LIBOR rates: transition has begun

As you have probably heard, 2021 is the last year where LIBOR can be used in corporate lending. This had been the recommendation of LIBOR’s regulator, the Financial Conduct Authority (“FCA”) for years, being officially announced in July 2017. This decision will have a great impact on financial transactions, given LIBOR’s global utilization. For instance in 2020, LIBOR was the benchmark index for over $400 trillion worth of contracts, with the syndicated loans comprising $12 trillion. The subject of this article is not to explore the reasons behind this recommendation, but rather to detail the different impacts of the LIBOR’s replacement in credit facilities, whether they are existing credit facilities with maturities spanning over 2021 and beyond, or new facilities to be implemented this year.

While it has been confirmed that the LIBOR will cease to be submitted after end-2021, it will not be possible to sign new LIBOR-based credit agreements within the year. The exact calendar however depends on the underlying currency, as the LIBOR is currently produced across 5 currencies (USD, GBP, EUR, CHF and JPY). Here is an overview of the situation.

 

LIBOR replacement with near Risk-Free-Rates (“RFR”)

In all for the 5 currencies affected by LIBOR’s cessation, working groups have been set up to identify and make recommendations on the most appropriate replacement rate. The purpose was specifically to identify a risk-free-rate that would be based on an active and liquid overnight interbank market.

GBP: The Bank of England (“BoE”) set up an industry-led Risk Free Rate Working Group (“RFRWG”) as soon as 2015 to start developing alternatives to LIBOR, and came up in 2017 with the SONIA (Sterling Overnight Index Average) as its preferred replacement. First introduced in 1997, the SONIA is already widely used, valuing roughly £30 trillion of assets each year, and is based on actual unsecured overnight transactions as it reflects the average of interest rates that banks pay to borrow.

USD: Anticipating the LIBOR cessation, the Federal Reserve appointed in 2014 a group of market participants to identify alternative reference rate. This group, the Alternative Reference Rates Committee (“ARRC”) came up with the Secured Overnight Financing Rate (“SOFR”) in June 2017 as its recommended alternative to USD LIBOR. Unlike the SONIA, the SOFR is based on overnight secured repo transactions, and its activity is much more recent, as its first fixing dates back to April 2018.

CHF: The Swiss National Working Group (“NWG”) recommended in October 2017 to use the Swiss Average Rate Overnight (“SARON”) as a replacement to the CHF LIBOR. It represents the overnight interest rate on the secured money market, and has already been included in Swiss syndicated facility agreements in 2020.

 

Replacement calendar and processes

In terms of timing related to the GBP LIBOR transition, both the BoE and the FCA recommend to cease new issuances of GBP LIBOR-referencing loans as soon as the end of Q1 2021. This means that starting from April 2021, credit agreements will be based on alternative methods of rate indexation, with the main scenario being the use of SONIA, with banks also advocating for the cost of funds definition. The ARRC has a slightly different approach and recommends to ban new USD LIBOR-based credit agreements by June 30th 2021. Recently, it has been announced that USD LIBOR will continue to be published until June 2023 (except for 1-week and 2-month tenors), which leave more time to amend legacy loans. In line with the GBP LIBOR, CHF LIBOR will also be discontinued by the end of 2021. Therefore the Swiss NWG recommends that no new contracts should reference LIBOR after the end of June 2021.

Regarding existing LIBOR-denominated credit agreements with no pre-empted LIBOR transition provision (“Legacy LIBOR Loans”), several options are available for borrowers.

• In the worst case, the transition has not been anticipated by the end of 2021. An amendment agreement will then be necessary to document the benchmark rate transition. However, this amendment will most likely require all Lenders’ approval, and would probably lead to a suboptimal outcome given the tight deadlines.
• Some banks may consider the insertion of a Cost of Funds provision to replace LIBOR. This alternative is based on each lender’s declarative cost of funds (or at least the Majority Lenders), conferring some discretion to the lenders, as opposed as a purely transaction-based rate such as a RFR. This solution is clearly unattractive for the borrowers.
• To avoid those situations, it is highly recommended to amend the existing credit agreement before the LIBOR cessation date in order to pre-empt the conditions under which the transition will effectively be conducted. Legacy LIBOR Loans can already be amended to directly calculate interest by reference to an RFR-based rate, thus deleting current provisions referencing LIBOR. It is also possible to amend credit facilities in order to include fallback provisions that would allow for a rate replacement at a later stage.

Fallback provisions overview

Most of the credit agreements signed after 2018 already include a “Replacement of Screen Rate” provision, based on a Loan Market Association (“LMA”) publication, specifying that under the discontinuation of the relevant LIBOR, the agreement would be amended with the Majority Lenders’ consent. However, since then, more sophisticated mechanisms have been drafted and are being included in credit agreements:

• The Hard-Wired Switch is a mechanism that allows for a switch from LIBOR to a RFR-based rate at a specified future date before the LIBOR cessation. This provision has been included in the September 2020 LMA Exposure Draft;
• The Hard-Wired Fallback is a mechanism that allows for the switch in relation with the occurrence of specific events related to LIBOR cessation or pre-cessation, not binding it to a specific date in the future. The ARRC published in June 2020 a recommended language related to this fallback for new USD LIBOR loans. The adoption of this provision remains however limited in Europe;
• In line with the 2018 LMA Replacement of Screen Rate provision, the transition can also be addressed through an amendment approach, which has been the favored solution so far. Less complex than Hardwired clauses, this allows for more flexibility in selecting the benchmark rate. This approach does not pre-empt the LIBOR replacement interest rate, but rather streamlines an amendment process (with a Majority Lenders’ approval) in case of LIBOR cessation.

 

LIBOR effective replacement in the interest calculation

One of the major differences between LIBOR and RFRs lies in their term. LIBOR fixings include a “term” element, a tenor spanning from overnight to 12 months. On the other hand, the RFRs are overnight borrowing rates, and therefore do not have a “term” element. Today, the LIBOR is fixed at the beginning of an interest period, using the appropriate term (e.g. 3-month LIBOR for a 3-month interest period). Since the RFRs are overnight rates, they can only be calculated by reference to historical transaction data, with a “backward-looking approach”.

The different RFRs regulators have started publishing compounded RFRs over the most commonly used interest periods (1, 3 and 6 months). One issue with this approach is that RFRs are not published on non-business days, resulting in a difference between interest period and RFR observation period.

Several methods for computing the compounded RFRs have been explored. Rather than deep diving into those calculations subtleties, it is important to underline that there is no market standard or even consensus for one calculation method. Some market participants have even advocated for forward-looking term RFRs rather than compounded ones. Those could be fixed at the beginning of an interest period as for the LIBOR. The working groups are currently opposed to this approach, as those “term” RFRs are not readily available and would partly lose their purpose of being solely based on overnight transactions.

Another major difference is that RFRs do not include credit risk elements as opposed to LIBOR, leading to a pricing gap between the rates. As a result, a credit spread adjustment has to be included to cover this pricing gap. The methodology to calculate this spread has already been determined for derivatives by ISDA: the median average difference between the two rates over 5 years. This spread is calculated and published by Bloomberg to be fixed on a cessation event. The ARRC and the RFRWG have already recommended this option. However, if a credit agreement is amended prior to a cessation event, spread adjustment would most likely have to be manually included in the documentation (in opposition of an automatic adjustment in the case of Hard-Wired Fallbacks). Bloomberg already indicatively calculates the fallback rates based on the ISDA methodology, so that it can be fixed on the Amendment date. As of February 8^th for instance, the indicative spreads to replace 3-month LIBORs were 0.3 bps for the SARON, 12 bps for the SONIA and 26 bps for the SOFR.

 

What about the EURIBOR?

Currently, the vast majority of EUR-denominated loans are based on EURIBOR and therefore are not impacted by the cessation of LIBOR, while LIBOR EUR is supposed to be abandoned and is not traded anymore currently.  EUR overnight index (EONIA) is already being replaced by the €STR with a transition deadline in January 2022, and even though there is a working group currently in the process of identifying potential RFR fallbacks for EURIBOR, no replacement is anticipated in a foreseeable future. Some credit agreements might however include a provision to amend the benchmark rate with a qualified lenders majority to smooth a potential transition.