Nov 16, 2017
The LIBOR phase-out, SONIA and BTFR: Actions banks should take now
It is officially the beginning of the end of the London Interbank Offered Rate (LIBOR). On Oct. 16, 2017, the Bank of England announced that it will commence publication of the Sterling Overnight Index Average (SONIA), LIBOR’s replacement, on April 23, 2018. This announcement follows years of LIBOR-related controversy, leading to the United Kingdom’s Financial Conduct Authority’s July 26, 2017, announcement that LIBOR will be phased out by the end of 2021. The LIBOR phase-out will significantly impact banks and other lenders worldwide.
LIBOR is one of the world’s leading rates for financial instruments. LIBOR is the average of the interest rates charged by leading London banks if such banks were to lend to one another. LIBOR rates are calculated for five currencies and are published each business day. Banks worldwide use LIBOR in calculating floating or adjustable rates for their financial products. Hundreds of trillions of dollars in financial products include an interest rate based upon LIBOR. Such financial products, to name a few, include derivatives, bonds, loans for real estate, business loans, interest swaps, lines of credit, student loans, and other financial contracts. It is highly likely that anyone, whether a business or individual, borrowing from a bank will have an interest rate based upon LIBOR.
Earlier this year, a group of banks agreed that a reformed version of SONIA will be LIBOR’s best alternative. SONIA will be calculated and published by the Bank of England. SONIA’s calculation will be a weighted average of all rates of actual overnight unsecured transactions negotiated between banks and borrowers, as well as those arranged by brokers, as reported in the Bank of England’s Sterling Money Market Data Collection. SONIA will be published the following business day. The intentions behind the transition from LIBOR to SONIA are to include a large number of transactions to ensure the rate is as close to real market conditions as possible, and keep it free of manipulation. Further, it has been reported that the Bank of England will assess and publish an annual report of SONIA’s compliance with regulatory guidelines. SONIA, based upon its existing methodology, will be published until Friday, April 20, 2018. The reformed SONIA publication will commence on Monday, April 23, 2018. However, LIBOR will continue to be published until the end of 2021.
In regard to the United States, earlier this year, a panel of 15 large U.S. banks, known as the Alternative Reference Rates Committee (ARRC), was established to handle the LIBOR phase-out’s impact upon the U.S. dollar. The ARRC created a new index entitled the Broad Treasury Financing Rate (BTFR), to be published by the Federal Reserve Bank of New York. The BTFR is calculated based upon overnight transactions secured by U.S. government debt.
Essentially, the rate is based upon actual repurchase transactions between banks and other financial institutions. The BTFR and SONIA differ from LIBOR in that they are based upon overnight rates, and are therefore backward-looking, as opposed to forward-looking rates. It was most recently reported that the BTFR will begin publication in the middle of 2018. However, the BTFR’s exact methodology is still in development and undergoing public comment. In the request for public comment, the Federal Reserve Board referred to the BTFR as the Secured Overnight Financing Rate (SOFR).
Regardless of the rate chosen, the LIBOR phase-out will undoubtedly require a great amount of discussion, strategy, time and resources from banks and other lenders. However, banks and their attorneys should take an immediate and pro-active approach to mitigate the impending issues. Banks and attorneys must determine which transactions will be impacted by the changes, identify the rate to be imposed and address any issues with the agreement’s terms.
For existing agreements incorporating LIBOR, particularly those with a term beyond 2021, banks and attorneys should review the agreements to confirm whether or not effective language contemplating a new rate was documented and, if not, begin the modification process. An example of ineffective but commonly used language is a provision allowing for the successor publisher of LIBOR. This would not suffice as LIBOR will completely cease to exist.
Alternatively, language allowing the lender to select a replacement, in the event LIBOR is no longer available or used as the market standard may be effective. However, this provision could require negotiation, as it may be in the lender’s complete discretion, the lender’s reasonable discretion or as agreed upon between the borrower and lender. For new agreements, banks and lenders must determine the rate or rates desired in accordance with the publication commencement dates, for which its attorneys must properly document. Banks should, however, carefully analyze the financial impact of the new rate and remain cautious until the rate becomes more established and the bank is more familiar and comfortable with it.
Contact a Chuhak & Tecson banking attorney to analyze the financial impact the LIBOR phase-out and SONIA rate has on new agreements.
This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.
Client alert authored by: Margaret M. Walsh, Associate