WHAT IS LIBOR?

Article by Yu Qian Lee and Nickolaus Ng

London Interbank Offered Rate (LIBOR), is the benchmark interest rate at which major global banks lend to one another, indicating borrowing costs between banks. LIBOR is calculated, published and administered by the Intercontinental Exchange (ICE) by consulting major global banks how much they charge other banks for short-term loans . There are other regional interest rates which are seen as the equivalents of LIBOR, including the European Interbank Offered Rate (EURIBOR), Shanghai Interbank Offered Rate (SHIBOR), and the Tokyo Interbank Offered Rate (TIBOR) .

LIBOR is widely used in financial products, including:

• Various credit products such as credit cards, car loans, and adjustable-rate mortgages. This change in LIBOR helps determine the ease of borrowing between banks and consumers.

• Standard interbank products like forward rate agreements (FRA), interest rate swaps etc.

• Commercial products like variable rate mortgages and syndicated loans.

• Consumer loan-related products like individual mortgages and student loans.

LIBOR is also used to gauge the market expectation for interest rates.

Controversies of LIBOR

Since the rates submitted are estimates and not actual transactions, banks have been reportedly submitting false figures. Major banks had come together to manipulate LIBOR rates, by taking the trader’s requests into account and submitted artificially low LIBOR rates to keep them at their preferred levels, increasing trader’s profits. Traders at several banks conspired to influence the final average rate, by agreeing to submit rates that were either higher or lower than their actual estimates. Since 2008, major global banks involved in the scandal have faced serious regulatory scrutiny from the US Department of Justice as well as the UK and Europe. During the past three years, Barclays Bank, JP Morgan, Swiss bank UBS, Royal Bank of Scotland and Deutsche Bank have all been fined by financial regulators for this malpractice, as it clearly amounts to market manipulation which is illegal .

These investigations have placed individual responsibility on the traders who sought to influence the LIBOR rate, as well as the managers, the brokers, and the rate-submitters. Bank executives pled ignorance of the misconduct, but a number of them, including former Barclay’s CEO Bob Diamond and Rabobank CEO Piet Moerland, have been forced out.

Phasing out of LIBOR

As the LIBOR scandal has reduced public trust in the marketplace, there is gradual disuse and phasing out of LIBOR leading up to 2022 when LIBOR is expected not to be the main indicator in use anymore.

Moving forward, there will need to be a replacement for LIBOR with equal or even more benefits as LIBOR. One option is the Sterling Overnight Interbank Average Rate (SONIA) which measures the rate paid by banks on overnight funds. SONIA is calculated as a trimmed mean of rates paid on overnight unsecured wholesale funds.

The Working Group on Sterling Risk-Free Reference Rates noted in November 2018 that SONIA is robust because it is anchored in active, liquid underlying markets. Notably, the average value of transactions underpinning SONIA since April 2018 is approximately £45 billion per day.

Since April 2018, SONIA has been administered and published by the Bank of England. The Working Group recommended SONIA as the replacement for LIBOR as:

1) SONIA can evolve over time and thus is robust to changes in its underlying markets.

2) SONIA tends to be more predictable than LIBOR and tracks Bank Rate very closely.

3) SONIA is referenced in the already liquid sterling overnight indexed swap (OIS) market, and this makes the LIBOR transition easier.

4) SONIA does not include a term bank credit risk component and therefore is a better measure of the general level of interest rates than LIBOR.

5) SONIA can be compounded to be used in term contracts and this often tends to be relatively predictable.

There are a few other Working Groups being set up in other jurisdictions such as the United States, Japan, Switzerland, and the EU. Alternative Reference Rates (ARRs) are selected for the currencies in those jurisdictions, but these will not be discussed in this article.

Legal implications of the transition

1) Fallback Language/Provisions

The transition from LIBOR will involve considerable costs and risks for financial firms. Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies.

LIBOR may become unavailable even though products referencing it remain in force. These contracts typically include “fall-back provisions” which specify contract terms in case LIBOR is unavailable. In other words, the fallback language within a contract acts as a “how-to” guide for identifying replacement rates should the original benchmark be unavailable.

To address this, industry bodies are working to develop robust fallback provisions for LIBOR-referencing transactions. For over-the-counter (OTC) derivatives, ISDA plans to amend the ISDA 2006 definitions – or all new transactions once implemented. ISDA will also provide a protocol for counterparties to implement robust fallback language for legacy transactions. For cash products, national working groups such as the US ARRC, have published proposed fallback language to implement new transactions referencing IBOR.

In addition to the fallback language, firms will need to consider other key contractual features that may impact the IBOR transition, including maturity date, firm’s role in the contract, benchmark use, amendment and consent provision, governing law and jurisdiction, and force majeure provisions.

2) Replacement rate amendment provision

There is a need to select an alternative reference rate in place of LIBOR and alternatives like SONIA can be one of the options (as discussed above). Provisions should be prepared and added to allow for greater flexibility for parties to agree on a reference rate without entering into a full consent process. By way of example, since November 2014, all Loan Market Association (LMA) loan agreements have included an optional provision that allows the majority lenders and the obligators to agree on a replacement if a "Screen Rate" ceases to be available. We understand that trade associations in other markets are considering whether an adapted form of this provision should be added to their standard documents.

The drafting of these provisions will require agreement on what level of consent would be acceptable in the relevant market for LIBOR to be replaced and the appropriate trigger for the provision. The current LMA provision is triggered upon the cessation of LIBOR. A broader approach would be for it to cater for a range of possible scenarios, for example, the market switching to an alternative rate while LIBOR continues to exist.

As with the automatic switch over to a replacement rate, there are likely to be substantial mechanical and pricing related changes required if an amendment is agreed. This may include the addition of an adjustment mechanism to protect the commercial deal.

3) Agent/trustee discretion

There has also been discussion in the U.S. leverage loans market and the securitisation market about giving the agent/trustee the discretion to elect a replacement rate in the scenario that there is a market-wide switch to one rate. There are some challenges to this proposal. The first is being able to describe the parameters of the modification in a manner acceptable to all parties, given the current uncertainty, although this may become clearer over time. A second is the likelihood of an agent or trustee being comfortable with the discretion of that order.

4) Customer issues

Financial firms will also face serious communication challenge with retail customers. For example, most variable rate mortgage customers in the US may understand that their rate is LIBOR+200 basis points (or similar) but have little understanding of LIBOR itself. Unless appropriately communicated, they are likely to think that a proposed alternative rate of the Secured Overnight Financing Rate (SOFR)+230 basis points is a worse deal, even if SOFR is on average 30 basis points lower than LIBOR.

If not properly handled, this may increase potential for litigation because financial products customers may think they have been misled by the bank or did not get the returns that they want because of the transition and change in the reference rate which they are not able to grapple fully.

5) Reputational Risk for Firms

Writing long-dated business that may extend beyond a LIBOR transition period entails conduct risk. Without clarity about the alternative rates or when the transition will happen, it is difficult to know how contracts should be priced. The longer uncertainty persists, the greater the mis-selling risk incurred by financial firms.

Importance of legal technology in this transition

1) Using technology to assess potential replacement rates

As discussed above, the LIBOR transition results in banks needing to select a replacement from several alternative risk-free reference rates (RFR) or identify a suitable proxy rate that is on par with LIBOR. To do this, the banks need to compare the values, trends, co-integration, and distribution features between LIBOR and ARR historical time series to identify the closest proxy for LIBOR. Moreover, the banks will need to assess the taxonomy, features, and volume build-up of the proposed risk-free rates and make an informed choice by weighing the risk and corresponding return. Deep learning feature extraction of time series can be employed to assess information on all these.

2) Evaluating LIBOR exposure and enhancing contractual robustness through technology

Banks and financial institutions should identify all contracts that use LIBOR as a reference rate and modify express fallback language. To do this, they should use AI-based model libraries, optical character recognition, and computer vision techniques to extract contextual information from digital documents. Natural language processing (NLP) technologies can be used to screen contracts and pinpoint language variations, identify contracts that have been impacted, and predict exposure in dollar value. Furthermore, they should leverage on robotic process automation (RPA) solutions to embed robust fallback provisions and mechanisms. This will enhance contractual robustness and reduce cycle time and manual interventions. The banks could also adopt automated modelling techniques built using machine learning (ML) algorithms and deep neural networks to adjust the Risk-Free Rates (RFR) for pricing the instruments.

However, banks should note that in leveraging AI strategies, there may be ‘black box’ factors that could result in difficulties explaining AI decisions to regulators. If unjustified, this could potentially result in the banks incurring penalties. Therefore, banks should keep up to date with regulatory bodies’ positions on the use of AI-led decisions, latest developments, and industry practices.

Moving forward, what to expect?

The transition away from LIBOR will affect the whole market, not just the small businesses but also the big multinational companies. However, larger companies and banks have much more capacities to deal with the transition smoothly whilst small businesses will have an unfair disadvantage as they do not have the resources to work through these challenges. In the long term, notwithstanding, this market-driven exercise is likely to bring about a fairer rates for smaller companies, free from manipulation. Thus, the pain suffered at the start will ultimately benefit the smaller businesses.

For law firms, preparing clients for a smooth transition is clearly the ultimate aim. To differentiate and stand out from other firms, some firms such as Norton Rose Fulbright have introduced a multidisciplinary LIBOR team which comprised lawyers from various practice areas to deliver services on transition away from LIBOR. At this juncture, AI is of high relevance as it is needed to efficiently recognise any LIBOR terms/IBOR terms in contracts and flag it to lawyers for necessary amendments and/or additions.