After the 2012 Libor scandal in which major international lending banks were fined by the relevant authorities and besides the measures adopted to reform the Libor market, Andrew Bailey, Chief Executive of the UK Financial Conduct Authority (FCA), has signalled with his speech on 12 July 2018 the discontinuation of Libor as a reference rate after 2021. The main argument for the discontinuation is the lack of actual transactions in the unsecured wholesale borrowing and related markets. Panel banks have been using “expert judgement” [1], their own estimates of what it could cost them to borrow funds.
Libor is widely used as a benchmark rate in the shipping finance industry. The discontinuation will affect ship financing loan agreements, floating rate notes (“FRNs”), leasing arrangements and derivatives among others.
With the encouragement of the Loan Market Association, banks over the last few years have introduced clauses, better known as fallbacks, to account for the case that a reference rate is unavailable due to market disruptions or other events, in any type of financial agreement.
Management and finance people should closely monitor and evaluate all their contracts where Libor is used as a reference rate and loan agreements are due to mature after 2021. They should identify the fallbacks that are included in the agreements, analyse the alternative reference rate options discussed in order to replace the Libor and the relevant lender consent levels. A similar process should be performed for any derivative contracts where the US$ Libor is also used as the benchmark rate. Discussions should be held well in advance of December 2021 to allow your company and your counterparties an adequate period of time to negotiate an appropriate alternative rate. An important element in this discussion is to agree who will bear the costs of any amendment due to the change of the reference rate. Once you have agreed the alternative rate you should consider the potential implications of
IFRS 9 paragraph 3.3 – Derecognition of financial liabilities.
The situation perplexes a bit more for the derivative contracts such as interest rate swaps and options. For this reason, the International Swaps and Derivatives Association (ISDA) has issued detailed guidelines which, if the disruption is activated, provides a series of fallbacks which may differ from what is specified in the relevant loan agreement. The mismatch may affect the hedge effectiveness and hedge ratio, which should be re-assessed after the modification of the loan arrangement. The imperfect correlation between the modified loan and the derivative may lead to excess gains and losses and completely derail the original hedging strategy. The International Accounting Standards Board (“IASB”) has recognised the significant impact the discontinuation of Libor will have on existing and future hedge accounting treatment of Libor related hedges. As a result IASB has proposed a number of changes in the accounting standards to mitigate its impact and allow companies to continue accounting for LIBOR-related hedges disregarding the discontinuation[2]. Stakeholders should provide their comments by the 17th June 2019.
The alternatives specified in the contract are only a temporary solution and, in most cases, could not be used over the long run. Some of the alternatives mentioned are interpolated rates, historical rates, reference rates and cost of funds.[3] The cost of funds is a last resort rate and banks and their agents may not be willing to reveal this sensitive information to their customers for an extended period of time.
Various alternatives are being developed by working groups in the major Libor currencies (US Dollar, Euro, Sterling, Swiss Franc and Japanese Yen).
| Currency |
Proposed Risk Free Rate |
Secured/Unsecured |
Working Group |
| USD |
SOFR (Secured Overnight Funding Rate) |
Secured |
Alternative Referecnce Rates Committee |
| Euro |
ESTER (Euro Short-Term Rate) |
Unsecured |
European Central Bank |
| GBP |
SONIA (Sterling Overnight Index Average) |
Unsecured |
Bank of England |
| Swiss Franc |
SARON (Swiss Average Rate Overnight) |
Secured |
Swiss National Working Group |
| Japanese Yen |
TONA (Tokyo Overnight Average Rate) |
Unsecured |
Study Group on Risk-Free Rates |
Source: LMA News H1 2018
The above rates are overnight rates and are risk free. The main differences with the Libor are:
- The above rates are backward looking whereas Libor is forward looking and there are quotes for different tenors.
- Libor is not risk-free and contains an element of credit risk.
- Libor also contains a liquidity premium on longer term tenors.
The differences between US$ Libor and the risk free rates (RFRs) pose a significant challenge for the banking industry, in general, as it raises a number of issues. More specifically, given that the RFRs are lower compared to LIBORs, the transition to RFRs potentially creates a pricing gap, which should be taken into consideration when negotiating your new reference rate. US$ Libor is set today but is applicable in the future. This allows the borrower to know their funding costs in advance and manage their cash flow accordingly. This may not be possible with a new backward looking reference rate.
So far, slow steps have been made to move away from the use of Libor as a reference rate and, since July 2018, Fannie Mae, the World Bank and Credit Suisse have issued debt tied to SOFR. Similarly, Lloyds Banking Group has issued debt linked to SONIA. There is a long way before the new reference rate is established but the consensus among financial analysts is that sooner or later the use of US$ Libor will eventually fade away.
How can we help?
Moore Global is considered one of the world’s leading shipping consultancy firms due to our specialist sector knowledge and wide-ranging advice and assistance. The analysis above does not cover all the implications of a debt restructuring. We are available to provide guidance on debt restructurings and how this will affect your business.
For more information or to discuss how we could help you with transitioning from US$ Libor to a new reference rate, please contact us.