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"The BAN Report: Bye, Bye LIBOR" (Clark Street Capital)

This week, the UK’s Financial Conduct Authority announced a plan to phase out LIBOR by the end of 2021, causing massive disruption in loans tied to this index.

On Thursday a top U.K. regulator said it would phase out the London interbank offered rate, a scandal-plagued benchmark that is used to set the price of trillions of dollars of loans and derivatives across the world.

Andrew Bailey, the chief executive of the U.K.’s Financial Conduct Authority, which regulates Libor, said that work would begin to plan for a transition to alternate benchmarks by the end of 2021. “We do not think markets can rely on Libor continuing to be available indefinitely,” he said.

Libor is calculated every working day by polling major banks on their estimated borrowing costs. Its integrity was called into question following a rate-rigging scandal where traders at numerous banks were able to nudge it up or down by submitting false data. Banks were fined billions of dollars and several traders were sent to jail.

Over the last five years regulators have tried to find ways to tie Libor submissions to actual trades, as opposed to estimations. But in several cases that proved impossible because interbank lending has hugely diminished, Mr. Bailey said.

The push to ditch Libor creates a headache for authorities who should drum up alternative benchmarks and banks that face having to rewrite trillions of dollars’ worth of contacts. In financial markets Libor is ubiquitous, being used to price financial products ranging from mortgages to complex derivatives. Industry bodies have yet to agree on fall back rates that can be inserted into existing contracts if Libor suddenly ceases to exist.

This is a big problem for loans that are priced off LIBOR.   Here’s what many standard loan documents say:

“If the 5-Year LIBOR SWAP Rate becomes unavailable at any time, Lender shall select a new index or other appropriate measure as a basis for setting the Interest Rate.”

Jason Kuwayama of Godfrey & Kahn said, “A great number of lenders switched away from using LIBOR as an interest index after the price manipulation scandal in 2012.  I don’t see this as a huge issue for commercial loans because most will mature before LIBOR is phased out.  But for those that still use LIBOR, the bigger issue arises with longer term loans for which the bank entered into an interest rate swap or a similar derivative instrument that was indexed to LIBOR.    Lenders who have hedged themselves into that position should look to amend their documents sooner rather than later.”

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