliance departments should take stock of existing loan and swap transactions and determine where LIBOR is referenced, and whether there are any LIBOR replacement terms in place. In addition, lenders should make sure that new or amended loans and swaps that reference LIBOR contain language that permits a replacement index.
For current loans and swaps that reference LIBOR but do not include a mechanism for a substitute rate index, all is not lost. If a loan or swap matures prior to 2021, no action is required – the parties can continue to rely on LIBOR for the next four years. For already-executed loans and swaps that extend past 2021, counterparties should put in place amendments that address replacing LIBOR along with the associated allocation of costs and risks. Going forward, new or amended loans and swaps should include LIBOR replacement mechanisms that specifically set forth the steps that the parties must take in the event that LIBOR is unavailable.
Because there is no universally adopted standardized LIBOR language for loan documents, each lender must review and evaluate current LIBOR terms to make sure that a replacement mechanism for LIBOR is available. While swaps are almost universally governed by ISDA documentation, the current ISDA forms and definitions do not at this time provide a reliable fallback or replacement framework. Eventually, we expect that ISDA and certain financial regulators will publish guidelines to market participants regarding a uniform approach to shifting away from LIBOR, and we will issue further recommendations to streamline the transition process at that time.
For now, significant uncertainty remains regarding the end of LIBOR, but lenders and swap market participants can mitigate inevitable chaos by taking time now to (i) understand the extent to which they currently rely on LIBOR, and (ii) incorporate new terms providing LIBOR replacement mechanisms into their existing and future swap and loan documentation.