'More work' needed before banks can complete LIBOR switch

Out-Law News | 03 Oct 2019 | 10:58 am | 2 min. read

Use of the London Interbank Offered Rate (LIBOR) as a reference rate in financial contracts remains "widespread", even though publication of the rate is expected to be discontinued from the end of 2021, the Bank of England has warned.

Many new contracts maturing beyond 2021 continue to reference LIBOR, according to analysis by the Bank of England. LIBOR-linked lending continues to dominate the loan markets, while many new long-dated derivative contracts also reference the rate. The number of cleared sterling LIBOR swap contracts maturing beyond 2021 is also growing, according to the Bank.

"Users of LIBOR need to prepare by transitioning to alternative, more robust benchmarks, such as overnight risk-free rates," the Bank said in its note, warning that continued use of LIBOR "poses risks to market stability".

It said that firms should "put in place a clear transition plan" to mitigate LIBOR-related risks from older contracts, and focus on shifting new business from LIBOR to alternative rates. It noted in particular the growing use of the Sterling Overnight Index Average (SONIA) benchmark for sterling-denominated derivatives and overnight bonds.

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While industry is working on the development of replacement rates, significant steps will need to be taken to have a replacement ready for end-2021.

"Firms must be able to run their business without LIBOR from the end of 2021, so it is not in their interests to continue to increase exposures to LIBOR, or to have a large stock of legacy contracts that will become subject to significant legal uncertainty beyond that point," the Bank of England said.

Financial regulation expert Andrew Barber of Pinsent Masons, the law firm behind Out-Law, said that more work was needed to ensure a suitable replacement for LIBOR for use in certain markets was in place by the end of 2021, by which time the panel banks whose submissions inform LIBOR are now longer expected to support the rate.

"While the Bank of England is keen for financial markets to look to alternate risk-free reference rates, perhaps they shouldn't be surprised by the results of their analysis that shows firms continue to write new LIBOR contracts," he said.

"Most LIBOR-linked lending is reliant on forward-looking term rates. Until an industry accepted replacement for these term rates is developed, many lenders are going to be reluctant to move clients from LIBOR. They may also struggle to develop viable products based on overnight risk-free rates if their loan books are not funded in this way."

"While industry is working on the development of replacement rates, significant steps will need to be taken to have a replacement ready for end-2021," he said.

LIBOR is a measure of the average rate at which banks are willing to borrow wholesale, unsecured funds. The rate has become less reliable as the number of transactions underpinning the rate has fallen, while previous attempts at market manipulation and false reporting have also decreased confidence in the rate.

SONIA, which is published by the Bank of England and based on an average of over £40 billion worth of transactions each day, is what is known as a 'risk-free rate' (RFR). However, RFRs are not an exact replacement for interbank offered rates, particularly forward-looking rates such as three-month and six-month LIBOR.