A recent speech by Andrew Bailey, Chief Executive of the U.K.’s Financial Conduct Authority (FCA) — in which he said the FCA would not compel banks to submit to LIBOR after 2021 — has the loan market buzzing about the impending demise of LIBOR.  Bloomberg reported that LIBOR was headed for the trash heap of history, the Financial Times reported that LIBOR was no longer fit for purpose and The Wall Street Journal offered a “Eulogy for the World’s Most Important Number."

While those headlines caught our eyes – and, based on the number of incoming calls, certainly caught the eyes of our members – the reality is that we do not believe LIBOR will disappear in the near term. But that doesn’t mean the market should just sit back and wait. To help loan market participants come up to speed (and prepare a plan), below we discuss what has been happening with LIBOR, what is likely to change in the next year (or two) and how the loan market can position itself.

First, the background on why LIBOR could theoretically go away. During the financial crisis, there were widespread allegations of attempted LIBOR manipulation by submitters. Since the financial crisis, there has been a decline in liquidity in LIBOR. To wit, more than 70% of 3-month LIBOR submissions are based on expert judgments by submitters, as opposed to actual transactions or interpolation of transactions. Submitters – who face liability – do not like providing quotes based on judgment, some LIBOR submitters have quit, and there are concerns that LIBOR liquidity may continue to wane. The decline in LIBOR liquidity is viewed as a potential systemic risk, and therefore major global financial regulatory entities – IOSCO, the Financial Stability Board, FSOC and more – have been working with market participants to reform benchmarks and find potential replacements.
 
At a high level, there are three efforts underway. First, there is an effort to strengthen LIBOR. To that end, the calculation of LIBOR has shifted to ICE Benchmark Administration (“IBA”), which is working to expand the number of submitters and tie LIBOR submissions as much as possible to transaction data. Second, and related, there are efforts underway to develop fallbacks in the event that LIBOR becomes unavailable. Third, there are initial efforts underway to transition from LIBOR to new Risk Free Rates (“RFR”).

Much of the effort in the U.S. thus far has centered on the $200 trillion US dollar derivatives market. This is why last month the Alternative Reference Rates Committee (ARRC) announced that “broad Treasuries repo financing rate” is the appropriate reference rate for “certain new U.S dollar derivatives and other financial contracts”. 

So what, exactly, is it? The broad Treasuries repo financing rate (currently known as “BTFR”, but likely to transition to “SOFR”) is based on the cost of overnight loans that use U.S. government debt as collateral. It will include data from actual transactions throughout the repo market, including tri-party repo transactions, inter-dealer transactions cleared by the DTCC and some bilateral transactions.  ARCC chose this rate because it felt that the rate was liquid and deep (with average daily trading volume of $660 billion), it would likely remain robust over time and its construction, governance and accountability is consistent with IOSCO’s Principles for Financial Benchmarks. One not-inconsiderable drawback: It is an overnight rate. To be fair, officials have noted that it is possible to create a compounded 3-month rate, but this still is backwards looking. Importantly, it is a secured rate, which means it is lower than three-month LIBOR.

Critically, LIBOR is not being phased out any time soon – even in the derivatives market. (Slides 15-18 of this ARRC presentation show the paced transition time for swaps; clearly there are many steps and preconditions. Critically, SOFR won’t even be published until mid-2018.)

So what does all this mean for the $4 trillion syndicated loan market? If LIBOR were discontinued, how do credit agreements read today? As described in The LSTA’s Complete Credit Agreement Guide, definitions of “LIBOR” customarily provide for fallbacks in case the LIBOR screen rate is unavailable. These range from the use of an interpolated rate to an offered quotation rate to first class banks for deposits in the London interbank market by the Agent or a designated bank, to a rate determined on the basis of quotes from designated “reference banks”.  Moreover, credit agreements customarily provide a “market disruption event” clause as a second fallback, which includes a trigger event entitling lenders to suspend making loans at interest rates calculated by reference to LIBOR, and when triggered, all loans otherwise bearing interest calculated by reference to LIBOR become base rate or prime rate borrowings. (Admittedly, these fallbacks were designed for temporary disruptions rather than the discontinuation of LIBOR.)

So, how might market participants begin to prepare for a transition?  At this point, parties drafting credit agreements should pay particular attention to LIBOR fallback provisions and the ability to amend agreements to address the discontinuation of LIBOR. Clifford Chance published a helpful client alert outlining key considerations for NY law governed credit agreements and indentures.  The key step in this process will be the market’s ultimate selection of a new rate, whether it is BTFR/SOFR or some other alternative rate. In absence of that knowledge, it is too early to select an alternative benchmark rate in current credit agreements.  The LSTA will remain engaged on this issue and, as a new reference rate is developed, will work with loan market participants to facilitate an orderly transition to the new rate and develop appropriate language for credit agreements.

A version of this story first appeared on the website of the Loan Syndications And Trading Association (LSTA) and is being republished with their permission.