Watson Farley & Williams on LIBOR Transition: What? Why? When? How?
“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”).
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).
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.
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.
Information Source: Read Full Report ..LIBOR TRANSITION: WHAT? WHY? WHEN? HOW?
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