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LIBOR Transition: What? Why? When? How?23 November 2020

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Synopsis

With the expectation that the publication of the London Interbank Offered Rate (LIBOR) will cease by the end of 2021, financial market participants need to be planning the transition of all LIBOR-based exposures to risk-free interest rates in the next six to twelve months. Working groups for the key currencies have identified the proposed benchmark rate for each of those currencies and are developing recommended conventions for the application of those benchmark rates. In addition, proposed legal drafting for the incorporation of those conventions into existing and new transactions is available. We recently advised the lender on one of the first project financings to be done using SONIA from financial close and we are currently advising on a number of other financings using risk free interest rates. In this briefing, we bring together our experience on these transactions to explore some of the challenges arising in the context of financing structures using interest rate hedging in relation to specific loan interest exposures (as opposed to more generic corporate hedging arrangements), such as project and asset backed finance (as seen in the aviation, real estate and shipping industries).

"Working groups for the key currencies have identified the proposed benchmark rate for each of those currencies and are developing recommended conventions for the application of those benchmark rates."

What is LIBOR Transition?

“LIBOR transition” is the movement of the financial markets away from using LIBOR as the interest rate benchmark to using alternative “risk free” benchmark rates (“RFRs”).

The background to the use of LIBOR

Since the inception of the syndicated loan market, pricing for loans has been set by reference to the interest rate at which deposits were offered by banks to other prime banks in that market – interbank offered rates or IBORs – with London being the leading market – the London interbank offered rate or LIBOR. This is because in the early days of the loan market banks funded their participations in loans by taking deposits in the interbank market for the relevant currency and tenor (interest period). Published IBORs were based on the panel banks’ submissions of the rates the panel banks considered they could be offered in the interbank market when transacting in reasonable market size¹. As the loan markets developed, LIBOR was quoted for a wide range of currencies and tenors and, as a result of its ease of use, found its way into a wide range of financial contracts (particularly derivative contracts) and other commercial arrangements as a pricing source.

However, over the years, banks have moved away from funding through the interbank market (it became a theory rather than a practice) and now fund themselves from other sources. New market participants (such as debt funds, insurers and the like) fund themselves from sources other than the interbank market.

The identification of appropriate RFRs

In the UK, the Sterling Risk-Free Reference Rate Working Group (the “Working Group”) has recommended the use of the Sterling Overnight Indexed Average (SONIA) and in the US the Alternative Reference Rate Committee (ARRC) has recommended the use of the Secured Overnight Financing Rate (SOFR) as RFRs to replace sterling and US dollar LIBOR respectively. Similar working groups in the relevant markets have recommended RFRs to replace LIBOR for currencies in those markets: Swiss Average Overnight (SARON) for Swiss Francs, Tokyo Overnight Average Rate (TONAR) for Yen and the Euro short term rate (€STR) for Euros. In this briefing, we will focus on SONIA and SOFR.

  • SONIA is administered and published by the Bank of England based on actual transactions and reflecting the average of the interest rates banks pay to borrow sterling overnight from other financial institutions and institutional investors; and
  • SOFR is published by the New York Federal Reserve based on transactions in the Treasury repurchase market where banks and investors borrow or lend Treasuries overnight.

An RFR is a different construct to an IBOR. Simply substituting an IBOR for a currency with the chosen RFR for that currency is not an easy or straightforward process because of the way in which the rates are formulated, set and administered.

"Following the investigation of scandals relating to the setting of IBORs arising from the 2008 liquidity crisis, regulators focussed on reforming how IBORs were set (by regulating the submission process) and encouraged market participants to consider RFRs."

LIBOR is a “forward-looking” term rate – this means the rate is fixed and known at the start of an interest period. RFRs are “overnight” rates and can only be produced on a backward-looking basis, although work is being done to develop a projected RFR that could be used on a forward-looking basis as a term rate. For now, however, the RFR-based interest rate for a period can only be determined using historical overnight rate data at the end of that period. The following table summarises the key differences:

 SONIASOFRLIBOR
TenorOvernight

Backward-looking and historic
Overnight

Backward-looking and historic
7 tenors from overnight to 12 months

Forward-looking
CurrenciesGBPUSDGBP, USD, YEN, SFR and EURO
Publication Time09.00 (London) on the following London business day (T+1)08.00 (EST) on the following New York business day (T+1)11.55 (London) on the London business day (T) for GBP and two London business days before (T-2) for the other currencies
Concept MeasuringUnsecured overnight borrowingSecured overnight borrowingUnsecured borrowing for the period in question

Why are the markets moving away from LIBOR as the benchmark rate?

Following the investigation of scandals relating to the setting of IBORs arising from the 2008 liquidity crisis, regulators focussed on reforming how IBORs were set (by regulating the submission process) and encouraged market participants to consider RFRs. In 2017, the Financial Conduct Authority (FCA) announced that it would no longer use its powers to compel market participants to make submissions for determining LIBOR after the end of 2021. The FCA cited a lack of activity in the underlying interbank markets as a key concern and reasoned that “if an active market does not exist, how can even the best run benchmark measure it?” Consequently, the market anticipates that LIBOR (at least in its current form) is likely to cease to be published after the end 2021.

"Given the expectation that LIBOR will cease to be published after the end of 2021, action by lenders, hedge providers and borrowers is required now."

When are market participants expected to start using RFRs?

Given the expectation that LIBOR will cease to be published after the end of 2021, action by lenders, hedge providers and borrowers is required now.

The Working Group published recommendations that from 1 October 2020, lenders should be offering loan products based on RFRs or if not, all LIBOR-based loan products should include clear contractual arrangements to facilitate (either through pre-agreed conversion terms or an agreed process for renegotiation) the move to SONIA or other RFRs. It further recommended that all new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.

The Working Group has recommended that by the end of Q4 2020, lenders should have identified all legacy contracts for conversion and be progressing with their conversion; by the end of Q1 2021, lenders should accelerate the conversion of legacy loans and by the end of Q2/Q3 2021 that conversion should be completed.

The ARRC has recommended that new US dollar business loans begin using RFRs by no later than 30 September 2020 and no US dollar business loans referencing LIBOR be made after the end of Q2 2021.

In October 2020, the International Swaps & Derivatives Association (ISDA) published the ISDA 2020 IBOR Fallbacks Protocol. Adherents to this protocol agree that with effect from 25 January 2021, derivatives transactions governed by ISDA documentation and in place on or before that date between adherent parties will incorporate the IBOR Fallbacks Supplement. The effect of this is that the IBOR Fallbacks Supplements provisions around the triggers for switching to the applicable RFR and the details of that RFR and the fallbacks associated with unavailability of the RFR will apply to all ISDA arrangements between adherent parties unless a specific bespoke agreement is made. The Financial Stability Board is encouraging adherence as soon as possible. New derivatives transactions governed by ISDA documentation entered into from 25 January 2021 will automatically incorporate the IBOR Fallbacks Supplement unless the parties agree to exclude them.

How will LIBOR Transition be achieved?

In the types of transactions on which this article is focussed, namely those where interest exposure under loans is hedged under related interest rate hedging, there are three main categories to consider:

  • existing financings expected to remain in place beyond the end of 2021, for which an amendment agreement will be required;
  • new financings expected to be in place beyond the end of 2021, which should either use the RFR from the outset or have built in a clear contractual mechanism to facilitate conversion to an RFR before the end of 2021; and
  • “tough legacy” financings, which are existing financings, more typically of a capital markets nature, where it is not thought to be possible to achieve the consensus required among the creditors to make the necessary amendments. Tough legacy financings are outside the scope of this article and are expected to be resolved using legislation.

"In September 2020, the Working Group recommended that SONIA should be calculated using a non-cumulative compounded in arrears methodology using a five banking day look-back without an observation shift."

For both existing financings referencing LIBOR and new transactions, the first step is to understand the differences between the recommendations of the various working groups and how to reconcile them in the context of the specific transaction. In relation to existing transactions and new transactions that are not RFR-based from the outset, the additional point to address is the timing of the transition of that particular loan (sometimes referred to as the “switch”).

Working group recommendations

Market participants and industry groups have been refining how RFRs may operate in the loan and derivatives markets and the market conventions which will need to be adopted to facilitate this: the basis for compounding (rate vs balance), cumulative or non-cumulative interest, length of look-back period (generally a short period allowing payment certainty for borrowers when using an in-arrears rate), inclusion (or not) of an observation shift (where the RFR for each day during the interest period is weighted according to the observation period and not the relevant interest period) and rounding conventions, amongst others. It should be noted that all working groups recognise that their recommendations may not be the most appropriate outcome for every transaction and parties are free to use amended or alternative mechanisms.

In September 2020, the Working Group published recommendations that SONIA should be calculated using a non-cumulative compounded in arrears² methodology (with conventions for how that should operate) using a five banking day look-back without an observation shift. This aligns in some respects with the approach recommended by the ARRC for SOFR.

The ARRC recommends the use of a term SOFR, with simple daily SOFR (using a five banking day look-back without an observation shift) as the initial fallback should that not be available.

As contemplated in the ISDA 2020 IBOR Fallbacks Protocol, with effect from 25 January 2021 derivatives transactions governed by ISDA documentation and in place on or before that date between adherent parties will incorporate the IBOR Fallbacks Supplement and await, from that point, the occurrence of a cessation event triggering the replacement provisions.

The following table compares, at a high level, the recommended conventions of the Working Group, ISDA and the ARRC.

"The Working Group recommends that accrued interest is to be paid at the time of prepayment, and if a floor is included, it is to be calculated on a daily basis."

TopicARRC (NY law governed, USD loans)ISDAWorking Group (English law, sterling loans)
Primary benchmark rateTerm SOFR³+ Benchmark Replacement AdjustmentTerm-adjusted SONIA/SOFR plus the spread as shown on the Bloomberg Screen for the designated periodNon-cumulative daily compounded SONIA, with the alternative of cumulative daily compounded SONIA⁴, in each case plus an agreed credit spread adjustment
Fallback proposals if primary benchmark rate is not available (i) Daily Simple SOFR + Benchmark Replacement Adjustment;

(ii) Agreed replacement rate + Benchmark Replacement Adjustment
Temporary unavailability: Term-adjusted SONIA/SOFR + the spread as most recently provided

SONIA/SOFR cessation: central bank or regulatory committee Recommended Rate + spread
Central bank rates
Spread adjustment⁵The Benchmark Replacement Adjustment if using Term SOFR or Daily Simple SOFR: the first that the agent can determine of (i) the spread adjustment selected or recommended by the relevant governmental body and (ii) the spread adjustment that would apply to a derivative transaction under the ISDA Definitions (after LIBOR cessation).

If the replacement rate is a rate agreed between the agent and the borrower, the adjustment is also as agreed between them.
As announced on Bloomberg and based on the median over a five-year period of the historical differences between LIBOR in the relevant tenor and SONIA/SOFR compounded over each corresponding periodMethodology to be agreed between the parties
Look-back periodARRC recommended or, if the agent considers this unfeasible, a period selected by the agent.Two business days Five business days
Switch triggerSpecified public statements by the administrator of USD LIBOR (or by its regulatory supervisor) of the permanent or indefinite cessation of the publication of USD LIBOR for all tenors, or that USD LIBOR has ceased to be representative; or
Notice by the agent to the other parties that at least [5] publicly available syndicated facilities, currently outstanding, are using a SOFR-based rate, together with the agreement by the agent and the borrower to trigger the switch.
Specified public statements by the administrator of the relevant LIBOR (or by its regulatory supervisor):
(i) of the permanent or indefinite cessation of the publication of that LIBOR for all tenors; or
(ii) that that LIBOR has ceased to be representative of the underlying market and economic reality that LIBOR was intended to measure, that such representativeness will not be restored and that such announcement is made in the awareness that contractual triggers will be activated by such announcement.
Other observationsARRC recognises that users may wish to use, as the primary benchmark rate or one of the fallback limbs, a Daily Compounded SOFR to align more closely with derivatives, or to use an advance rate based on SOFR Averages, which operates more like LIBOR.

Any floor should be applied daily to the combination of the benchmark rate and the spread adjustment.
ISDA distinguishes between a screen rate not being available because its publication has ceased, as opposed to a more temporary unavailability of the rate.On prepayment, accrued interest is to be paid at the time of prepayment.

If a floor is included, to be calculated on a daily basis.

"It will be important to tailor the suggested drafting to align the different parts of the transaction, whether across currencies or with hedging products, as well as to fit the specific transaction."

Documentation

The ARRC has published wording that market participants may want to use in amending existing facility agreements, or in preparing documentation for new financings, that reflects the ARRC’s recommendations but does leave a number of important factors for the agent or lender to decide unilaterally at the time of the switch and amend the document to reflect.

As noted above, ISDA has published a protocol enabling parties adhering to it to automatically apply a supplementary set of provisions to transactions covered by the protocol which introduce a switch mechanism to the ISDA recommendations. They will also automatically apply, unless excluded, to all new derivatives transactions governed by ISDA documentation entered into after 25 January 2021.

The Loan Market Association, working with the Working Group, has produced exposure drafts (i.e., for discussion but not formally recommended) that reflect the Working Group’s proposals for sterling LIBOR, and developing additional mechanisms and drafting consistent with that. Those drafts include similar proposed wording for other currencies based on the Working Group’s recommendations for sterling but does not reflect the conventions recommended by the separate working groups for those other currencies such as those published by the ARRC in July 2020 in relation to SOFR transactions.

The existence of these various sets of drafting will be helpful to parties in preparing documentation, whether for amendment or new transactions. However, as can be seen from the comparison table above, it will be important to tailor the suggested drafting to align the different parts of the transaction, whether across currencies or with hedging products, as well as to fit the specific transaction.

Market fragmentation

Market practice for using published screen rates for LIBOR (and associated fallbacks in the absence of a screen rate) is straightforward and transparent (even if the setting of the rate is not).

At least until the market develops further, given the number of different RFR conventions available and the suitability of those conventions to different lending institutions and transaction structures, we anticipate that parties will agree to calculate RFRs in different ways for bilateral financings and across different lending syndicates (depending on the presence of interest rate hedging specific to the loan, the nature of the lender and the identity of the facility agent or calculation agent). For borrowers with loan arrangements with different lenders, this may mean tracking and paying different rates for the same RFR. In addition, for multicurrency borrowings the RFR for each currency is likely to be calculated in a different way, in particular if a mix of term and in arrears rates are used. Loan documentation is going to become longer and more complex.

"With no standard approach to transition from LIBOR, different financial institutions may have different requirements and different approaches and borrowers will be looking to minimise the number of different arrangements they need to deal with."

What should you be doing now?

Borrowers have had (and continue to have) many issues to deal with. LIBOR transition may not be top of that list, but if you have arrangements which reference or refer to LIBOR you need to take action now.

Step one is the planning process and is of general application:

i) identifying contractual arrangements (including internal and external funding arrangements, interest rate derivatives and commercial contracts with LIBOR as a benchmark for, say, default interest) that extend beyond the end of 2021; and

ii) modifying accounting and operational systems to handle both existing LIBOR-based loans and loans referencing RFRs going forward (for example, previously, interest costs for a loan could be booked and accounted for at the beginning of an interest period; with loans referencing RFRs, these costs won’t be known until the end of the period).

Step two, in the context of loans with related interest rate hedging:

For existing loan arrangements extending beyond the end of 2021:

i) Check whether the existing terms of the loan and interest rate hedging arrangements provide for conversion terms or an agreed process for renegotiation, or any other kind of fallback arrangement. Prioritise dealing with those with no, or inadequate, provisions;

ii) Check whether, in syndicated financings, the consent level among the lender group for agreeing a replacement benchmark rate is a majority or an “all lender” decision and what voting rights hedge counterparties have in the process for replacing the loan benchmark rate. This will inform priority and strategy for reaching an agreement on those financings;

iii) Consider the implications of the transition on the financial covenants and any financial model; and

iv) Discuss transition arrangements and inform other parties of your own plans and processes. With no standard approach to transition from LIBOR, different financial institutions may have different requirements and different approaches and borrowers will be looking to minimise the number of different arrangements they need to deal with.

As with any significant amendment to debt terms in a secured financing, an eye must be had to the implications for the security package and any guarantees. In the context of ship financings, this forms part of the discussion in our article here.

For new loan arrangements:

Consider whether these should reference an RFR from the outset. If LIBOR-based, you will still need to consider pre-agreed conversion terms or an agreed process for renegotiation now. If entering into documentation now which contemplates an agreed process for renegotiation, consider how the costs of that renegotiation will be allocated between the parties; from transactions we are seeing now this tends to be a borrower cost. Entering into a fixed rate loan may be an alternative option (although default interest rates would typically reference a rate for calculation).

"If entering into documentation now which contemplates an agreed process for renegotiation, consider how the costs of that renegotiation will be allocated between the parties; from transactions we are seeing now this tends to be a borrower cost."

For both existing financings that require amendment and new financings:

i) Manage the transition of interest rate hedging arrangements and the corresponding loan arrangements in parallel. In particular, consider aligning:

a) whether to amend or close out any interest rate hedging;

b) timing of the switch to an RFR;

c) the RFRs applicable under the loan and the interest rate hedging;

d) the conventions around that RFR, such as term or in arrears, compound or simple, cumulative or non-cumulative, duration look-back period, with or without observation shift; and

e) the fallbacks if the RFR ceases to be available, whether temporarily or permanently.

ii) Manage the transition of different currency facilities in parallel, considering many of the same points as outlined above too. For multicurrency facilities where some currencies can continue on term rates and others use “in arrears” rates, particular consideration will have to be given to the transition between currencies;

iii) Many lenders will have a position on whether certain provisions typical of a LIBOR-based loan will apply and if so, with what modifications but to the extent that they have not or different lenders within a lending syndicate take different view, consider the applicability of provisions such as:

a) “Cost of funds” as the ultimate fallback arrangement;

b) Interest rate floors;

c) Compounding (or not) of the adjustment spread;

d) Market disruption;

e) Break costs;

f) Intra-period prepayments and loan transfers and the timing of the payment of accrued interest; and

g) Pro rata settlement of interest.

We are advising lenders and borrowers on their approach to LIBOR transition for documenting amendments to existing transactions and new transactions going forward, including documenting new transactions referencing RFRs with both pre-agreed conversion terms and an agreed process for renegotiation. Please contact one of the authors or your usual WFW contact if you would like to discuss LIBOR transition and its impact on your financing arrangements.

This article was authored by London Partners Richard Hughes, Daisy East and Rob McBride, and Professional Support Lawyers Elaine Ashplant and Sarah Tighe.

[1] The LIBOR question being: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?

[2] Compounding the rate.

[3] A forward-looking rate selected by the Relevant Governmental Body (Board of Governors of the Federal Reserve System or Federal Reserve Bank of New York or a committee endorsed by them) relating to a Corresponding Tenor (a period equivalent to a LIBOR tenor).  It is not certain that such a benchmark will be approved before discontinuation of LIBOR.

[4] The cumulative rate adds complexity when supporting intra-period prepayments or loan transfers. If the recommended rounding conventions are used, the overall effect of cumulative or non-cumulative will be the same.

[5] Reflecting the economic difference between the relevant IBOR and the replacement RFR. It may not be a specified limb in new transactions, where it is already taken into account in, e.g., the margin, although care should be taken to ensure compounding is applied appropriately in that situation.

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