The transition from LIBOR to alternative rates over the next year represents one of the biggest changes to the financial services industry ever. With an estimated $370 trillion of LIBOR related activity globally, covering loans, bonds, derivatives, working capital and trade products, the LIBOR transition will significantly affect how contracts are priced and how risk is managed by market participants, lenders, borrowers and guarantors which use LIBOR as their operating model.
The article provides an overview of the LIBOR transition, including:
For further information and details about how Clyde & Co LLP may be able to assist you worldwide, or to discuss any points in the article, we invite you to contact us using the following email address: LIBOR@clydeco.com
LIBOR, the London Interbank Offered Rate, is generally still the most referenced short-term interest rate in the world, reflecting the average rate at which major banks can obtain unsecured funding in the London interbank market, in a specified currency and for a particular period. It is still being produced for five currencies (US Dollars, Sterling, Euros, Japanese Yen and Swiss Francs).
In the aftermath of the global financial crisis of 2007/08, there were widespread allegations of LIBOR manipulation dating back to the 1990s or even earlier. This resulted in significant fines being imposed on several international banks and a loss of confidence amongst market participants in the accuracy and reliability of LIBOR.
Since the crisis, fewer banks have been reporting their rates, which has resulted in a sharp decline in the number of transactions being recorded. Many banks have been discouraged from participating on the panel following concerns over the increased potential for liability, and many only continue to do so as their regulators compel them to.
To combat this trend, LIBOR has leant on "market and transaction data-based expert judgment". The benchmark rate has therefore become increasingly reliant on opinion rather than actual transactions, as originally intended. This development has led to the market becoming insufficiently liquid and has called into question the long-term sustainability of LIBOR.
In July 2017, the FCA announced that, after 2021, it would no longer compel panel banks to make submissions to enable the calculation of LIBOR, and in July 2018, recommended that market participants transition to alternative risk-free rates.
Broadly speaking a RFR is a benchmark rate generally based on overnight deposit rates. As they are derived from a large volume of real observable transactions, they are considered "risk-free".
Although this article focuses on Sterling and US Dollars, the table below provides an overview of the working groups and proposed RFRs across several key jurisdictions in the lending market:
CURRENT INTEREST RATE
PROPOSED ALTERNATIVE RFR
SECURED OR UNSECURED
|Sterling Overnight Index Average (SONIA)||Bank of England (BoE)||Unsecured||Working Group on Sterling Risk-Free Rates|
|US dollar LIBOR||Secured Overnight Financing Rate (SOFR)||Federal Reserve Bank of New York||Secured||Alternative Reference Rates Committee|
|Swiss franc LIBOR||Swiss Average Rate Overnight (SARON)||SIX Swiss Exchange||Secured||Swiss National Working Group|
|Japanese yen LIBOR||Tokyo Overnight Average Rate (TONAR)||Bank of Japan||Unsecured||Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks|
|Euro LIBOR/EONIA||Euro Short-Term Rate (€STR)||European Central Bank (ECB)||Unsecured||Working Group on Euro Risk-Free Rates|
|EURIBOR||Imminent discontinuation is not envisaged but €STR can be used as an alternative or fall-back rate.|
|Canadian Dollar Offered Rate (CDOR)||Imminent discontinuation is not envisaged but Canadian Overnight Repo Rate Average (CORRA) can be used as an alternative or fall-back rate.||Bank of Canada took over, as administrator, from Refinitiv Benchmark Services (UK) Limited, on 15 June 2020.||Secured||Canadian Alternative Reference Rate Working Group|
As they are based on real observable transaction data, RFRs are considered more robust and stable; SONIA, for example, reflects the average interest rate that banks pay to borrow sterling overnight from other institutions. SONIA also tracks the Bank of England Bank Rate very closely, and the compounded rate is relatively stable and predictable.
The nature of these RFRs does, however, raise a number of issues if they are to be used as an alternative to LIBOR in financial instruments. For example:
As part of the transition process, in line with guidance provided by the Working Group on Sterling Risk-Free Reference Rates, parties will be expected to take the following steps:
STEP 1: Review the outstanding loan for LIBOR referencing loans (including multi-currency loans containing a LIBOR option).
STEP 2: Identify the alternative RFR to be used for each loan.
It is worth mentioning that an option being considered by Working Groups is a backward compounding of RFRs in arrears with a lag mechanism. Compounding in arrears involves aggregating overnight rates over a period to derive an interest payable at the end of the period. Such final interest payment is known a few days before it becomes payable.
STEP 3: Understand how the alternative RFR will be calculated, and how to calculate any economic difference between LIBOR and the selected RFR.
STEP 4: Consider whether treasury management and loan systems and operations can accommodate the alternative RFRs.
STEP 5: Document the transition of the loans.
All parties should undertake appropriate due diligence on any changes that are proposed.
In order to facilitate a successful transition from LIBOR to RFRs by the end of 2021, the Working Group on Sterling Risk-Free Rates advocates the following roadmap to document amendments to loan agreements maturing after the end of 2021:
Loan Agreements maturing after the end of 2021
End of Q3 2020 to end of Q1 2021
End Q1 2021 to end of 2021
|Existing LIBOR referencing loan agreements||Must be amended to be based on RFR (unless a switch mechanism has already been included)||Should now be based on an RFR following amendment exercise in previous period.|
|Existing LIBOR referencing loan agreements being amended or replaced due to a refinancing||Must (i) be amended to be based on an RFR or (ii) include provisions to assist with conversion to an RFR, for example a switch mechanism.||Must be amended to be based on an RFR (unless a switch mechanism has already been included).||Should now be based on an RFR following amendment exercise in previous period.|
|New loan agreements||Must (i) be based on an RFR or (ii) include provisions to assist conversion to an RFR, for example a switch mechanism.||Must be based on an RFR.||Must be based on an RFR.|
(a) each new loan agreement should be documented to incorporate the chosen RFR or include, where possible a switch mechanism to an RFR; and
(b) legacy loan agreement (i.e. a loan agreement which extends beyond 2021) should be amended by an amendment agreement to either incorporate the chosen RFR or, include where possible a switch mechanism to an RFR.
To assist with the transition, the Loan Market Association (LMA) has published a number of "exposure drafts" of their precedent documents. This includes:
(a) a draft multicurrency term and revolving facilities agreement incorporating rate switch provisions and term sheet for multicurrency term and revolving facilities agreements incorporating rate switch provisions to satisfy the working group's recommendations that contractual arrangements should comprise pre-agreed conversion terms;
(b) draft replacement of screen rate wording, which is predominantly suited for insertion into bilateral loan agreements and provides that the parties will agree amendments (with the consent of obligors and the lender(s)) to the loan agreement to incorporate an RFR to satisfy the working group's recommendation that contractual arrangements should comprise agreed process for renegotiation; and
(c) a draft Reference Rate Selection Agreement for use when transitioning syndicated loans whereby all parties agree the key commercial terms, but then delegate authority to the facility agent and obligors to make the necessary changes. This is particularly useful when any majority lender consent threshold is high and, therefore, impractical for making amendments where majority lender consent would otherwise be required.
In addition to considering the appropriate RFR to be chosen, and how to incorporate it into the loan agreement, parties will need to consider a number of other terms in the loan agreements, for example:
As part of the transition process, there are also likely to be additional conditions precedent for such transition to be met:
Whether it is an interest rate swap agreement, a cross-currency swap agreement or another hedging arrangement, the existing fall-back provisions in such hedging agreements should be reviewed.
If a derivative contract incorporates LIBOR, then it will need to deal with a transition to an alternative RFR.
On 23 October 2020, ISDA (International Swaps and Derivatives Association) published:
The Supplement and the Protocol are voluntary, and market participants may opt to use different fallback rates, if either preferred or required. The Protocol and the Supplement provide robust fallback provisions to be applied upon the permanent cessation of IBOR or any pre-cessation of LIBOR announcement.
On the assumption that the parties use ISDA documentation, we have summarised the main points to note ahead of the transition:
It is recommended that market participants amend their existing ISDA Master Agreements and other derivative contracts to incorporate new RFRs.
The Supplement amends the 2006 Definitions to incorporate certain RFRs and terms necessary to implement the new RFR.
For contracts that are already in place, the parties may enter into the Protocol to incorporate the fallback RFRs.
AUTOMATIC INCORPORATION OF TERMS
Market participants should access the Protocols section of the ISDA website, enter the required information and pay the applicable fee.
An adherence letter is to be signed and uploaded into the protocol system.
Once approved and accepted by ISDA, the adhering party will receive an email confirmation of their adherence to the protocol and the contract will incorporate the new fallback RFRs, avoiding the need for any separate negotiation and agreement between those parties.
The Supplement and the amendments made by the Protocol take effect on 25 January 2021 and will apply upon the cessation of IBOR (or any pre-cessation of LIBOR announcement).
The RFRs selected by ISDA are overnight, risk-free rates.
Two adjustments are made to the RFRs to function as fallbacks for their corresponding IBORs and, effectively, to arrive at a "compound" RFR, similar to that considered above:
Such adjustments are included in the Supplement and Protocol.
For parties that do not use ISDA documentation, each legacy contract should be re-negotiated to incorporate the new fallback RFRs (or any other applicable rate if the RFR is not appropriate).
On 1 July 2020, the Financial Stability Board confirmed that, whilst acknowledging temporary disruptions and delays due to the pandemic, all jurisdictions should continue to ensure that their transition programmes enable them to transition to LIBOR alternatives before the end of 2021.
For further information and details about how Clyde & Co LLP may be able to assist you worldwide, or to discuss any points in the article, we invite you to contact us using the following email address: LIBOR@clydeco.com.