The countdown to the end of Libor has begun but the scale of the work involved in transitioning to the new rate is immense.
For 40 years Libor has been the key benchmark for setting interest rates on various loans and contracts, underpinning trillions of dollars of transactions, before controversy hit.
From today no new loans maturing after 31 December 2021 will be allowed to be priced using Libor. By the end of the year businesses will have to move over to the alternative Sonia rate, which will not come without its difficulties, not least in a pandemic.
What issues does the transition pose and how prepared are businesses as the deadline approaches?
What is Libor and why is it being scrapped?
London Interbank Offered Rate, commonly known as Libor, is an interest rate for borrowing between banks, calculated from estimates provided by the member banks.
It is the key rate for mortgages, loans and contracts but then scandal hit in 2012 when it emerged banks had misstated their submissions to make better returns.
The price fixing scandal, which saw five bankers jailed, prompted an overhaul of the market with changes to be implemented by the end of this year.
What will replace Libor?
Earlier this month the Financial Conduct Authority (FCA) announced the formal end to most Libor rates by the end of the year. All sterling, euro, Swiss franc and Japanese yen denominations of Libor will end on 31 December. Overnight 1- ,3- , 6-, and 12-month USD Libor will come to an end on 30 June 2023.
Regulators have decided to switch from Libor to a risk free rate, which is a rate of return on an investment with zero monetary loss.
Sterling Overnight Index Average – commonly referred to as Sonia – is administered by the Bank of England and is the chosen rate for sterling loans.
The Sonia rate is based on actual overnight interest rates in active and liquid wholesale cash and derivative markets. The key difference is that it is backward-looking and cannot be determined until the end of an agreed interest period, while Libor is agreed at the start of the period.
What are the difficulties with transitioning to Sonia?
The regulator announced the move away from Libor in July 2017 but the transition is proving difficult. Sonia gives a different interest rate so the amount owed or paid out under the contract could be very different from the old Libor-based agreement.
There are a number of contracts still linked to Libor that will remain outstanding and unamended after the deadline. These so-called legacy contracts will include contracts where no agreement was reached between the parties as well as contracts that were not able to be converted, like securitisation bonds.
“Part of the challenge is that Libor has been used across such a wide range of contracts, over so many years, that contract terms can vary significantly,” Dan Hemming, disputes partner at RPC said. “For some types of ‘tough legacy’ contract, consensual renegotiation is likely to be very difficult, and sometimes impossible.”
How prepared are companies for the switch?
A research report from SDL published earlier this month shows 40 per cent of companies are yet to start planning or have been planning for less than a year.
“The global pandemic has made an already mountainous undertaking even more difficult for investment banks, market-makers and asset managers to get their internal processes aligned and ready for this change,” said Jon Hart, President of RWS’s Regulated Industries division.
It was widely believed the BoE and FCA would revisit the timetable during the pandemic which means companies are now scrambling to renegotiate contracts.
“Anecdotally a lot of businesses are still in the first process of cataloguing what they have before embarking on amending stuff,” Hemming told City A.M. Those who are not ahead of the game tend to be smaller or medium sized corporates who anecdotally are in many cases not as far advanced in that process.”
Eigen Technologies is one firm that is helping companies with Libor transition using artificial intelligence to help identify Libor-linked contracts.
Co-founder and chief executive Lewis Liu told City A.M. interest in his company’s services has seen a sharp uptick in the first quarter and not just from small businesses.
“It’s not so much the big banks but there are smaller ones and some corporates that actually have a lot of loans they need to review,” Liu adds.
Indeed the Loan Market Association, whose members include banks, institutional investors and law firms, asked for more flexibility on the deadline suggesting established players are scrambling ahead of 31 December.
So what next?
Given the scale and complexity of the transition the general consensus seems to be that there will be a wave of litigation in the coming years.
The first issue is the risk of a contract with a Libor provision disappearing and being switched off. “There could be an argument that it could be a frustrating event for the contract… there’s so much uncertainty the contract can’t be performed anymore,” Hemming said.
There could also be claims arising in the context of renegotiations and there is scope for lenders to try and exploit their bargaining position against their customers.
“We also see a potential risk of misselling claims arising from long-term LIBOR contracts entered into post-July 2017, when the LIBOR transition was already in prospect, where the lender failed to properly explain it to a borrower,” Hemming added.