News

Despite the enormous challenges caused by the coronavirus pandemic, the financial markets  are continuing their preparation for a historic moment – the transition from London Interbank  Offered Rate (“LIBOR”) to the alternative reference rates (“ARR”).[1] This is it! The final year  for LIBOR is 2021. No looking back and many decisions to be made ahead.[2]   

For more than 40 years, LIBOR serves as a globally accepted key benchmark interest rate that  indicates borrowing costs for short-term loans between banks in the international interbank  market. It is one of the best known and most important interest rates in the world.[3] LIBOR is  calculated for 5 currencies namely, the U.S. dollar (USD), the euro (EUR), the British pound  sterling (GBP), the Japanese yen (JPY) and the Swiss franc (CHF) at 7 different tenures i.e.  overnight, 1 week and 1, 2, 3, 6 and 12 month(s).[4] The combination of the foregoing has led  to a total of 35 different LIBOR rates calculated and reported every business day at around  11:55 a.m. London time.[5] 

Each day, a designated panel of global banks of between 11 and 18 banks will submit their  ideas of the rates they think they would pay if they had to borrow money on unsecured terms  from another bank to the Thomson Reuters data collection service. To safeguard against  extreme highs or lows that might skew LIBOR, ICE Benchmark Administration (“IBA”) strips out  the 4 highest submissions and the 4 lowest submissions before calculating an average. It is  important to note that LIBOR does not set on what banks actually pay to borrow funds from  each other. Instead, it is based on what they believe they would pay to borrow a “reasonable”  amount of currency for a specified short period.[6] 

LIBOR SCANDALS 

While LIBOR has been a long-established global benchmark standard for interest rates since  the 1980s, it has had its fair share of controversies including a major scandal of rate rigging.  Major banks allegedly conspired to manipulate the LIBOR rates to their advantage. They took  traders’ requests into account and submitted artificially low or high LIBOR rates to keep them  at their preferred levels, in an effort to support their own institutions’ derivative and trading  activities. Although the scandal came to light in 2012, there is evidence suggesting that the  collusion in question had been ongoing since as early as 2003. The scandal was also one of the  primary reasons why supervision of LIBOR has been shifted from British Bankers’ Association  (BBA) to IBA.[7] 

The scandal caused financial contracts to be mispriced throughout the world. The scandal also  sowed distrust in the financial industry and led to a wave of fines, lawsuits and regulatory  actions. Understandably, this led to a substantial public backlash, as parties throughout the  world wondered whether they may have been harmed financially. As a result, questions  around LIBOR’s validity as a credible benchmark rate have arisen and it is now being phased  out.[8] 

CESSATION OF LIBOR 

On 5 March 2021, the Financial Conduct Authority (“FCA”) announced that all LIBOR settings  for all currencies will either cease or no longer be representative immediately after the  following dates: 

REFERENCE LIBOR	TENURE	DATES
British pound sterling (GBP)	All	31 December 2021
Euro (EUR)
Japanese yen (JPY)
Swiss franc (CHF)
U.S. dollar (USD)	1 week, 2 months	31 December 2021
U.S. dollar (USD)	overnight, 1 month, 3 months,  6 months, 12 months	30 June 2023

Since then, the FCA has indicated that (i) all global market participants should assume that  there will be no LIBOR publication after 2021; (ii) even if LIBOR were to continue beyond 2021,  it would have fundamentally changed; and (iii) markets for LIBOR related contracts are likely to  be illiquid, and the ability to hedge outstanding LIBOR obligations is likely to be impaired.  Therefore, global market participants with LIBOR linked financial products must prepare to  shift to ARR by 31 December 2021.[9] 

Many banks worldwide (including in Malaysia) use LIBOR as a base rate for setting interest  rates on consumer and corporate loans. Without any doubt, this transition is one of the largest  upheavals of the financial markets in living memory. It creates enormous change requirements  for banks across multiple asset classes, including loans, bonds, Sukuk and derivatives with  estimated exposures totaling USD400 trillion globally on a gross notional basis. In line with this  global development, Bank Negara Malaysia (“BNM”) requires banks to cease new issuance of  LIBOR referencing contracts by 31 December 2021.[10] 

MOVING TOWARDS MORE TRANSPARENT TRADING 

Initial resistance to change has morphed to inertia, as players await first movers. This change  has put both Islamic and conventional financial institutions with significant exposure to LIBOR  in a difficult situation. Working groups from around the world have proposed ARR to replace  

LIBOR. ARR is considered to be more robust and less prone to manipulation, given the volume  of observable data. 

In line with global financial benchmark reforms, BNM has appointed the Financial Markets  Committee (FMC) which comprises representatives from BNM, Securities Commission  Malaysia, financial institutions, insurers, fund managers and corporate treasurers to oversee  the development of a transaction based ARR in Malaysia.[11] 5 ARR are emerging as  alternatives to LIBOR. The Shariah Advisory Council (SAC) of BNM at its 210th meeting on 23  December 2020 has ruled that the adoption of risk-free rate as an alternative benchmark rate  to LIBOR, or as a fallback benchmark replacement rate after the permanent cessation of LIBOR,  is permissible based on the following justification:[12] 

1. The compounding methodology is merely an arithmetic method in determining the  term rate which does not affect compliance of the transactions with Shariah requirements;  and 
2. Uncertainty (gharar) from the adoption of average risk-free rate or backward-looking  term rate at the point of payment is mitigated via proper determination and disclosure of the  ceiling price and formula to derive the periodic payment amount to the customer at the  inception of the contract. 

The ARR differs by region, currency, tenure and basis, as tabulated below:[13]

Currency	USD	GBP	JPY	CHF	EUR
ARR	Secured   Overnight   Financing Rate  (SOFR)	Sterling   Overnight Index Average (SONIA)	Tokyo Overnight Average Rate  (TONA)	Swiss Average  Rate Overnight  (SARON)	Euro Short  Term Rate   (€STR)
Administrator	Federal Reserve Bank of New  York (FRBNY)	Bank of England (BoE)	Bank of Japan  (BoJ)	SIX Swiss   Exchange	European   Central Bank  (ECB)
Secured/   unsecured	Secured	Unsecured	Unsecured	Secured	Unsecured
Description	SOFR is   overnight and  transaction  based   encompassing  multiple repo  market   segments	SONIA is   overnight and is calculated   based on daily  sterling money  market activity	TONA reflects  the   uncollaterised,  overnight call  rate market   encompassing  multiple repo  market   segments	SARON is an   overnight rate  that reflects   interest paid on  interbank   overnight repo  transactions	€STR reflects  overnight  unsecured   fixed   rate deposits  of euro area  banks

 The differences between ARR and LIBOR are as follows: 

Benchmark	LIBOR	ARR
Calculation   Methodology	Forward looking estimates based on  panel bank submissions	Backward-looking calculated mean based on historical transactions. They are  designed to be near risk-free, with no  premium for term.
Term structure	7 tenures: overnight, 1 week and 1, 2, 3, 6 and 12 month(s)	Overnight only
Secured/Unsecured	Unsecured	Secured: SOFR and SARON  Unsecured: €STR, SONIA, TONIA
Term and credit  premium	Incorporate a term and credit  premium	ARR neither include the panel bank  credit risk element nor a liquidity  premium related to the length of the  interest period as they are overnight  rates.
Volumes	Based on submission by contributor  banks	Based on actual transactions in a highly  liquid underlying market

 CHALLENGES ON LIBOR TRANSITION 

The ramifications of LIBOR discontinuance can be chaotic and extremely challenging if not  managed diligently. Some of the common issues and challenges that financial or business  institutions will face in managing the LIBOR transition include:[14] 

 The volume of contracts to be reviewed is daunting; 

1. to address the sufficiency of fallback language in legacy contracts on LIBOR dissolution,  where cases may arise for floating rate instruments deemed as fixed post 2021; c. to deal with timing problems as the fallback provision may trigger a new benchmark  rate at different times for different contracts with consequences to asset liability management  (ALM); 
2. the fallback provisions or proposed variations are viewed by one party as neither  lawful nor fair for being worse off than one would have been under LIBOR and this could skew  into a legal minefield; 
3. to agree on the acceptable spread adjustment on adopting ARR as the benchmark rate  to account for credit risk, as credit spreads are dynamic and will vary according to prevailing  market conditions; 
4. the selection of a suitable replacement benchmark rate; 
5. to address conduct risk in engaging with customers to curtail erosion of trust in dealing  with legacy contracts; 
6. to complete the readiness of corporate infrastructure and resources to facilitate the transition and to accelerate suitable corrective actions where weaknesses are identified; i. the vulnerability to regulatory and compliance risk that may arise as a result of new  rules of engagement for legacy contracts that could trigger additional disclosures or compel  the use of new benchmark rates; and 
7. to deal with hedge accounting matters as a change of reference rate will affect the  valuation of financial instruments / products and have aftereffects on the income statement  and balance sheet. 

WHAT DO I NEED TO DO? 

LIBOR is also the basis for consumer loans in countries around the world, so it impacts  consumers just as much as it does financial institutions.[15] For the consumers, the following  are amongst the steps to be taken:- 

1. Establish where your LIBOR exposures are i.e. in mortgages, loans, deposit facilities,  derivatives and floating rate notes. It can also be found in ancillary contract terms (leasing and  servicing contracts), company pension schemes, commercial contracts and discount rates used  in valuations. It is important to identify your exposure to LIBOR and to understand what will  happen to these contracts if LIBOR is no longer available. 
2. Check your contract terms. Your contracts may include “fallback” terms setting out  what will happen when LIBOR is not available. However, these terms often do not envisage  that LIBOR could be permanently unavailable. Check the fallback terms, what that means for  your financial product and whether they need to be amended. 
3. Familiarise yourself with ARR and what it means for you/your business. Given the  differences between the two rates, you/your business may need to make changes to systems  in order to use ARR. 
4. Speak to your bank, product provider, consult with a financial services professional or  advisor. Ask your bank what preparations they are making and what that means for you/your  business. You can seek further advice from financial service professionals as you consider how  to prepare for transition.

CONCLUSION 

Although the end of LIBOR is certain, it will not go without rumpus and there will be tears.  Regulators globally are coordinating closely to contain systemic risk with the transition and  firms must take diligent actions without delay to ensure this uncertain trajectory does not slip  off course. Doing nothing or not enough is not an option and would be a sure bet for financial  tragedy, whilst the current coronavirus pandemic is not helping the financial markets with the  transition. This transition is not a one-off switch — it is a long and complicated journey, with  participation from regulators. There will be no “one size fits all” solution and the solution itself  must be flexible, robust and resilient. Market participants need to take immediate action to  ensure a smooth transition.[16] 

This article is written by lawyers at Mohamed Ridza & Co, Kuala Lumpur, Malaysia. For more  information and legal assistance, please do not hesitate to give them a call at +603-2092 4822  or email at ridza@ridzalaw.com.my.  

Author: Siti Norafiqah Hassanor, Associate at Mohamed Ridza & Co 

norafiqah@ridzalaw.com.my   

Mohamed Ridza & Co 

Unit no. 50-10-9, level 10, 

Wisma Uoa Damansara 

Damansara Heights 50490 

Kuala Lumpur  

Malaysia 

+603-2092 4822 

www.ridzalaw.com.my 

________________________________________ 

[1] What Is Libor And Why Is It Being Abandoned? Retrieved from  

https://www.forbes.com/advisor/investing/what-is-libor/ 

[2] Goodbye Libor. Retrieved from https://think.ing.com/articles/rates-outlook-usd-goodbye libor/ 

[3] Back to Basics: What Is LIBOR? Retrieved from  

https://www.imf.org/external/pubs/ft/fandd/2012/12/pdf/basics.pdf 

[4] Investopedia: London Interbank Offered Rate (LIBOR). Retrieved from  https://www.investopedia.com/terms/l/libor.asp 

[5] Investopedia: London Interbank Offered Rate (LIBOR). Retrieved from  https://www.investopedia.com/terms/l/libor.asp 

[6] What Is Libor And Why Is It Being Abandoned? Retrieved from  

https://www.forbes.com/advisor/investing/what-is-libor/  

[7] Investopedia: London Interbank Offered Rate (LIBOR). Retrieved from  https://www.investopedia.com/terms/l/libor.asp 

[8] Investopedia: London Interbank Offered Rate (LIBOR). Retrieved from  https://www.investopedia.com/terms/l/libor.asp  

[9] LIBOR Transition: Frequently Asked Questions. Retrieved from  

https://www.adb.org/sites/default/files/page/649276/libor-transition-briefing-faqs.pdf [10] Cessation of LIBOR-Referencing Contract Issuance. Retrieved from  

https://www.bnm.gov.my/-/cessation-of-libor-referencing-contract-issuance [11] Libor Transition. Retrieved from  

https://assets.kpmg/content/dam/kpmg/my/pdf/LIBOR%20-Transition-Aug%202021.pdf

[12] Ruling of the Bank’s Shariah Advisory Council on the Adoption of Risk-Free Rate. Retrieved  from https://www.bnm.gov.my/-/ruling-of-the-bank-s-shariah-advisory-council-on-the adoption-of-risk-free-rate 

[13] Understanding Libor. Retrieved from https://www.rmb.co.za/page/understanding-libor [14] The Retirement of LIBOR. Retrieved from https://www.at-mia.my/2020/09/17/the retirement-of-libor/ 

[15] The Working Group on Sterling Risk-Free Reference Rates. Retrieved from  https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/factsheet calling-time-on-libor-why-you-need-to-act-now.pdf 

[16] Get ready for the IBOR transition. Retrieved from https://www.murex.com/iborsolution?