There are few certainties in life: death, taxes and the end of the London Interbank Offered Rate ("LIBOR") are at least three of those.
We've previously discussed the UK Financial Conduct Authority's ("FCA's") statement issued on 5 March 2021, which set hard dates for the end of LIBOR. In this statement, the FCA announced the future cessation and loss of representativeness of the LIBOR benchmarks after 31 December 2021.
However, This means that 31 December 2021 will be the last day on which:
- all seven Euro LIBOR settings;
- all seven Swiss Franc LIBOR settings;
- overnight, one-week, two-month, and 12-month Sterling LIBOR settings;
- spot next, one-week, two-month, and 12-month Japanese Yen LIBOR settings; and
- one-week, and two-month US Dollar LIBOR settings,
will be published. For the remaining rates and LIBOR settings the FCA announced that:
- the one-month, three-month, and six-month Japanese Yen LIBOR settings; and
- the one-month, three-month, and six-month Sterling LIBOR Settings,
will cease to be provided, or subject to consultation with the FCA, be determined on a synthetic basis after 31 December 2021.
The overnight and 12-month US Dollar settings will only permanently cease after 30 June 2023. The remaining US Dollar LIBOR settings of one-month, three-month and six-month, will cease to be provided immediately after this date, or subject to consultation with the FCA, be determined on a synthetic basis.
The FCA also confirmed that settings that are determined on a synthetic basis will no longer be representative of the underlying market they are intended to measure and representativeness will not be restored.
Although South Africans have breathed a collective sigh of relief given the extension for US Dollar LIBOR settings, market participants would be ill-advised to take this as a sign to postpone the work required to transition to the reference free rate. An active transition is recommended for the following reasons:
ISDA 2020 IBOR Fallbacks Protocol And Supplement
- The FCA announcement is an "Index Cessation Event" for the purposes of the International Swaps and Derivatives Association ("ISDA") IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol. The publication of the announcement also triggers the fixing of the spread adjustment for each LIBOR setting under the terms of the Bloomberg IBOR Fallbacks Rate Adjustment Rulebook. In the derivatives world, the market now has a clear timetable for the cessation of the LIBOR benchmarks and, for transactions that include an index cessation event trigger, confirmation of the dates from which the adjusted risk-free rate fallbacks for transactions referencing these LIBOR rates will apply as well as the quantum of the spread adjustment to be applied to these adjusted fallback rates.
- For US Dollar LIBOR derivatives contracts, although one-week and two-month LIBOR will cease to be published at the end of this year, the ISDA adjusted risk-free rate fallback will not immediately take effect. Instead, the rate for one-week and two-month LIBOR will be calculated using linear interpolation of the next shorter and next longer settings which continue to be published. The index cessation effective date for all US Dollar LIBOR settings will be 1 July 2023 unless the FCA were to make a later announcement prolonging the date for cessation or loss of representativeness.
- The spread adjustment required to compensate users for a loss in the credit risk premium (implicit in the LIBOR setting) has also been fixed by Bloomberg Index Services as of the 5 March 2021 FCA announcement. The spread has been calculated for all 35 LIBOR settings using the historical median approach over a five-year lookback period.
Although the ISDA provides a globally recognised mechanism to actively transition, participants should consider whether signing up to the protocol is appropriate for all transactions as some may be linked to underlying financial instruments. Signing up to the protocol and supplement without also actively transitioning the underlying LIBOR exposure would lead to mismatches in the benchmark rates applicable.
For South African users of LIBOR as a benchmark, choice of the governing law of the financial instruments governing those instruments becomes a critical factor to assess. For South African users of LIBOR financial instruments, the choice of governing law is typically (but not exclusively) English law. The aim of a governing law clause is to make clear which country's substantive law will be applied to identify and interpret the rights and obligations of the parties to a contract. A governing law clause applies to a wide range of contractual issues. It governs not only interpretation and performance, but also the consequences of breach, including the assessment of damages and limitation.
Where parties choose not to actively transition or where there is no immediate solution to transition a tough legacy contract, the UK has proposed changes to its Financial Services Bill (currently making its way through the parliamentary process) to deal with these situations. South Africans who have elected English substantive law to apply to their contracts would be bound by these legislative amendments. In this proposed legislation, the FCA will be granted powers to designate critical benchmarks as unrepresentative or at risk of becoming unrepresentative. In terms of the proposed changes, once the FCA designates a benchmark as unrepresentative, UK regulated firms will be prohibited from using that benchmark (unless the FCA expressly permits the use of that benchmark by way of a published notice). The FCA will also have to power to impose changes to the calculation methodology of that designated benchmark allowing it to continue on a "synthetic basis" using the new calculation methodology imposed by the FCA (synthetic LIBOR). Items still to be settled include the scope of permitted legacy use of any synthetic LIBOR setting. Of this, South Africans should take heed.
There is, however, no single legally mandated or government endorsed approach to transitioning to an alternative reference rate. The EU Commission and legislators in the USA have taken a rather more robust approach than the UK by, inter alia, applying LIBOR transition legislation to contracts governed by the laws of an EU member state or the laws of New York, respectively. There are, of course, other considerations, and variables to how these provisions will be applied and the description in this note is not exhaustive by any means.
South African borrowers with LIBOR exposures would be advised to start not only a commercial risk analysis but also a legal one. How these various pieces of legislation will play out may give rise to a complex choice of law questions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.