What is LIBOR?
The London Interbank Offered Rate is a benchmark interest rate that forms the basis of trillions of pounds’ worth of financial instruments across the world. It is derived from the interest rates at which banks are willing to lend money to each other and is calculated with reference to the pool of rates submitted daily by panel banks. However, the well-publicised rigging scandal that occurred following the 2008 financial crash has in-part contributed to the growing feeling of discontent with the current system and led to the head of the Financial Conduct Authority, Andrew Bailey, announcing in 2017 that LIBOR would be phased out and replaced in 2021. However, LIBOR is an ingrained reference point throughout the financial world and is not something that can be amended without consequence.
Why is the removal of LIBOR important to me?
The challenge for financial regulators is to find a reference rate that does the same job as LIBOR but one that is calculated by reference to actual transactions and financial data rather than ultimately being a judgment call of the panel banks. Merits of the change aside, any such amendment must be met by a replacement reference that delivers financial equivalence to the instruments which rely on it to function as intended. If not, then payments would have to be made between the parties to a contract in order to ensure that the effects of the amendment did not mean that either party was worse off. Ensuring that consumers, both private and commercial, understand the position that they are in is crucial to making the process fair. Banks should be placing themselves well to ensure that they can advise their customers on any changes that may be caused to existing instruments, but knowing where you stand will be vital when the time comes for your lender to make contact on the inevitable changes.
For example, if payments are being made on a mortgage at a rate of LIBOR plus x%, any substitution of LIBOR for an alternative reference rate may lead to a variance of thousands of pounds over the lifetime of the product. When it comes to larger scale instruments, the impact could be much higher. Therefore, if it is proposed that a payment is made either way to account for the change, parties need to be confident in the figures being discussed to ensure fairness and equivalence.
What are the other issues?
LIBOR also has provided the benefit of being what is known as a ‘forward-looking’ rate. LIBOR could be calculated in a way as to provide a fixed rate for certain periods, and so the rate payable over the next, say, six months could be known from the beginning of the term. For a fixed-rate term loan for example, this provided the advantage of knowing exactly how much interest would be charged on the loan from day one, allowing certainty to the benefit of the borrower and its cash flow. However, some current proposals for LIBOR’s replacement are calculated on an overnight basis, and so the rate changes daily. Therefore interest payments would need to be calculated on a periodical basis or at the end of the term and would be inherently ‘backward-looking’. The amount payable would be unknown until it was due, which is in and of itself problematic.
Any contracts that exist with reference to LIBOR once it ceases to be a published rate will no longer be appropriate, and even where fall-back provisions are included in those drafted more thoroughly, the replacement may not be satisfactory. Such a forced change will cause ramifications for the sums due to be exchanged under the contract and may well alter the agreement to an extent clearly unimagined by the parties upon its inception.
In short, the problems to be overcome and the questions to be answered by the replacement rate are staggering. The technical issues involved and the pervasion of LIBOR as a reference rate amongst the financial system makes it ever more unlikely that the phase-out and replacement will be a smooth process. This means that disputes are likely to arise and negotiations may be required to settle differences before the world can properly move forward into the new, post-LIBOR regime.
What action can I take?
Borrowers may soon be approached by their lenders offering a solution to the problems that have been identified with current products and any such rate chosen to replace LIBOR. However there is no guarantee that such offers of redress will be suitable for the issue at hand, and given the complicated nature of the adjustments, potential for error is high. Understanding your rights and options when such an amendment takes place will be key to ensuring that you or your business are not negatively affected by a systematic change that was never envisaged as an uncertainty. The key thing to remember, as with any similar dilemma, is that getting the right advice and not making decisions under undue pressure will always assist in taking appropriate steps. Preparation for change and understanding what the likely effects are will be key drivers to ensure that you come out on top.
If you would like advice as to the impact of the amendments on your business, click here to speak to a member of BLM’s commercial litigation team.
Written by BLM’s Craig McAdam and Robert Ferdinando