The discontinuance of LIBOR is necessarily a multi-jurisdictional, multi-currency and multi-product issue. In the interests of brevity and simplicity this loan markets product page of the microsite is concerned primarily with LIBOR discontinuance and transition (“LIBOR Transition“) as it affects:
- English law governed secured lending documents and the European loan market;
- Sterling and euro denominated lending, although brief reference will be made to other currencies, including US dollar; and
- the UK regulatory regime.
LIBOR is currently used extensively as the interest rate benchmark for loans in major currencies globally.
For the reasons explained in Overview section of this microsite LIBOR Transition was initiated by the Financial Conduct Authority in July 2017 and while other global regulators, notably in the US and Europe are stakeholders in the issue, the UK regulatory position is a dominant feature. European Benchmark reform (under the EU Benchmark Regulation) is concerned with the appropriateness and robustness of financial benchmarks and while this necessarily overlaps with LIBOR Transition in the wider financial markets, corporate loans are currently excluded from the requirement to be EU Benchmark Regulation compliant.
We anticipate that a degree of product, currency and sector fragmentation is now inevitable. It is highly unlikely that a post-LIBOR environment will reflect the comparatively universal position under LIBOR. That is, the rates offered by banks and non-banks are likely to vary relative to their funding models and that the suitability of particular rate bases to particular products and sectors will become more marked.
The most recent and prescient UK regulatory statements on LIBOR Transition as it affects the cash (loan) markets, have been those joint Bank of England and FCA statement on 16 January 2020. The key points from that statement and related documents were:
- urging stakeholders:
- not to issue/originate Sterling LIBOR loans from September this year (Q3 2020); and
- to take steps to promote and use new risk free rates (RFRs), such as compounded SONIA (for more on RFRs, including SONIA, as they apply to the loan markets, see Alternatives to LIBOR: risk free rates);
- to focus on transitioning legacy LIBOR products by Q1 2021, including so-called “tough legacy” contracts.
On 16 February 2020, the Bank of England indicated that from October 2020 it would discount LIBOR-linked collateral used to secure central bank funding. The clear message is that market participants must limit further LIBOR exposure and accelerate remediation and transition plans to reduce existing LIBOR exposure.
In April 2020, as a consequence of the Coronavirus (COVID-19) pandemic, the FCA and the Bank of England modified their position by relaxing the target date for ending new issuances of Sterling LIBOR loans from Q3 2020 to the end of Q1 2021. However, the overarching timetable for transition/cessation has not changed and progress is expected to continue, notably on, among other things:
- encouraging lenders to be in a position to offer non-LIBOR loans by end of Q3 2020;
- ensuring that, from the end of Q3 2020, new and re-financed loans should all have clear contractual mechanisms for a transition to new rates (i.e. not just “fall back” rates); and
- dealing with “tough legacy” contracts.
This obvious regulatory pressure is accompanied by the potential for regulators to deploy their supervisory powers. Various regulatory risks can be highlighted in pursuing with LIBOR issuance including in terms of conduct, customer education and transparency, the suitability of products and the potential for revised risk-weighting for regulatory capital purposes or attributing higher counterparty risk for LIBOR exposures.
The Sterling Risk-Free Rate Working Group (“RFRWG“) has estimated that it is “operationally achievable” for 90% of new Sterling loans by value to use a form of compounded SONIA (backward looking) – that is including ‘large corporate’ deals, ‘mid to large corporate’ transactions of between £10 million and £25 million and ‘specialist’ real estate and project finance totalling approximately 90% of the market by value. The RFRWG anticipates the remaining 10% will use alternative fixed or floating (base) rates.
The UK regulators anticipate forward-looking term rates (based on risk-free rates) being appropriate for only a limited number of use cases and that , in any event, such rates may not be available until late in the transition process (if at all).
The Loan Market Association (LMA) is actively helping to drive the EMEA syndicated loan market’s readiness for LIBOR Transition and participates alongside other stakeholders (including borrowers, represented by the Association of Corporate Treasurers (ACT)) in the various UK working groups. Alongside briefing papers and educational initiatives, there are some documentary solutions available but these are presently limited in scope. They include:
- screen rate replacement language: used in existing LMA templates to assist parties in agreeing appropriate amendments in upon certain LIBOR Transition events (see Current position for new loans: Document flexibility);
- exposure drafts of SONIA and SOFR-based loan facility agreements: these are template documents published as “exposure” drafts rather than as formal templates. They are designed to facilitate discussion on structural/product issues to encourage market development and borrower adoption.
- an exposure draft reference rate selection agreement: essentially a discussion draft of a document designed to streamline the amendment process for legacy transactions transitioning from LIBOR to RFRs.
The Loan Syndication and Trading Association (LSTA) in the US is treading the same path as the LMA and the approaches are broadly in alignment, including in terms of draft documentation. There may be more significant divergences in approach when it comes to legacy contracts (see The position for existing (legacy) loans).
While all currency denominations (and tenors) for LIBOR (i.e. Sterling, euro, US Dollar, Swiss Franc and Japanese Yen) are expected to cease at the end of 2021, there is an increased focus on Sterling LIBOR transition because of the UK regulatory pressure noted above. LIBOR (and other interbank rate) reform differs across currencies and the timetable for the production (and liquidity) for replacement rates varies considerably. Particular characteristics that diverge include their secured/unsecured nature, the underlying securities markets they are based on and their publication dates/timings and calculation methodologies – in some instances (e.g. Swiss Franc) it is not anticipated that there will be forward-looking RFR-based term rates available and that any RFRs will be backward looking only.
Euro: It is anticipated that most euro LIBOR exposure will transition to EURIBOR. EURIBOR remains viable as a credit term rate in the short to medium term following a reform programme. The euro version of an RFR is ESTR (the Euro Short-Term Rate), which is an unsecured rate, published (since October 2019) at 8:00 am Central European Time. See also, What is happening with EURIBOR?.
US Dollar: It is anticipated that US Dollar LIBOR will transition to SOFR (a secured rate, published at 8 am Eastern Time). A term version of SOFR is not expected until at least the end of 2021. There are some continuing reservations as to how appropriate SOFR is generally for the loan markets since it is based on transactions in the repo market. (For more information, see What is SOFR?).
Efforts are ongoing to coordinate and align reform and transition programmes internationally however multi-currency lending presents a significant difficulty in the short to medium term.
We understand the LMA are working on a multi-currency form of exposure draft facility agreement to assist with settling conventions in the case of Sterling, US dollar and euro denominated facilities.
Other markets (e.g. the floating rate note and derivatives markets) are actively progressing transition to RFRs where there is increasing liquidity. For example, the derivatives market switched over to SONIA issuance from March this year.
This is likely to lead to borrowers, who need to hedge their floating rate position (assuming there is no large-scale shift to fixed rate lending), demanding a loan product that allows them to access the most liquid and tightly priced part of the swaps market, which we anticipate would motivate cross-product alignment of conventions.
The intention is that the effect of rate transition should be economically neutral for the party responsible for paying interest. That is, parties should avoid any transfer of value.
For more information on other products including Asset-Backed Securities, Bonds and Derivatives, see the individual product pages using the dropdown menus above.
While, publicly at least, there have been some early SONIA, SOFR and SARON issuances, the reality is that the alternative rate options, particularly those based on RFRs, are not at a stage where they can be deployed by most lenders. Whether any non-LIBOR rate is appropriate for a given lender will depend on numerous factors but significantly including that lender’s funding and business model. For example, banks currently funding from the interbank market may have different requirements to other lenders funding from their balance sheet/capital.
Unless and until lenders are comfortably (commercially and operationally) issuing loans on alternative rate bases, it is likely that LIBOR issuance will continue in the short term at least. This must be balanced with the growing regulatory risk in doing so and which is identified above.
In such circumstances, there are certain steps that can be taken in mitigation.
- Transparency: lenders must communicate with customers about LIBOR discontinuance. This means customer education and transparency/openness as regards pricing options. For example term sheets should make clear that where a loan is being provided on a LIBOR basis and payment obligations thereunder will extend through to 2021 and beyond there is a significant risk that the pricing basis will change and that a replacement benchmark rate will need to be used, including in respect of any related products (e.g. finance-linked swaps).
- Document flexibility: documentation must include the flexibility to respond and adapt to a new interest rate basis. This includes using an appropriate version of the LMA’s screen rate replacement language, which includes trigger events that allow the parties to amend the arrangements before the ultimate disappearance of a LIBOR rate. There has been some industry discussion as to whether a “hardwired approach” may be appropriate in terms of specifying a particular rate basis (e.g. compounded SONIA) as a replacement benchmark upon certain LIBOR (pre-)cessation events. While the LSTA and other stakeholders in the US loan markets have more actively advocated a hardwired approach, this is not currently something we are seeing in the UK market. Since early 2020, the screen rate replacement language has been included in LMA template facility agreements (previously it existed as an additional ‘rider’).
- Fallbacks: so far take-up of a hardwired approach to fallbacks (that is, including an RFR benchmark as a permanent replacement), anecdotally at least, appears to be limited (currently typical interest rate fallbacks in loans do not contemplate LIBOR discontinuance or the permanent replacement of an interest rate benchmark). However, there is scope to include more specific non-LIBOR alternative rates and to modify fallback triggers so that they apply pre-cessation. Note this would be as an alternative mechanism to the amendment approach currently offered by the LMA screen rate replacement language.
- Finance-linked swap: loans documented now on a LIBOR basis must consider any finance-linked swap (hedging) where the basis for that swap may be a difference rate to that used in the underlying loan.
Alternatives to LIBOR
The FCA and other global regulators have indicated that they expect RFRs to be the new industry standard benchmark rates. For the Sterling markets, the RFRWG’s view is that SONIA (compounded in arrears) will, and should, become the norm in most derivatives, bonds and bilateral and syndicated loan markets. The RFRWG also stresses the benefits of consistency across markets and the robust nature of SONIA as an overnight and nearly risk-free rate. However, RFRs present certain challenges operationally in the loan market and their development and roll-out is not as straightforward as may be the case for other financial products.
Although some RFR-based loans have been issued, these have been limited to bilateral deals and at least one syndicated deal that used a SOFR fallback. The RFR conventions for such loans have broadly followed the conventions used in the floating rate note market, which has seen more widespread SONIA issuance. Most lenders are presently unable to model, price and service RFR-based loans and there are a number of variables that are still to be resolved on an operational level before all institutions can begin to issue RFR-based loans.
Because current RFR bases, such as SONIA, are backward-looking compounded rates, they require a significant departure from current LIBOR based conventions and methodologies.
- LIBOR is a forward-looking term rate, with seven tenors, whereas backwards RFRs relate only to overnight periods. By way of illustration, LIBOR is set at the beginning of the selected interest period (typically 1, 3 or 6 months) at 11am London time. That determines the amount of interest payable at the end of the relevant interest period, enabling borrowers to know what their interest payment will be in advance. Loan systems would need to be entirely rebuilt to calculate interest due on the relevant interest payment date on the basis of backward-looking, compounded overnight rates;
- as a means of calculating the cost of interbank lending, LIBOR already prices in credit risk, whereas RFRs are near risk-free;
- LIBOR includes a premium on long-dated money, while current RFRs do not. That is to say, RFRs do not compensate lenders for making money available long-term. This leaves a credit and liquidity spread (or ‘pricing gap’) between LIBOR rates and RFRs (on an overnight indexed swap basis); and
- currency divergences are magnified, particularly with multi-currency facilities, as LIBOR methodologies and publication times are the same for all currencies whereas this is not necessarily true for alternative rate options in other currencies.
The LMA in publishing their “exposure draft” facility agreements have sought market views as to how to resolve some of the variables including:
- Calculation methodologies: where will the rate appear (a “screen rate”, index or calculation service?) and who calculates it? Under what formula including the compounding basis, rounding, business days and decimal place conventions? On 26 February 2020, the Bank of England said that it intends to publish a compounded index (in addition to the overnight rate) for SONIA. The index should be available from July and will be a helpful tool for borrowers and lenders alike in determining a compounded rate.
- Lag periods: how can borrowers get cashflow certainty as to their interest payment when the rate is an overnight/daily compounded rate? Similarly, how does this work operationally in terms of notifying, paying and distribution interest among syndicates? The solutions appear to centre around a so-called “lag” mechanism to observe the daily compounded average rate over a period equivalent to the interest period but starting five days before the start of the nominated interest period and ending five days before the interest payment date. This lag mechanism itself includes a number of variables such as the period of lag and the conventions for compounding the rate or the balance, and whether or how to compound over weekends/holidays or where interest periods are shortened.
- Credit adjustment spread: it will, in most cases, be necessary to apply a spread to reflect the difference (the term credit risk element) between LIBOR rates and RFR rates. The methodology for calculating and applying this spread is not yet settled and will need to align with the spread adjustment as it applies in related products (e.g. finance-linked swaps). It is envisaged that any spread adjustment would be a static (not dynamic) figure for the duration of the loan albeit one that varies with the tenor (i.e. the spread vs. 1 month LIBOR would differ to 3 month LIBOR).
- Modified fall-back positions: existing LIBOR loans fall back to various rate options if LIBOR cannot be determined, including historic or interpolated LIBOR rates, reference bank rates or a cost of funds basis. A modified fallback would need to exist for RFR based loans (not using LIBOR or reference rate bases).
- Break costs and market disruption: it is not clear to what extent break costs and market disruption provisions are appropriate where loan is funded on a rolling overnight basis (as opposed to interbank funding) as the economic justification for such provisions may not exist for a rate based on overnight funding. That is, for a LIBOR loan repayments of principal align with interest payment dates and where payments do not align a borrower is required to compensate the lender for interest that would have been payable had the payment not been made inside the interest period, reflecting the lender’s matched funding obligations to the interbank lending market.
- While positions appear to be converging there is currently no market consensus on these variables, and the structural differences they bring to the market, such that the market does not have an agreed RFR loan product. For this reason the LMA “exposure drafts” do not represent a formal template for a SONIA or SOFR loan. However, in some instances, certain options or variables do not necessarily need a market consensus and we understand some of the bilateral issuances to date used the drafts, at least partially, as their basis.
Effective hedging requires derivatives that align in referencing of the floating rate and yet it is not currently certain that RFR cash and derivatives markets will develop in this way.
Alignment is not simply in terms of the rate but the conventions. For example, a long ‘lag’ or ‘lock-out’ period (which may be required for operational reasons as well as borrower cashflow certainty) might diminish the effectiveness of any interest rate swap that does not include the same lag mechanism.
Not all RFRs are the same and it is possible that the conventions and structural features of those rates will not align. For example, SOFR, is a secured overnight rate whereas SONIA and ESTER are unsecured. Publication times also vary in accordance with local conventions. Currently, in a multicurrency facility, the interest rate in respect of Dollar and Sterling facilities, for example, would both be calculated using a LIBOR benchmark, albeit on USD LIBOR and GBP LIBOR respectively and with rates published at the same time.
Moreover, the transition timetables across currencies vary. This may create problems, mostly on an operational and documentary level. We understand the LMA are working on a multi-currency RFR loan template, however this is likely to be limited to closely aligned or known conventions for Sterling (SONIA), US Dollar (SOFR) and euro (EURIBOR/ESTR).
We understand that in some jurisdictions usury laws may present difficulties when using a compounded average rate. That is, it may be contrary to local law to apply “interest on interest”. Note this is a governing law issue, rather than a currency issue and it may be that deployment of central “index” rates may assist in this regard. We await further developments on this.
Term rates, by which we mean forward-looking rates over a specified term are the most drag-and-drop replacement for existing LIBOR tenors, certainly on an operational level. However they are complicated to calculate (based on RFR rates) and the development timeline is such that they are not expected to be available in the short to medium term given LIBOR’s anticipated cessation at the end of 2021.
It is also apparent that term rates may not exist for some currencies (e.g. the Euro and Swiss Franc).
The FCA are unconvinced there are enough use cases for term rates, except perhaps for certain legacy contracts and sectors. Moreover there are question marks as to whether:
- there are structural vulnerabilities similar to those experienced with LIBOR (because it is derivative of the transactions underlying SONIA) meaning that it is not as robust as a SONIA on a look back basis over the same period; and/or
- there will be sufficient liquidity to produce even SONIA or SOFR term rates.
Accordingly the regulator and industry position is that participants should not hold out or prepare for term rates and should form transition plans on the basis of other alternatives.
For more information on term SONIA, see What is TSSR?.
A fixed rate basis provides certainty (and obviates the need for interest rate hedging and possible basis risk) although there are obvious market risks in setting a rate, particularly on longer-dated debt. For this reason we would anticipate fixed rates coming in at a premium against variable rate alternatives.
There is no current market consensus as to whether break costs are appropriate for fixed rate loans. Some lenders will charge costs associated with breaking any notional hedge before the end of an interest period whereas others will roll up costs into a prepayment fee or make-whole amount. Again the commercial or economic rationale would need to be justified to customers and not simply operate as a vestige from LIBOR conventions.
Fixed rates may represent a simplistic fix in the short term and particularly for those lenders whose funding model can more readily align with a fixed rate basis. However, they will not be suitable for all lenders or customers and consideration must be given to regulator pressure to ensure rates, and products, are in all instances suitable for customers.
A floating rate, most likely based on a central bank base rate (e.g. Bank of England or the Fed) also constitutes a straightforward fix. However, whether such a rate, which is wholly subject to monetary policy fluctuation, is appropriate to lenders and customers in the relevant circumstances must be considered.
Synthetic or reformed LIBOR
There are some suggestions that a variant of LIBOR may remain post-2021 (perhaps with voluntary panel bank submissions or on a reformed methodology) or that a LIBOR rate may be derived from historic data. However while it may be possible to calculate or derive such a rate, the UK regulators have continually expressed concern at this, primarily because it is likely that such rate would be unrepresentative of the market – which is precisely the issue in relation to current LIBOR, which is based on a dwindling set of unrepresentative transactions.
It is envisaged that the only role for a synthetic form of LIBOR would be in respect of the so-called tough legacy contracts and rate fall-backs, where it may not be possible to transition to alternatives. It is not thought to be a viable rate for new loan issuances.
Existing (legacy) loans
It is important that lenders know the extent and nature of their LIBOR exposure and actively reduce it. This requires a comprehensive audit of legacy contracts to identify the impact of LIBOR Transition. Services such as Condor Alternative Legal Solutions can help with targeted and intelligent data extraction and analysis. For more information, see Condor IBORSolve.
For most loans, the initial focus will be on any documentary fallbacks and amendment mechanisms. That is, the contractual arrangements for LIBOR’s replacement in the event of its discontinuance.
Most contractual fallbacks in the loan market are designed for short-term disruption to benchmark rates, technical failures and/or the disappearance of an IBOR where any market replacement or substitute would be broadly analogous to an IBOR rate. The trigger points for the these provisions are typically where the relevant benchmark/IBOR is unavailable either temporarily or where market disruption means that the lender’s cost of funding is greater than the underlying IBOR rate. Unless the more recent LMA screen rate replacement language is used (or a variation thereof), fallbacks do not allow for proactive change or for circumstances where a form of LIBOR, EURIBOR or any other IBOR lives on, perhaps with a different (reformed) methodology or calculation mechanism that might not work within the current documentary framework.
Whether any fallback is appropriate must also be seen in the context of what happens in the wider market. That is, although the contractual fallbacks might lead the parties to a particular rate, it may not be appropriate in the prevailing LIBOR Transition market (such that a lender might not want or be able to insist on strict contractual interpretation). For example, although contractually agreed, a fallback to historic LIBOR rates or rates interpolated or extrapolated from LIBOR is unlikely to be appropriate or workable following LIBOR cessation, not least since a floating the rate may end up fixed (on an historic basis), as opposed to floating relative to the lender’s funding costs.
In most cases (under loans) rates will ultimately fall back to the cost to each lender (assuming a syndicated loan) of funding its participation in the loan for successive interest periods from “whatever source it may reasonably select” (known as “cost of funds”) – although, it should be noted that fallbacks may differ in relation to any interest rate swap.
There are operational issues when calculating cost of funds in terms of identifying and notifying customers of the relevant rate. However, there are also commercial implications relative to the nature of the underlying funding model as a borrower will be exposed to the credit standing of the lender which may have high funding costs (relative to its competitors).
As with new loans, it is key to ensure that customers are kept informed about what is (or may be) happening with their loans. This includes lenders working with customers to understand fallback positions and any amendment or repapering programme to transition to a new benchmark rate. Similarly any switch to a new rate must be a rate that is suitable and appropriate for the customer and communication and transparency at all times (including as to the composition of any new rate, including elements of margin and/or adjustment spread) will help to allay any anxiety that customers may have that LIBOR Transition might be used as an excuse to reprice a product or transfer value. Regulators have stressed that LIBOR Transition should be economically neutral.
Regulators have stressed that moves to transition legacy contracts to non-LIBOR rates should not wait for discontinuance or for a particular RFR product or solution. However, as with new loan issuances, amending legacy documents pre-emptively, particularly for multi-currency debt, needs to be balanced with the practical reality of the absence of developed conventions, methodologies and infrastructure for alternatives to the underlying IBOR benchmarks.
Where customers elect not to proceed with a rate switch and instead decide to prepay or cancel facilities, it may not be appropriate in all cases to levy prepayment or cancellation fees. This will depend on various factors (including the alternative rate options presented, the proximity to LIBOR cessation and the extent of any consultation and negotiation period) however since the rate change is regulatory-driven there is an argument that it is equivalent to an “illegality” prepayment or cancellation event (i.e. a borrower “no fault” scenario), which does not typically incur a fee.
The RFRWG have identified a category of legacy loans that may present certain difficulties in terms of transitioning away from LIBOR to new rates. Broadly, these include:
- non-performing loans;
- loans that require unanimous consent or third party consents; and
- loans where one or more parties is in dispute.
A task force has been set up to look at issues relating to this “tough legacy” and how to manage transition and we await further developments in this regard.
Despite initiatives to streamline any repapering process, loans will need to be amended on a case by case basis – and a protocol solution, as used by the derivatives (ISDA) market, is not appropriate for loans given the composition of lending syndicates and the unique features of the loan product. The need to repaper, and any trigger event for doing so, will be determined by the loan documentation and should be identified when auditing LIBOR exposures.
Where loans include the LMA screen rate replacement language, this includes certain pre-cessation triggers (and lower lender consent thresholds) to bring the parties together with a view to negotiating and processing the relevant changes.
We envisage that the syndicated loan market will, in time, use a variation of the LMA’s amendment approach and that to some degree this process may be commoditised by service providers however, the LMA amendment documentation remains an exposure draft at this stage, rather than an approved market template. Bilateral amendments are likely to follow an LMA approach where appropriate however, there will be a significant number of transactions that require bespoke repapering solutions.
When repapering loans, thought must also be given to the basis risk involved with any finance-linked swap and the need to align products. Security documents and guarantees are also worth thinking about. Even where the loan documents flex to accommodate new terms, there is a risk that such changes may not be within the purview of the security or guarantee (or both), which may make them vulnerable to challenge.
In the US it is notable that on 6 March 2020 the Alternative Reference Rates Committee (ARRC) representing private market participants in the US (and broadly equivalent to the RFRWG) announced a proposal for a New York State Law to cover US LIBOR contracts that are governed by New York law. The rationale being to try and minimise basis risk when US LIBOR ceases to exist and to create a smoother path to transition to alternative rates without the risk of litigation. No equivalent legislative fix is currently proposed for English law contracts.
Further pressure points: new and legacy loans
Operational readiness and systems capability
Clearly, it is vital that lenders (and borrowers) are able to continue to operate in a world where LIBOR no longer exists. There is a pressing need to have systems that can work with new rates and conventions (and dual running with multiple rate bases, including LIBOR) and the timeframe for developing, testing and deploying new or updated systems is rapidly shrinking. Moreover as 2021 approaches, we anticipate significant resource compression as market participants engage suppliers and advisers and a failure to rewire systems in time may mean lenders are unable to participate in new issuances.
Communication, education and outreach
Lenders need to know the breadth of issues and risk in relation to LIBOR Transition and there is a need for both internal and external education. That is, do relevant business units understand the issues/risks and are they able to communicate these to and (where appropriate) advise clients accordingly?
Education should be considered at all levels from sector to product. However there is a balance to be struck between early engagement and having sufficient knowledge and clarity of the LIBOR Transition landscape.
Communication and transparency challenges may also occur in relation to loans issued under new rate bases (whether as fallbacks under legacy loans or new issuances) for example ensuring borrowers are able to receive interest notifications on a more compressed timetable (e.g. under a 5 day lag mechanism) and that there are processes in place for borrowers to query or challenge rate calculations.
Competition law risk
The RFRWG and others have expressed concern that discussions around pricing, particularly in a syndicated lending context, may be contrary to measures designed to prevent price fixing or manipulation. This includes activity among competitors involving disclosing, receiving or exchanging competitively sensitive information and avoiding price coordination, the restriction of products or market sharing.
On the buy-side, purchasers of debt maturing after 2021 will need to look closely at the underlying loan documentation and the existence of any fall-back language. On the sell-side it may be increasingly difficult to trade debt that does not adequately address the need to transition to new benchmark rates after that date. Risk disclosures may need to be made. Marketing information, including information memorandums, may need to address how loans referencing LIBOR may operate through any discontinuance or transition period, or at least include appropriate disclaimers.
Secondary market transactions documented on LMA terms currently include their own definitions of LIBOR. In December 2017, the LMA’s Standard Terms and Conditions for Secondary Debt Trading were amended to add an additional fall-back provision to the “Relevant Benchmark Rates” to take into account IBOR discontinuance. Clearly the underlying benchmark rate is fundamental to the calculation of trades, including delayed settlement compensation, and it will be important to ensure that there is a consistent approach to alternative benchmarks spanning the primary and secondary markets.
It is worth stating that LIBOR Transition is taking place in a relatively stable and low interest rate environment. In that context, differences between rates may seem minor, if not inconsequential, particularly with regard to the need to avoid any transfer of value (that is, the transition should be economically neutral). However, it is crucial for lenders and borrowers alike to understand the fundamentals underpinning any rate change and to recognise the commercial consequences, including as they vary in a more volatile and/or rising interest rate environment.
Anecdotal evidence suggests borrower engagement with the issue is mixed. Although it is regulator-driven change, the emphasis is that there should be market-driven solutions. However that presents something of a conundrum as to what needs to be developed first: products, systems or documentation. Many of these challenges lie with lenders on the sell-side. However, all parties should be encouraged to consider the issues relevant to their business now, and not defer in the hope that suitable market solutions will be developed – not least because of the fundamental operational changes to loan servicing that switching to a backward-looking RFR brings
Borrowers are likely to be anxious about anything that might encourage banks to revise pricing upwards and particularly to pass on market-related costs that have, since the demise of the mandatory costs schedule, previously been excluded. Accommodating any pricing adjustment (credit spread) in the margin is less transparent for borrowers since a margin typically reflects credit risk and not funding cost (and “backup” rates may reflect higher cost of funding). Term sheets should ideally include language that informs the borrower that the pricing they are being offered (particularly where on a LIBOR basis), is likely to change on or before the end of 2021.
Changes based on pre-emptive (that is, pre-cessation) triggers may be unwelcome as borrowers may assume a lender is more likely to want to transition to new rates (or activate a fall-back position) where the relevant IBOR remains but is no longer as attractive. There may also be issues with transitioning to new rates or methodologies where the infrastructure and conventions are not fully developed for the loan markets, particularly so in markets outside the major financial centres.
Equally, the necessity to re-open legacy contracts in particular may encourage refinancing and buy-backs, which may, depending on where things are in the business cycle (or any change in credit quality), present opportunities to renegotiate a better deal elsewhere. Refinancing may be preferable if lenders are going to try to reprice, especially if debt matures in the near term. In each case, there’s no guarantee any party will get a more favourable outcome.
For the most part, many borrowers will want to maintain the forward-looking and term features of current benchmarks that allow for certainty of funding costs and therefore cash flow planning. For example, calculating interest costs well in advance allows for a more informed repayment or refinancing strategy.
A backward-looking or overnight rate may require cash retention to accommodate rate movements during the period between interest payment dates. Equally, current RFR conventions used in other markets compress the timetables for calculating, invoicing and paying interest to as little as 4 days. However, some larger borrowers in the sterling markets have nevertheless expressed a preference for transitioning to a backward-looking compounded rate. Much will depend on a borrower’s ability to adapt their operations and treasury management systems to work on that basis and their familiarity and use of other markets where such rates are used.
Borrowers should consider the wider impact of new benchmark rates on budgeting/forecasts, hedging strategies, taxation, intercompany debt (including cash-pooling), valuations and both domestic and cross-border accounting, as well as other commercial contracts (not just financial market instruments) As the Association of Corporate Treasurers advise, every instance where an IBOR is referenced in the organisation needs to be identified and a decision taken about what to replace it with.
Frequently Asked Questions
Q. What should we be doing about our existing contracts and arrangements?
A. Lenders and borrowers (of all types) should conduct due diligence and identify affected agreements across the full range of their business, having regard to the proposed discontinuation of LIBOR in 2021. This may include loan agreements, related products and financial instruments (e.g., hedging) and identifying other commercial (non-lending) agreements where IBORs may be used as a base rate, for example in penalty (interest) clauses.
Due diligence should identify matters such as:
(a) what calculation mechanics are used?
(b) what rate fall-back provisions (if any) are used, including identifying and analysing trigger events and who selects the replacement rate?
(c) what amendment provisions are there, including consent thresholds, instructing groups and authorisations including in intercreditor structures and the scope for amendment flexibility?
(d) what interdependencies are there with other products and instruments?
(e) can loans be repaid or prepaid if no agreement can be reached on IBOR replacement?
Once documents are identified and analysed, it may be necessary to put in place processes to effect appropriate amendments to those arrangements (including aligning arrangements where possible to avoid basis risk). In some instances the arrangements may be refinanced or revisited within the timeframe for transition. However other documents may need to be amended more proactively.
In each case any amendments should pay close attention to, among other things, the progress of development of any replacement benchmark rates, the prevailing market view and the respective commercial interests of the parties. It is almost inevitable that there will be significant time and cost implications in any repapering exercise.
Q. What should we be doing about new transactions?
Before drafting provisions that contemplate new rates with different calculation methodologies and conventions, an analysis should be done as to whether the parties are set up operationally to work with any replacement benchmark, before committing to its use, even in fall-back scenario.
Where new loans or agreements will include payment obligations that extend beyond the likely discontinuation date in 2021, the parties should consider to what extent they need to future-proof any change in interest rate benchmarks.
For LMA-based documents this will likely come down to a consideration of the extent to which the Screen Rate Rider, including the various options within those riders (see New transactions and the LMA Screen Rate Rider), should be incorporated in the loan agreement.
For non-LMA documents a more bespoke solution may be required that more closely reflects the respective commercial interests of the parties.
However some market commentary has advocated an approach that avoids continuing to use IBOR benchmarks, for the time being, with enhanced fall-back provisions, preferring to draft agreements without any reference to IBORs (including, for example, fixed rates). However this remains problematic in instances where a suitable alternative rate is not yet available. In most instances a future “amendment” option will be required and this is likely to have time and cost implications.
Parties should also consider the need for term sheet risk disclosures, warning about possible changes to the interest rate basis in the event that LIBOR is discontinued.
Q. Why can't we just say "if LIBOR is discontinued then the rate shall be SONIA"?
A. SONIA (certainly in its current form) is not a drag-and-drop replacement for LIBOR. They are fundamentally different rates, calculated and applied in different ways.
Q. Why are the markets pursuing a forward-looking term rate?
A. Loan market documentation, operations and systems are not currently set up to work with a backward-looking rate that fluctuates on a daily basis. There are practical difficulties for both borrowers and lenders in administering loan obligations on the basis of such rates. Transitioning to a rate that has more features in common with IBOR-based benchmarks will minimise the documentation, systems and operational challenges. That being said, regulators take the view that the market will need to adopt backward-looking compounded rates regardless (and/or that term rates will not be ready in time) and the industry is exploring the conventions for referencing such rates in new agreements.
Q. What about the potential for mismatches in e.g., hedging arrangements and other financial instruments?
A. Given the range of products and currencies involved, there is a significant risk that other financial products and instruments will adopt different successor rates. Counterparties in the loan markets should be alive to any basis risk and consider their options carefully when documenting new transactions or amending legacy arrangements. However there are concerted efforts to coordinate the transition away from LIBOR across financial markets, products and jurisdictions to avoid any potential disruption and instability this may cause.
Q. Will lenders and borrowers have to change their processes, operations and systems?
A. RFRs and LIBOR are not equivalent rates. They are calculated differently and, even with forward-looking term rates, it is unlikely that existing processes, operations and systems will be able to accommodate new benchmarks without significant adjustment, across the full range of currencies.
Check list of things to consider
- Finalise and action plans to mitigate the risks of IBOR discontinuance and reduce the dependencies on IBORs (across all products, not just loans).
- Review existing documents (legacy contracts) and the way your business uses IBORs. Consider the full range of products/instruments and currencies and the need to align your approach across swaps, bonds and loans.
- Take note of fallback and amendment provisions, cancellation and repayment terms, with a view to developing a strategy for remediating legacy contracts.
- Consider approaches to new loan issuances and refinancings, taking into account both and economic and operational factors relevant to the full range of alternative benchmark rates, with a view to future-proofing for benchmark rate transition (as a minimum) and/or ceasing new LIBOR loans early in 2021.
- Lenders should ensure client-facing teams are fully informed and working within regulatory parameters when discussing rate options for both new and legacy contracts and maintaining transparent dialogue with customers.
- Borrowers to be pro-actively aware of the most appropriate rate alternatives and relevant products. At the same time they should accelerate operational readiness for non-LIBOR benchmarks and gearing up for remediation of existing loans