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]
- 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
- 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;
- 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);
- 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;
- 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;
- the selection of a suitable replacement benchmark rate;
- to address conduct risk in engaging with customers to curtail erosion of trust in dealing with legacy contracts;
- 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
- 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:-
- 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.
- 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.
- 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.
- 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?
