UK: The Transition From LIBOR To Risk-Free Rates - An Overview Of Recent Developments

Last Updated: 17 April 2019
Article by Catriona Lloyd, Matthew Sapte and Catherine Astruc

In our December 2017 article What now for LIBOR in finance documents?, we considered the initial reaction of regulators, industry bodies and market participants to the prospect that LIBOR might no longer exist after 2021. This note summarises the key developments since then.

IS IT ANY CLEARER WHEN OR IF LIBOR WILL DISAPPEAR?

In a speech on 21 February 2019, Megan Butler of the FCA commented that "in two years the production of LIBOR is likely to end". Not everyone sees this as inevitable. In December 2018, ICE Benchmark Administration Limited (IBA), LIBOR's administrator, launched a survey on the continued use of LIBOR, stating that "the results of the survey will be used to inform IBA's work in seeking the support of globally active banks for the publication of certain LIBOR settings after year-end 2021." However, regulators have been consistent in urging businesses to prepare for LIBOR to disappear after 2021.

Even to survive until the end of 2021, LIBOR has had to continue to evolve. To ensure LIBOR complies with the EU Benchmarks Regulation (BMR), the IBA began transitioning LIBOR panel banks onto a new "Waterfall Methodology" in April 2018. (In February 2019, EMMI published a blueprint for similar reforms to EURIBOR following a consultation in 2018.)

The BMR may nevertheless hasten LIBOR's demise. It imposes obligations not just on administrators and users of benchmarks, but also on benchmark contributors. LIBOR's panel banks have agreed with the FCA to continue submitting until the end of 2021. In deciding whether to continue submitting after that, they will have to weigh up the regulatory risks of doing so against the risks to their own business of LIBOR disappearing.

DEVELOPMENTS IN RISK-FREE RATES

Identifying preferred risk-free rates 

Across the full range of financial products that use LIBOR, regulators want market participants to use overnight risk-free rates (RFRs) instead. Regulators in the home jurisdictions of each of the five current LIBOR currencies have now identified the preferred RFR for their local currency. However €STR, the preferred RFR for euro, will not be published until October 2019. The Bank of England (BoE) completed reforms to SONIA, the preferred RFR for sterling, in April 2018.

RFR-based forward-looking term rates

There are disadvantages to using an RFR to price a loan or bond instead of LIBOR (or other IBORs). In particular:

  • the interest rate fluctuates daily, rather than being fixed at the beginning of each interest period; 
  • the parties therefore cannot determine the interest payable during an interest period until the end of that period (unless the parties use a "lag" mechanism – see below).  

In light of this, over the last year working groups and industry bodies have focused on developing forward-looking term rates based on RFRs (term RFRs), which are closer in nature to an IBOR. For example:

  • In July 2018, the BoE's Working Group on Sterling Risk-Free Reference Rates (the BoE Working Group) published a consultation paper on developing forward-looking term SONIA reference rates (TSRRs). It suggested the most feasible method of creating a TSRR in the short term was using data from the SONIA Overnight Index Swap (OIS) market. However, as SONIA OIS are generally traded over-the-counter rather than on a regulated exchange, it noted that "the necessary price transparency..is currently insufficient to produce a [term rate] based on firm quotes". One of the perceived advantages of RFRs over IBORs is that RFRs are in the main derived directly from transaction data, rather than from submissions. If some products instead transition to term RFRs, it is important that those term RFRs are also directly based on transaction data. Despite these hurdles, the BoE Working Group anticipated that a TSRR could be available in the second half of 2019. The BoE Working Group published a summary of responses to the consultation in November 2018, which broadly endorsed its suggested approach to developing a TSRR.
  • Meanwhile, in October 2018 IBA marched ahead by launching the ICE Term Risk Free Rates (RFR) Portal, in which it publishes daily forward-looking one, three and six month term RFRs for sterling. It calculates these using data from SONIA futures contracts and other published SONIA data. At the same time, it published ICE Term Risk Free Rates, a paper setting out its "preliminary methodology" for calculating these rates.

It remains to be seen whether the OIS markets or the futures markets will prove to be the main source of data for producing term RFRs, and whether a consistent approach will be taken across different currencies. But it seems clear that term RFRs will be underpinned by derivatives, and have highly complex methodologies.

Conventions for using RFRs

Despite its hopes for developing a TSRR, the BoE Working Group has emphasised that users of LIBOR should "progress their transition from LIBOR to the greatest extent possible, independently of any further progress on the development of a TSRR". To support this, in March 2019 it published a discussion paper on Conventions for referencing SONIA in new contracts. For parties wishing to measure interest by reference to SONIA itself (rather than a TSRR), this sets out a useful checklist of mechanical and operational considerations, including:

  • whether to calculate interest over the relevant period by compounding SONIA, or by applying a simple average of SONIA; and
  • whether the period over which SONIA is calculated - sometimes called an "observation period" - should "lag" (i.e. start and end a specified number of days before) the relevant interest period, so that the parties know the interest payable at the end of that interest period a few days in advance. 

MARKET CHANGES TO PRICING BENCHMARKS AND DOCUMENTS

Derivatives

In vowing to wean financial markets off LIBOR, regulators quickly identified derivatives as the product area most worryingly over-reliant on LIBOR. However, derivatives (excluding finance-linked swaps hedging IBORs) are also arguably more suited than other affected financial products to using RFRs instead. The FCA has reported that the notional traded monthly volumes of SONIA cleared, over-the-counter derivatives is already now broadly equivalent to that of sterling LIBOR.

Nevertheless, it is clear that if LIBOR does disappear soon, this will affect many existing derivative contracts. ISDA has taken a leading role in developing fallbacks based on RFRs to include in legacy IBOR-based contracts with a view to ensuring contractual continuity.  In July 2018 it began a consultation on how to calculate these fallbacks and published the responses in December 2018. The overwhelming majority of respondents preferred a "compounded setting in arrears rate" for the RFR, and a majority also preferred the "historical mean / median approach" for spread adjustment. After further consultation, it plans to incorporate the new RFRs and fallbacks as amendments to the 2006 ISDA Definitions (which will then flow through into the updated Definitions as and when they are launched) as well as publishing a Protocol to address legacy trades.

ISDA has already published a Benchmarks Supplement (in September 2018) and a Benchmarks Supplement Protocol (in December 2018). It did so primarily to help parties comply with the BMR by ensuring fallback mechanisms in their contracts are as robust as possible while IBOR fallbacks are finalised. But the Benchmark Supplement also provides that once IBOR fallbacks have been incorporated into the 2006 ISDA Definitions, they will automatically take precedence over other fallbacks on an "index cessation event".

In finance-linked hedging, market participants are also grappling with the risk that hedge accounting rules may not apply if there is a mismatch between the fallbacks in the derivative and those in the product it is hedging.

Lending

Lending has seen much more limited changes in pricing benchmarks and documents. LIBOR originated in the loan market and that market is more wedded than any other to its continuing use. We are not aware of any significant loans having been priced using RFRs to date, with the market waiting for  reliable term RFRs to become available. (The IBA's "preliminary" term RFRs for sterling appear to have gained little traction so far.)

There has also been little change to contractual interest fallback terms in the European loan market. Lenders may be taking the view that they will be able to rely on existing LMA fallback language on a discontinuation of the relevant benchmark. This is likely to give them their own cost of funds plus margin until alternative terms are agreed (however inconvenient this may be for agents and borrowers).

So if LIBOR does disappear soon, huge numbers of facility agreements will need to be amended on a deal by deal basis. In anticipation of this, the LMA published a revised "Replacement of Screen Rate" clause in May 2018. This potentially makes it easier to amend a syndicated facility on an actual or imminent discontinuation of LIBOR (or other relevant interest rate benchmark). It does so by providing that relevant amendments require Majority Lender, rather than all Lender, approval. The clause is therefore of limited scope and is not relevant to a bilateral facility.

The US loan market appears to be moving in a slightly different direction. The Alternative Reference Rate Committee launched consultations during the second half of 2018 on contractual fallback language across various products, including syndicated lending.  It asked whether, in anticipation of the discontinuation of US dollar LIBOR, market participants preferred to:

  • rely on a right to amend the pricing terms at the relevant time; or
  • "hard-wire" into the original loan agreement an automatic switch to an alternative rate based on a term RFR. 

Many respondents preferred the latter option, although a term version of SOFR (the preferred US dollar RFR) does not yet exist.

Debt capital markets

In July 2018, the BoE Working Group published New issuance of sterling bonds referencing LIBOR, which highlighted the risks of continuing to issue, offer or purchase bonds referencing LIBOR.

Some financial institution, sovereign and supranational issuers have begun to respond to that message, using "simple" RFRs to price their bonds. The FCA reported 15 issues of sterling bonds referencing compounded SONIA in the first seven weeks of 2019. The "observation period" for calculating the SONIA element of the interest accruing during an interest period would typically start and end five business days before the interest period itself. SONIA is also increasingly being used as the benchmark rate in new sterling-denominated securitisations.

Where LIBOR-referencing notes are still being issued, they will usually be subject to updated fallback and amendment mechanics. The nature of these mechanics depends on the type of capital markets product.

  • Securitisations. These usually include negative consent provisions which apply if LIBOR ceases to exist or the market no longer accepts it. The issuer can propose an alternative benchmark rate to the trustee and the bondholders. If it does so, and gives certain certifications about the alternative rate, the bondholders have a specified period (usually 30 days) to object. If enough bondholders (usually 10% or more) do so, the change will only be effective if approved by an extraordinary resolution of the bondholders. If no or fewer bondholders object, the proposals are deemed to have been approved. AFME has proposed model wording for these negative consent provisions, and is currently updating this to reflect current practice. 
  • Eurobonds and MTN programmes. Some new bonds provide that the issuer, in consultation with an independent financial adviser, is able to replace LIBOR with an alternative or successor rate without requiring bondholder consent, subject to certain prescribed conditions. Where there is a bond trustee, amendments to the bond conditions and trust deed would require its consent. But the bond trustee would be required to give that consent if the issuer provides certain certifications and satisfies specified conditions. Importantly, the bond trustee is therefore not exercising discretion in consenting to the amendment.

Issuers and holders of legacy LIBOR-based notes with tenors extending beyond 2021 should also review the fallback provisions in them and consider whether these should be amended. As the International Capital Market Services Association explained in its October 2018 Bulletin 181018/44:

  • if they are not amended, there is a risk that the notes could convert from a floating to a fixed rate on a discontinuation of LIBOR; and
  • this type of amendment is highly likely to fall outside the scope of a bond trustee's discretion, and so will require bondholder consent. 

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions