The search for an alternative benchmark in derivatives and loans markets

1. Overview

The financial crisis crystallised a number of key issues with interest rate benchmarks used and relied on in the financial sector. Most importantly, it became increasingly clear that the unsecured interbank lending market which LIBOR and other interbank offer rates (or "IBORs") are based on is virtually non-existent, as banks have come to rely on other forms of funding. The lack of depth to this market contributed to the IBOR manipulation scandals, which in turn have led to increasing calls for a more robust benchmark to replace the IBORs.

In the UK, the FCA CEO, Andrew Bailey, stated in July 2018 that LIBOR will be discontinued after 2021. The FCA, as the regulating body that oversees the publication of LIBOR, has made it clear that firms need to make plans for transition to an alternative benchmark rate in advance of the permanent cessation of LIBOR. Similar regulatory statements have been made in other key jurisdictions. While the discontinuation of LIBOR and other IBORs is certain, identifying a suitable replacement rate for the range of financial products which reference it presents a number of challenges. As an example, LIBOR is estimated to be used as a financial benchmark linked to more than US $350 trillion in financial instruments around the globe, and accordingly the process of replacing it presents a substantial challenge for market participants.

A key development is the identification of an alternative risk-free-rate ("RFR") to be used to replace IBORs. In the UK, the Sterling Overnight Index Average ("SONIA") has been selected as an alternative RFR for GBP LIBOR by the Working Group on Sterling Risk-Free Reference Rates. However, the suitability of SONIA varies across products and, while some sectors of the market are making progress towards transitioning into SONIA, others are presented with certain challenges.

2. SONIA

As noted above, SONIA has been selected as an alternative RFR for GBP LIBOR. SONIA has been in existence for some time and is currently administered by the Bank of England. On each London business day, SONIA is measured as the trimmed mean of interest rates paid on eligible sterling denominated deposit transactions. There is an average of about 350 such transactions, with an aggregate value of 50 billion per day. The number and weight of these transactions far outweighs the equivalent unsecured inter-bank funding transactions, on which LIBOR is intended to be based.

SONIA has been used as a benchmark for financial products for some time (e.g. SONIA derivatives). However, whilst SONIA is a more robust benchmark, the way it is calculated reflects past transactions on an overnight basis. In other words, SONIA is backwards looking and does not include the term elements of a typical period interest rate (e.g. the inclusion of credit risk and expected changes in interest rate). This raises substantial challenges in its application to different financial products, as described below.

3. Derivatives

ISDA has conducted significant work on the transition from IBORs to RFRs by convening two working groups, one that is working on the RFRs and term rates and a second that is considering issues for legacy contracts which reference IBORs. ISDA therefore conducted a market consultation in Q2 2018 in order to identify a replacement term RFR rate for IBORs, and published its results in late December 2018.

The consultation asked participants to select (i) a favoured method to convert an overnight RFR into a term rate and (ii) the adjustment to be applied to that converted overnight rate to create a term interest rate by the application of an adjustment factor or "spread".

A significant majority of the respondents were in favour of the "compounded setting in arrears" method to create the converted overnight rate with the "historical mean/median" approach to the spread adjustment. Taking these in turn, the "historical mean/median" approach means that the relevant RFR will be averaged over the relevant accrual period to create a term rate, and the "historical mean/median" approach will be calculated on the historical spread between the IBOR and RFR over an extended period. ISDA is currently working on identifying whether the mean or median approach is more effective, as well as the length of the period for the historic spread (either 5 or 10 years), and whether any other variables should be included in the calculation. ISDA had also issued an RFP for vendors to publish the replacement rate on a platform that would be accessible to market participants worldwide, which would facilitate the replacement of the relevant IBORs.

It should be noted that, as stated by ISDA in the consultation response, the new rate selected through the ISDA consultation will not operate on the same basis as the current IBOR rates and so, on transition, will not be "present value neutral". This means the pricing and valuation of instruments which reference the new rate will not be the same as those referencing the old IBOR rates, with obvious consequential economic impact on the parties to the contracts. In particular, given the backward looking nature of the historical mean/median approach and the historically low interest rate environment over the lookback period it is expected that the transition is more likely to negatively affect those receiving the IBOR-linked payments in existing contracts. A one year transition period is expected to mitigate, to a certain degree, the effect of this valuation change.

It is expected that, for a large number of legacy contracts, incorporation of a replacement rate will be implemented through an ISDA sponsored protocol, which will amend the 2006 ISDA Definitions to include reference to the relevant replacement RFR and associated fallback triggers. ISDA had clarified that effective implementation of the replacement rate would require bilateral ratification of the protocol, at which point all subsequent transactions would reference the alternative RFR instead of LIBOR. ISDA will also accordingly amend the 2006 ISDA Definitions to reflect the transition to the new rate.

Although interest rate derivatives are the largest instrument that references IBORs, there is evidence to suggest that a market shift to SONIA and other RFRs is already occurring. As an example, cleared sterling swaps referencing SONIA have grown to 19% of the cleared sterling market in the second half of 2018, and on a monthly-basis, the cleared notional for SONIA swaps is now higher than that for sterling LIBOR swaps. However, the backward looking nature of the term converted means that it is not immediately transferrable to other financial products (such as loans and bonds), which raises the possibility of a fragmentation of interest rate benchmarks between different markets.

4. Loans

The wider lending market covers a wide variety of products, including large syndicated loans to corporate borrowers, bilateral facilities, mortgages, and consumer loans. The wide range of borrowers, driven by vastly different concerns and requirements, and the concomitant absence of standardised documentation across the entire lending market, creates a significant impediment for any truly market-wide solutions to a LIBOR replacement rate.

The Loan Market Association ("LMA") recommended form of documentation serves as a starting point for negotiation in the syndicated lending market but still requires amendment by parties on a deal-by-deal basis, meaning that the process for amendment of benchmark references will require borrower and some level of lender consent, creating a potential administrative and costs burden, as well as carrying the risk of reopening other, previously settled, issues.

The LMA and the Association of Corporate Treasurers have raised various commercial and operational concerns in relation to the adoption of a backward-looking, overnight rate such as SONIA or the rate described above for use in the derivative markets, rather than a forward-looking term rate, as LIBOR is, as the replacement for LIBOR in the syndicated lending market.

The importance of a term rate to some markets in the short term, at least, has been reiterated in the responses to the Working Group on Sterling Risk-Free Reference Rates' consultation on term SONIA reference rates. Providing there is increased liquidity as expected, the conclusion of that consultation was that spot OIS swap quotes could be used to provide a term rate derived from SONIA, or alternatively a combination of futures and OIS swaps contracts could be used. It is hoped that a term RFR will be developed later this year.

It remains difficult to draft meaningful, detailed contractual provisions now which will cater for the possible future replacement of LIBOR by a new reference rate, since it is still not clear exactly how that replacement rate will operate and when it will come into operation as the market standard. It is therefore important that documents which refer to LIBOR continue to include robust fallback provisions to allow the relevant interest rate to be determined even if LIBOR is not available. However, the practicalities of administering these fallback options would not be straightforward in all cases.

In the meantime, parties may also wish to consider the consent threshold for replacement of the reference rate in facility agreements; the LMA published some expanded provisions to allow this to happen on the occurrence of various trigger events in 2018. We note that, while this wording has been generally accepted in the market as at Q4 2018, some lenders are reluctant to agree to the lower consent threshold.

5. Next steps

As indicated by the FCA in the 'Dear CEO' letters sent to the largest financial institutions in October 2018, the cessation of LIBOR is a certainty for which firms must prepare in order to avoid the burden of having to deal with a large volume of legacy contracts and implementation of alternative RFRs from January 2022 onwards. In the derivatives market, this is likely to be made easier for vanilla products by the wholesale use of standardised documentation and the work undertaken by ISDA on the proposed publication of a protocol and amended documents which it is hoped will allow for a more straightforward transition to a new RFR. The success of these measures will depend on how much adoption there is in the market, with the expectation that a number of market participants will not necessarily wish to participate immediately. No simple solution yet exists for loan market participants, although it is worth considering the incorporation of clauses in loan documentation that would allow for a smoother transition to a fallback rate at the time that suitable alternative RFRs are being considered with a view of lessening the burden of repapering legacy documentation in the future.