The use of the London Interbank Offered Rate (LIBOR) in financial transactions is coming to an end. LIBOR is an interest rate average based on rates at which a panel of banks estimate that they can borrow short-term funds from other banks in the London Interbank Market. LIBOR has been used by financial institutions for decades as the prevailing reference rate for determining interest rates in commercial and financial transactions. The phase out of LIBOR is a result of changes in the financial markets and a response to the manipulation of LIBOR by several banks more than a decade ago. It is estimated that LIBOR is currently used worldwide in nearly $200 trillion of financial transactions. The transition to a new interest rate benchmark is an enormous undertaking for the global financial markets.
Over the past nine months, we have seen the U.S. financial markets coalesce around two broad categories of successor interest rate benchmarks: the Secured Overnight Financing Rate (SOFR) and new credit-sensitive rates (CSRs). This article provides a brief overview of the current state of LIBOR, how financial markets are handling the transition to a new interest rate benchmark and which benchmarks have gained the most traction among market participants.
Where Things Currently Stand
On March 5, 2021, ICE Benchmark Administration and United Kingdom’s Financial Conduct Authority announced that 1-week and 2-month U.S. dollar (USD) LIBOR will cease to be published on December 31, 2021. Overnight and 1-, 3-, 6- and 12-month USD LIBOR will cease to be published on June 30, 2023. Following the announcement, the International Swaps and Derivatives Association confirmed that the announcement constituted an index cessation event, and, as a result, spread adjustments have now been fixed as of March 5, 2021 for most major currencies. The intent is that a replacement benchmark rate plus the applicable spread adjustment will result in a rate that approximates LIBOR for the relevant tenor.
On March 8, 2021, the Alternative Reference Rate Committee (ARRC) confirmed that the ICE and FCA announcement of the definitive cessation of LIBOR constituted a “Benchmark Transition Event.” The occurrence of a “Benchmark Transition Event” does not require an immediate transition to a successor interest rate benchmark, but it does mean that the “Benchmark Replacement Date” will be on or about June 30, 2023, for overnight and 1-, 3-, 6- and 12-month USD LIBOR and December 31, 2021 for 1-week and 2-month USD LIBOR.
The U.S. financial regulatory agencies have recommended that all new financial contracts, including all loan agreements, should either utilize a reference rate other than LIBOR or have robust language that includes a clearly defined protocol to select an alternative reference rate after the publication of LIBOR ceases.
Prevailing Successor Interest Rate Benchmarks
Two broad categories of successor interest rate benchmarks have generated the most interest and consideration among U.S. financial market participants: SOFR and CSRs.
SOFR is an interest rate published daily by the Federal Reserve Bank of New York (New York Fed) which is used in inter-bank overnight borrowings secured by U.S. Treasury securities. Because SOFR is based on actual interbank transactions with daily volumes of nearly $1 trillion, ARRC considers it to be, among other things, a rate that is more resilient than LIBOR because of the depth and liquidity of the markets that underlie it. SOFR is considered a transparent rate that is representative of the market across a broad range of market participants which helps protect it from attempts at manipulation, and a robust rate that meets international standards.
Because LIBOR is a credit-sensitive rate (based on the creditworthiness of the borrower in the interbank loan transaction) and SOFR is a daily, risk-free rate (because such overnight borrowings are secured by U.S. treasuries), ARRC and its members have been working diligently over the past few years to develop forward-looking SOFR term rates that more closely align SOFR-based rates to LIBOR tenors. On July 29, ARRC formally recommended CME Group’s term rates for SOFR (Term SOFR) and ARRC recently published conventions on how to use Term SOFR in syndicated and bilateral business loans. Term SOFR offers financial institutions some level of comfort due to having similar operational aspects as LIBOR.
The U.S. financial markets have recently developed several credit-sensitive rates that are daily or forward-looking term rates that incorporate a creditworthiness component. They are more responsive to market conditions and are more similar to LIBOR. The most discussed credit-sensitive rates include:
- American Interbank Offered Rate (Ameribor): A new interest rate benchmark based on overnight unsecured loans among small, medium and regional U.S. banks on the American Financial Exchange.
- The Bloomberg Short-Term Bank Yield Index (BSBY): A proprietary index developed by Bloomberg Index Services Limited that is calculated daily; BSBY seeks to measure average yields at which large global banks access USD senior unsecured marginal wholesale funding.
- The Bank Yield Index: Proposed by Intercontinental Exchange, Inc. (ICE) as a potential replacement for LIBOR, it will measure the average yields at which investors are willing to invest over one-month, three-month and six-month periods on a wholesale, senior, unsecured basis in large, internationally active banks.
While CSRs respond to changes in market conditions, such as raising in times of economic stress, risk-free rates such as SOFR are less responsive to changes in the markets and may even decrease in times of economic stress. Because a component of cost for financial institutions is embedded in credit-sensitive rates, the use of SOFR as an interest rate benchmark could leave financial institutions with higher costs and lower SOFR-benchmarked returns in times of economic crisis.
Although ARRC and large U.S. banks have focused primarily on SOFR as the successor to LIBOR, certain portions of the small cap and middle market may find CSRs an attractive and more user-friendly alternative to SOFR.
Action Items for the Remainder of 2021
As we enter the fourth quarter, all existing loan agreements and other financial contracts, as well as all new financing arrangements, should either (A) include robust language: (i) that provides that the financial institution and its counterparty will mutually select a replacement interest rate benchmark at a mutually agreeable time prior to the Benchmark Replacement Date (i.e., the “amendment approach”) or (ii) that sets forth a pre-agreed automatic protocol for selecting and implementing a replacement interest rate benchmark (i.e., the “hardwired approach”) on or prior to the occurrence of the Benchmark Replacement Date, or (B) be amended before year-end to include a replacement interest rate benchmark.
We note that contract language that only addresses the temporary unavailability of LIBOR is likely not sufficient to address the permanent discontinuance of LIBOR or could result in an interest rate tied to the current prime rate. The prime rate is a consumer interest rate based on creditworthiness offered by certain banks and is also published in certain daily newspapers. In contrast, LIBOR is a rate calculated based on transactions between banks. As a result, any conversion to the prime rate will increase the interest rate paid under financing arrangements unless a negative spread adjustment is applied. Although the prime rate and LIBOR are both CSRs, the prime rate includes a much larger implicit spread, so the prime rate does not easily substitute for LIBOR.
Although there is still some uncertainty on what the LIBOR transition will bring — this transition may be disruptive in the short term — financial market participants have made incredible strides in the past 12 months to establish contract language and protocols for an orderly transition to one or more successor interest rate benchmarks that should result in further stability to the financial markets over the long term.