The London Interbank Offered Rate (LIBOR) has long been a global benchmark interest rate used to set contract terms between international banks. Traditionally, LIBOR has been used to set interest rates on everything from multinational business loans to adjustable-rate residential mortgages.
Despite this broad global use, Financial Conduct Authority, the organization that has overseen regulation of LIBOR since 2013, has stated that it cannot guarantee its availability beyond the end of 2021. This has left many organizations scrambling to replace existing contracts utilizing LIBOR with an alternate benchmark by January 1, 2022. In LIBOR’s place, a new set of standardized rates are likely to be used in different markets and regions around the globe.
This change brings significant considerations and challenges for financial services businesses, especially those that rely on LIBOR to set rates with their clients, as well as other financial institutions. Here’s a look at some of the top need-to-know facts about this upcoming change.
Why financial institutions are moving away from LIBOR
LIBOR’s decline is the product of several different factors. The most significant factor is an overall decline in lending between global banks, which limits the volume of transactions used to set LIBOR on a daily basis. With fewer transactions involved in this calculation, the average rate has become more volatile, making LIBOR’s ability to reflect global market conditions less reliable.
The small volume of transactions also makes LIBOR easier for financial institutions to manipulate by intentionally reporting false rates. Manipulation is difficult to catch and prevent in real-time, so trust in LIBOR as a global benchmark has gradually eroded over time. At the same time, challenges in regulating LIBOR-reporting banks have led LIBOR’s own regulators to conclude that the benchmark’s availability may not last beyond the end of 2021.
Alternative rates will replace this standardized approach
LIBOR may go away, but index-based rate-setting will still exist in some form. The most likely approach is that global regions and markets will embrace one of a small number of alternative reference rates (ARRs), all of which are aligned with major international currencies.
Likely ARRs used as replacements for LIBOR include:
- Secured Overnight Financing Rate (SOFR), aligned with the U.S. Dollar;
- Sterling Overnight Indexed Average (SONIA), aligned with the GBP;
- Euro Short-Term Rate (ESTER), aligned with the Euro;
- Swiss Average Rate Overnight (SARON), aligned with CHF;
- Tokyo Overnight Average Rate (TONA), aligned with JPY.
Financial institutions are likely to have a preference for one or more of these ARRs. In many cases, though, global banking transactions will require institutions to agree on a mutual ARR to set rates for a contract, even if one of those parties has to use an ARR other than their preferred option.
Transitioning away from LIBOR will affect existing contracts and securities
All LIBOR-based contracts with adjustable rates are likely to see changes once financial institutions transition from LIBOR to alternative reference rates. While this is most likely to happen once LIBOR is discontinued, financial institutions could choose to make this switch prior to that date of termination.
Financial institutions will need to communicate these changes to contract-holders to help them understand the changes and implications. Any changes to rate-setting should be documented in contract language, with a clear identification of the ARR that will be used in rate calculations.
If you’re a financial institution with clients whose contracts will be affected, you will need to set up a system to communicate these changes and answer any questions they may have. This communication should take place on multiple fronts, including not only the legal contract language of any loan or other transaction, but also through printed and online disclosures and materials explaining these rate-setting changes.
Financial companies will want to be proactive in outreach and education among their clients to prepare them for these changes before they occur. This will ensure a smoother transition that experiences fewer client complaints, and the potential loss of future business.
Future contract and loan shopping will be changed
For contracts that have not yet been created, the impending changes to LIBOR and rate-setting are likely to affect your current lending and financial practices. A growing number of financial institutions are changing their rate-setting practices to incorporate real-world transactional data that prevents LIBOR volatility from affecting rates in the final days of the benchmark’s use.
Any changes to these practices should be clearly communicated to your clients, explaining both the risks LIBOR might pose and the protections you are implementing to protect both your own business and the client in any contract. Pay close attention to the feedback you receive from clients during these initial changes, and use their questions and concerns to guide content and communication strategies that can help facilitate a smooth transition for the rest of your client base.
To manage this transition away from LIBOR successfully, financial institutions need to produce educational materials and develop communication channels that serve their client base across many different regions and languages around the world. Contract language will also need to be revised to reflect these changes.
A language service provider can help your organization develop high-quality educational materials while also ensuring that legal language is precise and clear across all languages you serve. Contact Protranslating today to find out how we can help.