The London Interbank Offered Rate (Libor) is no more, but what new system will be put in place remains a key question for the private debt market.
Yesterday, the Financial Conduct Authority (FCA) chief Andrew Bailey pledged to scrap the scandal-ridden benchmark by 2021.
The metric has come under increasing scrutiny in recent years as a fall in interbank lending means that the data is increasingly reliant on the judgment of those operating at the banks which provide the information. Last year, just 15 transactions of relevant size were completed, Bailey said.
“In our view it is potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them,” said Bailey.
He added: “As well as an inherently greater vulnerability to manipulation when rates are based on judgments rather than the real price of term funding, there are a host of questions about whether and how such reference rates can respond to stressed market conditions.”
All loans completed within the direct lending space are floating rate loans that use Libor as a benchmark. Corporate financings use the six-month Libor rate as a benchmark for pricing and mid-market investment funds include floors, unlike mid-market banks or larger institutions where the presence of floors varies.
While the dropping of Libor as a base rate may have an impact on banks, for funds the effect is less muted. Where concerns lie, however, is that there are less data points for three-month and six-month rates – the traditional time period corporate borrowers prefer. This contrasts with overnight reference rates, where plenty of data exists.
Regulating Libor has been under the remit of the FCA since 2013.
There will be a three-year period between the FCA’s announcement and the implementation of a new system. Uncertainty for direct lenders surrounds what the replacement system will be, but in his speech yesterday Bailey noted some of the reference rates put forward by numerous bodies.
These include the Sterling Over Night Index Average (Sonia) and the Treasuries Repo rate, the latter of which was nominated by the US-based Alternative Reference Rates Committee.
Max Mitchell, h0ead of direct lending at ICG, said: “We don't expect the transition to an alternative benchmark to Libor to change the nature of the market, which we see remaining on a floating rate basis.
“I see the key challenge being around the practicalities of having to deal with the transition arrangement for all of the existing loans that have maturities out past 2021. Bailey has stressed the need for work to begin on planning for a transition to alternative reference rates, and Sonia has already been identified as a potential alternative. But transitioning legacy contracts has to be the priority of IBA and the panel banks,” he added.
Issues regarding the rigging of the Libor rate has caused some to question the usefulness of the benchmark. In 2012, Barclays was the first bank to be fined by authorities for its role in the scandal, and it was joined by UBS, JPMorgan, Royal Bank of Scotland and Deutsche Bank. In 2015, trader Tom Haynes was sentenced to 14 years in jail, which was later reduced.
“We do not think we will complete the journey to transaction-based benchmarks if markets continue to rely on Libor in its current form. And while we have given our full support to encouraging panel banks to continue to contribute and maintaining Libor over recent years, we do not think markets can rely on Libor continuing to be available indefinitely,” Bailey said.