The lending market and the London Interbank Offered Rate: What next?
Contrary to common lore, money hardly sits idle in the bank. It is almost always going about the business of multiplying, primarily through lending. Lending could be from bank to customer, or even between banks; known as ‘interbank lending’. Interbank lending allows banks to lend each other unsecured funds at an agreed interest rate, and for a specified term. The term could range from one week to lesser terms like the overnight term, or longer periods. The interest rate for this type of lending; the interbank rate, varies widely across the world, with many countries fixing their own rates. Interbank market dynamics usually impact the general money market indirectly, and it is not unusual to reference interbank rates in determining interest rates for financial instruments and products.
Over the years, as the market for interest-rate-based products has progressed, the need for a uniform measure of interest rates across financial institutions became necessary. The London Interbank Offered Rate (“LIBOR”) has become the foremost financial standard in the international interbank market. LIBOR is globally accepted as a reference rate by most financial institutions, and by this token helps to achieve certainty and uniformity in the financial market. It is employed by financial institutions for various financial instruments including derivatives, mortgages, and general loan transactions.
LIBOR is calculated using submissions from select panel banks for five currencies: the US Dollar, Pound Sterling, Euro, Japanese Yen, and Swiss Franc, and seven borrowing periods ranging from overnight to one year. It is published every weekday at about 11 am London time and sets the tone for a significant portion of financial products globally. However, recent scandals have put LIBOR on the chopping block by the end of 2021. Those who rely on LIBOR must be prepared for this. In Nigeria, the financial market depends on the LIBOR rates for its foreign-currency-denominated loans, loans with foreign counterparties, and derivatives trading.
LIBOR takes a bow.
LIBOR’s sustainability as an international benchmark rate came into question when panel banks were discovered to be habitually presenting rates indicative of their ‘conclusions’, not the transactions which reflected their actual cost of borrowing. The allegations of underreporting and manipulation to make unethical gains on LIBOR-based contracts, have diminished the public confidence in LIBOR and consequently sparked the phasing out discussion.
As the discussion goes, each prior LIBOR currency is to be replaced with a risk-free rate. The replacement rate for the Pound is the Sterling Over Night Indexed Average (SONIA). For the Swiss Franc, the replacement rate is the Swiss Average Rate Overnight (SARON). The Bank of Japan has replaced LIBOR with the Tokyo Overnight Average Rate (TONAR). In the United States of America, the Secured Overnight Financing Rate (SOFR) is LIBOR’s replacement, while in the Euro Zone, LIBOR is replaced by the Euro Overnight Index Average (EONIA). It does not appear that the application of these rates is to be mandatory, as parties are at liberty to choose a suitable benchmark for their financial transactions.
Nigeria’s possible replacement for LIBOR
The interbank market in Nigeria operates with the Nigerian Interbank Offered Rate (NIBOR), representing the short-term lending rates of select Nigerian banks; except for foreign-currency-denominated loans, loans involving foreign counterparties, and derivatives trading, which all currently rely on LIBOR.
It remains unclear what will happen when LIBOR is phased out of the Nigerian financial market. There does not appear to be consensus on a replacement and in the meantime, the parties will be at liberty to elect the interbank rate that will apply. In October 2019, the Loan Market Association (LMA) announced the publication of the Reference Rate Selection Agreement (RRSA), for use in relation to legacy transactions transitioning from LIBOR to alternative reference rates. Under the RRSA, each loan agreement referencing LIBOR would need to be amended to refer to a replacement benchmark rate upon the phasing out of the LIBOR, and parties would then agree on the basic commercial terms for the selection of the applicable alternative reference rate for their transaction. Some alternatives are the New York Funding Rate (NYFR), SOFR, SONIA, TONAR, SARON, and US American Interbank Offered Rate (Ameribor), amongst others.
Regulatory reform of benchmark rates is crucial to guarantee public confidence in interbank lending and the global financing system. There are several other interbank rates serving as reference rates in parts of the world. For instance, the European Interbank Offered Rate (EURIBOR), Emirates Interbank Offered Rate (EIBOR), Mumbai Interbank Offered Rate (MIBOR), Tokyo Interbank Offered Rate (TIBOR), and the Shanghai Interbank Offered Rate (SHIBOR).
It seems likely that the SOFR will become dominant globally starting in June 2023, as it is already a broad credit-risk measure leading the LIBOR replacement race. Also, a higher volume of trade is based on the SOFR, making it safer from manipulation than LIBOR. As against LIBOR, which is an unsecured rate based on panel banks’ estimates, SOFR is a secured risk-free rate. It would seem, that amongst other alternate rates, SOFR is ahead and preferred.
Nevertheless, in choosing alternative benchmark rates, parties to a financial transaction must be mindful of the fact that those rates are usually subject to periodic national and international regulatory reforms or may be phased out or discontinued in response to growing consciousness, as is the case with the LIBOR. Where a benchmark rate is non-compliant with regulations or laws, parties will not be permitted to reference that benchmark in their contracts or financial instruments. Also, the performance of a particular benchmark rate may change, especially where there is a dearth of data needed to determine the benchmark. Parties are therefore advised to familiarize with the alternative benchmark rates, weigh the circumstances of their transaction and choose carefully. In any case, parties may prepare an addendum to make provisions for successor benchmark rates in the event of the phasing out or disappearance of the rate reference in their contracts or financial instruments.
This article is written by Emmanuel Abraye & Olabisi Tinuala, both Associates of the Banking and Finance Department at Perchstone & Graeys, a leading commercial law firm in Lagos.