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LIBOR game over

What are the implications now that the most widely used benchmark will soon no longer be useable?

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Benchmarks

The timeline for the end of LIBOR is now clear. Recent announcements by the administrator of LIBOR (an interest rate benchmark measuring the rate at which major global banks lend to one another in the interbank market for short-term loans) have made it clear that the most widely referenced benchmarks globally will, mostly, no longer be useable as early as the beginning of 2022. Market participants must prepare for this - continued reliance on LIBOR benchmarks, particularly the most widely used USD LIBOR, poses risks to financial stability.

Transition phase

The impending end of LIBOR means that LIBOR references embedded in existing contracts need to be changed. For these existing contracts to move away from LIBOR, contract parties can either a) negotiate to immediately replace the reference to LIBOR with a reference to an alternative rate; or b) insert a contractual clause (a fall-back clause) that will have this effect when a specified trigger event occurs.

The relatively short timeframe, as well as the features of certain contracts using LIBOR, means that there is the risk that not all existing LIBOR references can be addressed in time. Replacing the benchmark is now considered easier in the derivatives market, where the International Swaps and Derivatives Association has developed contractual templates that are proving helpful to incorporate fall-back language and amend existing contractual documentation. However, it is hard to renegotiate certain bond contracts, which require consent from a very large majority of bondholders. The same holds true for some retail contracts such as mortgages, which would require the re-negotiation of hundreds of thousands of contracts.

LIBOR is also used widely in the EU. In order to avoid negative consequences of the cessation of LIBOR, the EU rules on benchmarks were recently amended, granting the Commission the power to designate a statutory replacement for references to a benchmark in existing contracts and financial instruments governed by the laws of one of the EU Member States. The power may be used in cases like that of LIBOR, when a critical benchmark is going to be discontinued. This new tool will ensure continued orderly functioning of contracts and, as a result, financial stability and the proper functioning of financial markets in the EU.

New powers

The first attempt to exercise these new powers by the European Commission in the context of the discontinuation of LIBOR is currently under assessment. A public consultation was launched in March to ascertain the suitability of designating a statutory replacement for certain settings of the Swiss Franc LIBOR to products such as savings accounts, mortgages and loans, including consumer credit agreements and small business loans. The consultation ended on 18 May and garnered significant interest from the market.

The European Commission, the European Securities and Markets Authority (ESMA), the European Central Bank in its banking supervisory capacity (ECB Banking Supervision) and the European Banking Authority (EBA) issued a joint public statement in June on the forthcoming cessation of all LIBOR settings. They recommended the financial industry to:

  • stop using the 35 LIBOR settings, including USD LIBOR, as a reference rate in new contracts as soon as practicable and in any event by 31 December 2021
  • limit the use of any LIBOR setting published under a changed methodology (also known as “synthetic” LIBOR) only to contracts that are particularly difficult to amend ahead of LIBOR’s cessation (commonly referred to as “tough legacy”)
  • include robust fallback clauses nominating alternative rates in all contracts referencing LIBOR

The European Commission, ESMA, ECB Banking Supervision and EBA will continue to closely monitor the situation and LIBOR exposures.

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