The London Inter-Bank Offered Rate (LIBOR), established in 1969, is an estimate of the interest rate for which London banks can borrow from each other, and it became the leading international interest rate benchmark. This estimate is based on the average rate at which panel banks can obtain unsecured funding in the London interbank market. It is especially prevalent in five leading global currencies: the U.S. dollar, the Euro, the Pound Sterling, the Swiss franc, and the Japanese yen – the locations correspondent with where the panel banks can be found. LIBOR is produced across seven tenors (overnight, 1 week, 1 month, 2 months, 3 months, 6 months, and 12 months), and is administered by the Intercontinental Exchange Benchmark Administration which is now regulated by the United Kingdom (UK) Financial Conduct Authority (FCA).
LIBOR is being replaced by alternative risk-free rates such as the Secured Overnight Financing Rate (SOFR) for the U.S Dollars and Sterling Overnight Index Average (SONIA) for Pound Sterling. SOFR is administered and published by the Federal Reserve Bank of New York, and it was based on the recommendation of the Alternative Reference Rates Committee (ARRC) that the US LIBOR should be replaced with a rate derived from a repurchase agreement with Treasury securities as collateral. SOFR differs in several key respects from LIBOR; for example, LIBOR includes credit risk, is unsecured, and is based on expert judgment, whilst SOFR is a risk-free rate, is collateralised, and is based on market transactions. This article examines the transition from LIBOR to SOFR and the implication of the transition on dollar-dominated loans in Nigeria.
Motivations for changing LIBOR
LIBOR came under scrutiny following the financial crisis years (2007–2009), when it was discovered that some panel banks manipulated the system by misrepresenting their borrowing rates. As a result of the LIBOR manipulations, there were calls by regulatory bodies for the reformation of the LIBOR rates. In July 2017, the chair of the United Kingdom Financial Conduct Authority announced that the 20 rate-submitting banks will stop contributing to LIBOR by the end of 2021. According to him, “After 2021, users of USD LIBOR must take into account the risk that the rate may no longer be available” and that even if the rate is available, the Financial Conduct Authority may deem it to be no longer representative of the market and therefore non-compliant with European rate regulation. The Financial Conduct Authority further announced the:
a. Publication of all 7 euro LIBOR settings, all 7 Swiss franc LIBOR settings, the Spot Next, 1-week, 2-month and 12-month Japanese yen LIBOR settings, the overnight, 1-week, 2-month and 12-month sterling LIBOR settings, and the 1-week and 2-month US dollar LIBOR settings will cease immediately after 31st December 2021; and
b. Publication of the overnight and 12-month US dollar LIBOR settings will cease immediately after 30th June 2023.
Within the U.S. specifically, the Alternative Reference Rates Committee (ARRC) was created in 2014 by the US Federal Reserve to identify viable alternatives to LIBOR. The ARRC came up with SOFR as a preferred replacement rate for LIBOR-linked dollar-denominated loans and securities.
SOFR as the replacement for LIBOR
SOFR measures the cost of overnight borrowing via repurchase transactions that are collateralised with U.S. Treasury securities in the triparty repurchase market. Thus, SOFR is as secure as it can possibly be. It is believed that SOFR will be more robust, and therefore less subject to manipulation than LIBOR because it will be based on actual market transactions. The transition from LIBOR to SOFR will not be seamless, as there are a plethora of differences in their most basic characteristics. The differences between SOFR and LIBOR are:
i. LIBOR has many different tenors, the most common of which are 1 day, 1 week, 1 month, 2 months, 3 months, 6 months, and 1 year; SOFR, by its very definition, is an overnight rate and thus only matches tenors for LIBOR at 1 day. Accordingly, LIBOR is forward-looking and has a term structure, whilst SOFR is backwards-looking and has no immediate term structure;
ii. LIBOR is an unsecured bank lending rate and contains an element of credit risk; SOFR is a secured rate, in the sense that it is based on overnight loans collateralised by U.S. Treasuries, and is thereby considered to be risk-free (i.e., without credit risk);
iii. LIBOR is published by the Intercontinental Exchange Benchmark Administration and is based on bank submissions and expert judgment; SOFR is published by the Federal Reserve Bank of New York and is based purely on market transactions.
Implication of transition to SOFR on dollar-dominated loans in Nigeria
LIBOR is the preferred rate in Nigeria where the currency of the transaction is the US Dollar, Pound Sterling or other currency published by LIBOR. It is commonly used as the interest rate benchmark in transactions with international counterparties such as the International Monetary Fund, World Bank, and Africa Development Bank. The transition from LIBOR to SOFR will have a significant impact on dollar-dominated loans in Nigeria.
Parties to LIBOR-linked contracts in Nigeria should actively manage risk and anticipate any exposures relating to the LIBOR transition. This includes a general review of both existing and new contracts, and a determination of whether the contracts, either individually or in aggregate, may create a material risk to their operations.
Market participants in Nigeria must cease entering new loan transactions with interest rates linked to LIBOR. Parties should seek to negotiate risk-free interest rates such as SOFR in place of LIBOR. Parties should also ensure that any new contracts to be entered into contain fallback provisions to ease the transition to SOFR. A fallback provision is a term in a LIBOR contract for determining a benchmark replacement, including any terms relating to the date on which the benchmark replacement becomes effective.
The key issue is what will happen to such contracts when LIBOR ceases to be applicable. Are there contractual fallbacks in place that are satisfactory to all contractual counterparties if such fallbacks are triggered? Contracts often contain fallback language in case LIBOR rates should become unavailable. However, many fallback rates are only appropriate for short-term disruptions to LIBOR and are therefore not practical if LIBOR is permanently discontinued. If existing fallbacks fail to produce an alternative rate, or if existing parties fail to agree on an alternative rate, contracts could either be terminated or end up in litigation. Another unattractive alternative is that many legacy contracts could revert to a fixed rate, the level of which is set at the last available floating rate when LIBOR ends. This rate would persist for the remaining term of the contract, even if the contract was originally intended to be based on floating, market-based rates.
This transition process would likely be event free if there is consistency and agreement across the industry and if the new fallback language (and rates employed) is simple and standardized. The Loan Market Association drafted a Reference Rate Selection Agreement (the “Agreement”) on the basis that parties to loan transactions will need to amend the loan documentation when LIBOR ceases to be published. The Agreement is a guide on how parties can transition from LIBOR-based loans to alternative reference rate-based loans. The Agreement suggests that parties, under existing LIBOR-based loan documentation, can agree on a new applicable alternative reference rate(s) which will be used to calculate interest under that facility agreement.
The parties to a LIBOR-linked dollar loan in Nigeria can either renegotiate the benchmark for interest rate by relying on the fallback provision or, for new contracts, agree on SOFR as the benchmark. Commercial banks operating in Nigeria, they are required by the Central Bank of Nigeria to ensure that their foreign currency assets and liabilities (both on and off-balance sheet) do not exceed 10% of shareholders’ funds unimpaired by losses. Accordingly, in renegotiating the reference rates in their LIBOR-linked dollar loans, Nigerian banks must take this restriction into account.
Market participants in Nigeria must cease entering new loan transactions with interest rates linked to LIBOR. Parties should seek to negotiate for risk-free interest rate such as SOFR in place of LIBOR
With the transition from LIBOR to SOFR inevitable and the interest rate benchmark for dollar loans shifts, Nigerian Lenders and borrowers of LIBOR-based loans would need to renegotiate the interest rate benchmark of existing loans from LIBOR to an alternative reference rate such as SOFR.