The London Interbank Offered Rate ("LIBOR") will be discontinued, as panel banks will no longer be required to provide quotations for its computation after 2021. The Singapore Interbank Offered Rate ("SIBOR") will also be reformed, to modify its computation methodology in a manner that promotes reliance on market transactions. Banks will need to consider the impact on rate fixing and documentation.
The UK Financial Conduct Authority has announced that LIBOR will be discontinued after 2021. Following allegations of LIBOR manipulation, reform of LIBOR has been suggested, such as the confirmation of submissions on LIBOR against transaction data and the involvement of market participants in the surveillance of LIBOR. In essence, doubt has been cast on whether LIBOR remains a true representation of the unsecured funding costs of banks.
What are the alternatives to LIBOR?
Examples of alternatives include the following:
1. Secured Overnight Funding Rate (SOFR) for US Dollar;
2. Sterling Overnight Index Average (SONIA) for pound Sterling;
3. Euro Short-Term Rate (ESTER) for Euro;
4. Swiss Average Rate Overnight (SARON) for Swiss Franc; and
5. Tokyo Overnight Average Rate (TONAR) for Japanese Yen.
Banks should note certain key differences between LIBOR and the alternative rates. The alternative rates are backward-looking in nature, unlike LIBOR, which is forward-looking in nature. In loan documentation, LIBOR is typically fixed at the start of the interest period. This fixes the interest payable at the end of the interest period. Thus, LIBOR gives parties advance notice, which is important for cashflow management.
Backward-looking rates may not reflect a bank's future credit and liquidity premium. Also, different rates and methodologies are being proposed for the various alternative rates, which may not be aligned with a bank's funding costs. The practical effect of the difference between the actual cost of funding and the alternative rate chosen is that lenders may wish to consider reflecting such difference in the interest margin. Different pricing or margins may be required for different currencies.
LIBOR is quoted on the same basis for each LIBOR currency, whereas the alternative rates are currency-specific. LIBOR is also published at 11:00 a.m. across each currency, whereas the alternative rates are published at different times to LIBOR and each other. Banks that extend multi-currency facilities will need to note how these may impact their operations.
However, the disadvantages of the alternative rates must be weighed against their value as market transaction-based benchmarks. The alternative rates are based on active and liquid underlying transactions that provide an objective measure of the banks' unsecured funding costs, which help to guard against manipulation. This has been the approach taken in the reform of SIBOR, which is discussed below.
What is the impact of LIBOR reform on banking documentation?
(a) General provisions on unavailability of screen rate
Existing loan documentation should already have general provisions to cater for the unavailability of screen rate. These include: interpolated screen rate; shortened interest periods; and fall back to historical screen rate, reference bank rate and cost of funds.
However, each option has its own inherent problems and these are also not intended to be long term solutions.
(b) Replacement benchmark rate
In light of the discontinuance of LIBOR in 2021, lenders should consider inserting mechanisms in the loan document for a replacement benchmark rate. The issues to consider are:
(i) the trigger events for the replacement benchmark rate;
(ii) the replacement benchmark rate; and
(iii) the level of consent required for the trigger event, the replacement benchmark rate and the replacement itself.
Lenders should also consider related issues such as the impact on security arrangements, foreign law issues in the case of cross border transactions, consistency with similar provisions for related transactions in other markets, such as the draft International Swaps and Derivatives Association (ISDA) Benchmark Supplement, and the cost and expenses involved.
(c) What has LMA suggested?
The Loan Market Association has suggested incorporating a contractual mechanism to replace the benchmark rate upon a trigger event.
A trigger event occurs upon the following:
(i) a material change in methodology, formula or other means of determination of screen rate;
(ii) a cessation or discontinuance of screen rate;
(iii) a calculation of screen rate based on reduced submissions or other contingency or fallback arrangements; and
(iv) the screen rate is no longer appropriate for interest calculation.
The replacement benchmark is determined by:
(i) the administrator of the existing screen rate or central banks, regulators or supervisory authorities, etc;
(ii) the relevant syndicated loan market; or
(iii) a selected group of lenders and the borrower.
The stipulated consent level for the trigger event, the replacement benchmark and the replacement itself, can be commercially tailored to the facts of each transaction.
There is also a proposed "snooze you lose" provision in relation to lenders who do not respond in time on the replacement exercise.
However, this is just one method and it remains open to the industry to decide on other ways of determining the replacement benchmark.
Following the UK's reform of LIBOR, the Association of Banks in Singapore Benchmarks Administration Co Pte Ltd ("ABS") and the Singapore Foreign Exchange Market Committee ("SFEMC") conducted a consultation exercise to gather proposals to strengthen SIBOR. The ABS-SFEMC joint public consultation to enhance SIBOR concluded in July 2018, and the key proposal is to compute SIBOR using the following waterfall methodology:
(a) transactions in the underlying wholesale funding markets;
(b) transactions in related markets; and
(c) expert judgment.
Such modification in computation methodology is designed to reflect the structural changes in banks' funding sources, and to improve clarity and consistency across panel banks that provide input for the computation of SIBOR. The implementation of these changes is slated to occur around end-2019.
Will SIBOR be discontinued?
No, SIBOR will be retained. There is no need to replace SIBOR in banking documentation, as the conclusion of the public consultation conducted by ABS and SFEMC is to retain the SIBOR screen rate, but with an enhanced computation methodology.
What is the impact on banking documentation?
Currently, significant changes to banking documentation will unlikely be necessary. This is because the change only concerns the computation methodology of SIBOR, with the name "SIBOR" and the data vendor pages publishing the rates being retained.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.