For almost half a century, the London Interbank Offered Rate, better known as Libor, has been one of the most important numbers in the world of finance. But we are approaching the end of the era of Libor dominance, with major implications for private credit funds.
Libor has underpinned debt markets around the world as a reference rate for everything from futures contracts to variable-rate mortgages and floating-rate notes. No other benchmark has been as influential, and this has made it a popular tool for banks and alternative lenders alike.
Such an important rate should have been beyond reproach, but in 2012 the Financial Times published an article by a former trader revealing that the rate has been manipulated for much of its life. This was followed by a series of scandals around banks rigging Libor for their own benefit, and thereby costing the markets billions of dollars. Since at least 1991, banks had been colluding to submit false rates to the British Bankers Association, which was responsible for administering the benchmark. In 2017, UK regulator the Financial Conduct Authority announced that the rate would be phased out.
Libor has been subject to greater scrutiny and regulation since the scandals surfaced and is now managed independently by the ICE Benchmark Administration. However, it has faced another problem: that it simply isn’t relevant to the way modern credit markets work.
When Andrew Bailey, CEO of the FCA, announced that the rate would be phased out, he said: “The underlying market that Libor seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active. To take an extreme example, in one currency-tenor combination, for which a benchmark reference rate is produced every business day using submissions from around a dozen panel banks, these banks, between them, executed just 15 transactions of potentially qualifying size in that currency and tenor in the whole of 2016.”
This fact alone should have set alarm bells ringing for private debt funds. Most of the funds’ contracts are based on a floating-point rate pegged to Libor. If the benchmark is not sufficiently reflective of real movements in interest rates, then fund managers are basing their contracts – and ultimately their returns – on unrepresentative and highly unreliable data.
Despite this, most firms continue to use Libor in their contracts. Yet these contracts could be obsolete by 1 January 2022, and firms will need to take action to ensure they can continue beyond then.
It is notable that there is, as yet, no firm date for the benchmark to be phased out. But with just 30 months to go until the earliest date by which it could disappear, it makes sense for firms to start thinking about this issue now. Loans made today will have durations that last well beyond this date, and many existing contracts could be affected as well.
Contractual documents may offer fund managers the provision to replace Libor in circumstances where the rate is unavailable. However, according to lawyers we have consulted, such documentation is unlikely to consider the possibility that Libor will cease to exist. Firms not only need to adjust their documentation; they also need consider what benchmarks they will use in future to ensure their loans are defended against changes in interest rates.
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