Many credit agreements refer to LIBOR as reference interest rate. This LIBOR interest rate has lost its importance as from 1 January 2022.

This reference interest rate is determined based on estimates and information provided by a number of leading banks on the London market.

This fact is not only important for interbank loans of the big players in the financial world, but may also impact your company.

Numerous (credit) agreements are linked to this reference interest rate. What to do with them, you will read in this article. In addition, this article may also be valuable with respect to contracts referring to the EURIBOR reference interest rate.

1. What is the LIBOR reference interest rate?

An Interbank Offered Rate (IBOR) is an average interest rate at which large banks worldwide borrow money from each other. Every day the competent financial regulator asks the largest banks in the world how much interest they would charge for a short-term loan to other financial institutions. An average is made of this. Such reference interest rates are calculated for different maturities.

The London Interbank Offered Rate (LIBOR) was one of the most important of these IBOR reference rates. LIBOR was the average interbank interest rate at which a selection of banks on the London money market lend to each other. It was drawn up for ten different currencies, including the pound sterling, the US dollar and the euro.

2. The decline and fall of the LIBOR reference rate

Initially, IBOR rates were considered very reliable.

However, in the aftermath of the financial crisis, some studies shed a different light on interbank interest rates, especially LIBOR. Some of the leading banks were alleged to have manipulated the reference rate to increase their own creditworthiness or profit margins on derivatives.

Moreover, the number of interbank loans decreased due to the financial crisis. As the LIBOR is based on this market, it had to further lose its reliability. The Euro Interbank Offered Rate (EURIBOR), the European counterpart of the LIBOR, suffered the same fate.

In short, due to the lack of underlying transactions, the LIBOR reference rate has lost a great deal in terms of representativeness and reference value.

What is more, it is linked to estimates made by the banks and not to actual transactions.

This trend prompted the British financial authority, the FCA, to regulate the use of LIBOR interest rates less. Firstly, it was decided that from 1 January 2022, the banks concerned will no longer be forced to pass on information for the purposes of determining the LIBOR reference rate. In March 2021, it was announced that many of the LIBOR interest rates will no longer be published as of 1 January 2022.

3. Consequences of the disappearance of the LIBOR reference interest rate

In many commercial contracts and credit agreements concluded with and between companies, the LIBOR interest rate was used as the reference interest rate.

Now that this LIBOR reference rate is no longer published, this may have consequences for these existing contracts. Contracts that refer to or are based on IBOR will have to be adjusted to an alternative interest rate benchmark and/or be provided with a robust fallback provision.

For existing LIBOR-referenced contracts, financial regulators have recommended that a new reference rate be agreed in a timely manner. Although many organisations have worked hard in recent years to ensure that their contracts are ready for the transition away from LIBOR, there will still be many contracts that refer to LIBOR and continue beyond 2022.

With LIBOR gone, such reference clauses will essentially be an empty shell. This will inevitably lead to disputes about the application of a (new) reference interest rate.

More recent contracts foresaw the disappearance of LIBOR and implemented a so-called 'back-up' reference rate via a fallback clause. A fallback clause is a clause in a contract that determines which interest rate parties should use in case the originally agreed reference rate (such as EURIBOR or LIBOR) is not available. This back-up will then become the relevant reference interest rate from 1 January 2022. Remember that such fallback provisions are subject to regulation through the EU Benchmark Regulation.

4. What Alternative Reference Rates are available?

Worldwide, the LIBOR reference rate will be replaced by risk-free reference rates (RFRs - "Risk-free Interest Rate"). An RFR is a theoretical return on an investment with no risk of financial loss.

In the sterling markets, the preferred reference rate is the Sterling Overnight Index Average (SONIA). SONIA is based on actual transactions and also reflects the average of the interest rates banks pay to borrow sterling overnight from other financial institutions and other institutional investors. SONIA operates in a fundamentally different way from LIBOR. SONIA is a "looking back" interest rate, whereas LIBOR is an "estimating" interest rate. With LIBOR, the interest rate payable is known for the future period starting on the day it is published. With SONIA, the interest payable is known only at the end of the period.

A similar SOFR reference rate has been developed for the US dollar. The European Central Bank has also developed a risk-free reference rate. The so-called €STR (or Euro Short Term Rate) reflects the rate for euro loans between banks in the euro zone.

5. The fate of the EURIBOR reference interest rate

The development of the €STR currently remains in the shadow of the existing EURIBOR reference rate. Unlike LIBOR, EURIBOR will continue to be published by the ECB as a reference rate. Credits in euro are therefore less impacted.

6. What do we recommend?

The trend away from IBOR to RFR reference interest rates continues. We therefore advise companies to include a 'fallback provision' in their credit agreements denominated in euros or in their (international) commercial contracts that refer to an IBOR reference rate. Based on such fallback provision, EURIBOR will in due course be replaced by €STR if the publication of EURIBOR were to cease in the future.

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Leo Peeters

Leo Peeters