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 However €STR, the preferred RFR for euro, will not be published until October 2019.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
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 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.
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