LIBOR is likely to come to an end after 2021. In the global financial and leasing markets, loans, leases, bonds, hedging, sale and purchase and other agreements worth trillions of dollars annually use LIBOR in their interest rate calculations. Despite this, 18 months after the likely end of LIBOR became apparent in 2017 there is no replacement interest rate that can be plugged into aircraft leasing or finance documents as a direct LIBOR substitute. Accordingly, we examine below:
- what has led to "LIBOR discontinuance";
- the search for LIBOR replacements;
- what aircraft financiers and lessors can do to prepare for the end of LIBOR.
Why is LIBOR ending?
Despite many market participants strongly preferring to keep LIBOR, its likely discontinuance after 2021 is a product of:
- global financial regulatory reforms requiring benchmark interest rates to be calculated with greater rigour and transparency and using real underlying transactions (rather than expert judgment);
- the post-2008 financial crisis drying up of much of the wholesale term lending among banks in the London market for many of the tenors and currencies in which LIBOR has been calculated; and
- the UK's Financial Conduct Authority announcing in July 2017 that it will no longer seek to compel or persuade increasingly reluctant LIBOR panel banks to continue making their submissions beyond the end of 2021. Without that persuasion or compulsion, it is likely that many panel LIBOR banks will be unwilling to continue with that role.
What will replace LIBOR?
LIBOR is to be replaced by a number of "risk free rates" (RFRs). Each currency for which LIBOR is currently quoted will have its own RFR. Each RFR will be:
- based on the rates charged in overnight lending in that currency in the previous 24 hours among banks and other financial institutions in the principal financial centre for that currency; and
- regulated by the central banking or other financial regulatory authorities in the country of that currency.
Three of the key RFRs are:
- US Dollars – SOFR (the Secured Overnight Financing Rate), which is a (secured) repo rate administered by the Federal Reserve Bank of New York;
- Euro – ESTER, an unsecured rate that the European Central Bank will administer; and
- Sterling – SONIA (the Sterling Overnight Index Average), an unsecured rate administered by the Bank of England.
Apart from ESTER, which is to be published from October 2019, the RFRs mentioned above are already being published. By themselves, however, these RFRs are not a direct replacement for LIBOR. This is because LIBOR:
- is a forward-looking term interest rate;
- measures bank credit and term risk over (for example) a one, three or six month period.
RFRs, however, are backward-looking rates (looking back over the previous 24 hours) that do not measure bank credit or term risk to any material degree. Instead, they are designed to be as near risk free rates as you can get when using interest rate quotations from real world interbank lending.
It may, in theory, be possible in future for new aircraft leases, loans and related agreements to use a raw RFR as an interest rate benchmark. However, raw RFRs cannot simply be slotted into existing leases or loans to replace LIBOR because, as noted above, raw RFRs do not price in the same risks as LIBOR. If an existing aircraft lease (or related loan) did replace LIBOR with a raw RFR, the lease or loan would need to be significantly amended to bridge the gap between the RFR being slotted in and the LIBOR rate it replaces. Alternatively, the RFR being slotted in would have to measure term and bank credit risk, or their equivalent, to a greater degree than the raw RFRs developed to date. This latter approach is being taken in the search to replace LIBOR by looking for methods to:
- produce term RFRs that can, for example, fix interest rates for the most common LIBOR tenors; and
- find a way to bridge the pricing gap between LIBOR and the raw and term RFRs that are to replace it.
Producing term RFRs is proving harder than the initial task of coming up with the raw overnight RFRs. Among other difficulties, there is a debate over whether term RFRs should be forward or backwardlooking. Most market participants strongly favour forward-looking term RFRs. Some regulators prefer backward-looking term RFRs.
Forward-looking term RFRs
A forward-looking term RFR would work in the same way as, for example, interest rate fixing under a syndicated loan. The rate is fixed at the beginning of each interest period. That rate then applies in advance to that interest period so that the parties know at the start of the interest period how much interest is due at its end.
Backward-looking term RFRs
With a backward-looking term RFR, the interest rate is fixed at the end of the interest period, or other period to which it applies. So again, with a syndicated loan, a backward-looking term RFR would involve interest being calculated at or near the end of each interest period. There are many practical disadvantages, and greatly increased administration costs, to fixing the interest rate in this way, which have made this proposal very unpopular with market participants.
Bridging the pricing gap between LIBOR and the new RFRs
To bridge this gap, the search is on for a way to price term and bank credit risk, or their equivalent, back into the new RFRs. There is no agreed methodology for doing this to date. One common theme is the use of credit spreads. If credit spreads are used, a separate spread for each currency and tenor could be added to each new raw RFR. In theory, the resulting rate should be equivalent, or closer, to the rate one would have had if LIBOR had continued. Other methodologies are being examined.
What should aircraft financiers and lessors do?
Aircraft financiers and lessors would be prudent to consider whether their current or future transaction documents which use LIBOR and which may run beyond 2021 contain robust language:
- providing a fallback interest calculation method that would work for the remainder of the transaction; or
- providing an efficient process for replacing any LIBOR-based interest rate calculation, or fallback interest rate calculation that can only work in the shortterm,
that would kick in if LIBOR were to end during the transaction.
An efficient process in a free-standing aircraft lease might involve, for example:
- the lessor and the lessee agreeing to negotiate in good faith for a set period to find a replacement for LIBOR in their lease. Failing such agreement, the interest rate might be based on the lessor's cost of funds from whatever source it reasonably selected; or
- adopting a fixed rate (and entering into related hedging agreements).
For any syndicated loan linked to an aircraft lease, an efficient process might involve replacing LIBOR by majority lender consent rather than all lender consent. However, the smaller the likely syndicate the less need there is to move away from all lender consent.
For English law syndicated loans, the Loan Market Association has produced a Screen Rate Replacement clause for this purpose, which has the option of agreeing amendments with majority lender consent, as well as with the consent of the borrower(s) or its (or their) parent. Where the syndicated loan is linked to a finance lease, for example, the lessee would want its consent to be required as well.
The Screen Rate Replacement clause can optionally be triggered in a wide range of situations in which it may be desirable to substitute a new rate for LIBOR. This is done by adopting the defined term "Screen Rate Replacement Event". The clause also contemplates a range of related amendments – such as replacing the fallbacks from LIBOR with fallbacks from the replacement rate for LIBOR.
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