What’s new? In December 2020, we produced an article on the transition of the London Inter-bank Offered Rate (LIBOR) to alternative risk free rates (RFRs). The pace of the transition has picked up and by now market participants should be finalising their transition plans. In this context, we are pleased to provide you with our high-level summary and update for the following topics:
GBP LIBOR & “Tough Legacy” Contracts - SONIA: On 5 March 2021, the Financial Conduct Authority (FCA) confirmed that (with the exception of certain “tough legacy” contracts) the hard cut-off dates for LIBOR is as follows: - 31 December 2021 for the Sterling, Euro, Swiss Franc, Japanese Yen, and 1-week and 2-month USD settings; and - Immediately after 30 June 2023 for the remaining USD settings. The Working Group has also produced a revised priorities list and roadmap for 2021, to replace LIBOR with the RFR for Sterling: Sterling Overnight Index Average (SONIA).
Overnight Rates & Backward-Looking Compound RFRs - SONIA: On 28 January 2021, the Loan Market Association (LMA) published Exposure Drafts of facilities agreements (with and without observation shift), which is a method of calculating interest that is becoming increasingly popular in the market.
USD LIBOR & “Tough Legacy” Contracts - SOFR: On 24 March 2021, New York State passed a Bill which provides that once LIBOR has been discontinued, the benchmark replacement for any contract that does not already contain fallback provisions will be Secured Overnight Financing Rate (SOFR).
ISDA’s Fall Back Provisions Are Now in Effect: On 26 January 2021, ISDA's new fall-back provisions came into effect; meaning that all transactions incorporating the 2006 ISDA Definitions that are entered into on, or after 26 January 2021, will incorporate the new Inter-Bank Offer Rate (IBOR) fall-backs, unless parties specifically exclude them.
Asia Update: Here we consider the up-to-date position of IBOR transition in Singapore and Hong Kong.
For further information and details about how Clyde & Co LLP may be able to assist you with any IBOR enquiries worldwide, or to discuss any points raised in this article, we invite you to contact us using the following email address: [email protected]
1. UK Update & “Tough Legacy” Contracts - SONIA
On 11 January 2021, the Bank of England (BoE) re-affirmed the BoE and FCA's commitment to replace LIBOR with the RFR for Sterling: Sterling Overnight Index Average (SONIA) by the end of 2021.
On 5 March 2021, the FCA confirmed the hard cut off dates for LIBOR settings, as outlined above. The exception to the deadlines is “Tough Legacy” Contracts. Tough legacy contracts are contracts that refer to the existing LIBOR rate and which cannot readily be amended to refer to a non-LIBOR rate or to include fallback provisions.
Consultations are ongoing but powers should be granted to the FCA under the Benchmarks Regulation (BMR) to require the continued publication of some LIBOR settings (including Japanese Yen LIBOR settings for one additional year) after 31 December 2021 and some USD LIBOR settings after 30 June 2023. LIBOR settings will be calculated on a “synthetic” basis.
This “synthetic” LIBOR rate will only be available for use in existing tough legacy contracts, and formal guidance has not yet been provided as to what exactly constitutes a tough legacy contract. In respect of loan agreements, however, we are of the view that tough legacy contracts are likely to include:
- Syndicated loans requiring the consent of all lenders to the replacement of screen rate wording (where such loans have not been successfully amended to include a lower lender consent threshold for the replacement of screen rate).
- Syndicated and bilateral loans still relying on cost of funds wording which may give rise to regulatory issues and may be difficult to calculate for the relevant lender(s).
- Dealing with less informed parties and borrowers in some cases means that their consent is difficult to obtain.
- Those loan agreements where the large volumes and complexities of negotiations make an end of 2021 deadline challenging.
The Working Group Revised Priorities and Roadmap
It is worth noting that the Sterling RFR Working Group has produced a revised priorities list and roadmap for 2021, a copy of which is included below. Firms are now advised to stop issuing new loans, bonds and securitisations which feature LIBOR.
2. Overnight Rates & Backward-Looking Compound RFR - SONIA
The LMA has published a list of transactions which details how LIBOR replacement has been addressed in the loan market over the past year or so, and there is a growing trend for lenders to opt for compound in arrears provisions.
The overnight backward-looking RFRs were criticised for creating a level of uncertainty regarding the cost for market participants. The new RFRs are published daily and are based on recent historic market performance and this rate fluctuates, reduces predictability, surety and could bring unwelcome price variation.
Backward-looking compound RFRs provide greater certainty to market participants. By adopting a "lag" approach, the RFR is compounded and calculated over an "Observation Period". The Observation Period covers a certain number of banking days (such number, to be determined by the market participants) before the start of an interest period.
On 28 January 2021, the LMA published its exposure draft of multicurrency compounded rate/term rate facilities agreements (with and without observation shift) (the Exposure Drafts).
Although the Exposure Drafts are not “recommended forms” because the market’s approach is continually evolving, they provide a useful starting point for negotiations.
The Sterling RFR Working Group recommends the following approach for loan agreements:
- implementing SONIA via a compounded arrears methodology in place of Sterling LIBOR;
- implementing a five banking day lookback without observation shift (though lookback with observation shift is also a viable and robust alternative);
- that, where an interest rate floor is proposed, it may be necessary to apply the floor to each daily interest rate before compounding; and
- that accrued interest could be paid at the time of the principal repayment.
There is currently no independent third-party provider of a compounded rate and the Exposure Drafts published by the LMA relate only to the SONIA (GBP) loan market conventions. The ICE Benchmark Administration has however published a White Paper for calculating compounded SONIA (with or without lag) which will likely provide an important reference point for future rate settings.
Market participants should also still consider whether the Exposure Drafts are suitable for use in each particular transaction and for the relevant currency.
3. USD LIBOR Deadline & “Tough Legacy” Contracts
USD LIBOR Deadline - Extended
On 25 January 2021, a consultation carried out by the IBA reviewing the replacement USD LIBOR rates closed. The consultation considered the IBA’s intention to:
- cease publication of USD LIBOR (1-week and 2-month settings) on 31 December 2021; and
- cease USD LIBOR publication (overnight, 1, 3, 6 and 12 months) on 30 June 2023.
On 5 March 2021, the IBA published a feedback statement for the consultation and announced that the IBA will not publish LIBOR settings beyond the dates specified above.
SOFR is the proposed alternative RFR to USD LIBOR. SOFR will be a secured rate, administered by the Federal Reserve Bank of New York, and is currently being prepared for market by the Alternative Reference Rates Committee (ARRC) working group.
The delayed full implementation of SOFR to 30 June 2023 may mean that a considerable number of loans and contracts may mature before ICE ceases to publish USD LIBOR rates.
ARRC has emphasised that the delay does not alter the regulatory perspective for new loan issuances. Market participants should still see the end of 2021 as the cessation deadline for new loans based on the historic LIBOR rate.
New York State Bill And “Tough Legacy” Contracts
New York State passed Senate Bill 297B/Assembly Bill 164B on 24 March 2021 (the Bill) which provides that once LIBOR has been discontinued, the benchmark replacement for any contract that does not already contain fallback provisions will be SOFR.
SOFR will automatically replace LIBOR in legacy contracts, including contracts which had a benchmark replacement provision that involved a poll, survey, or inquiry for quotes for a replacement to LIBOR.
The content of this Bill largely follows ISDA’s provisions and recommendations as outlined below and provides welcome surety to the market as it prepares to transition from LIBOR.
The Bill also provides that the selection of a replacement LIBOR rate will be irrevocable and automatically applied to any applicable contract, security, or instrument. However, parties can contract out of this automatic application whether by direct reference to this Bill or by including any appropriate wording which would cover such a Bill in their contract, security, or instrument.
Please do note that this Bill only applies to contracts governed by New York law, and has not yet been formally signed into law by the Governor. Once signed into law by the Governor, the Bill will take immediate effect.
4. ISDA Documentation Update - Fall-Back Provisions For Transactions Incorporating The 2006 Definitions
On 26 January 2021, ISDA's new fall-back provisions came into effect meaning that all transactions incorporating the 2006 ISDA Definitions that are entered into on, or after 26 January 2021, will incorporate the IBOR fall-backs, unless parties specifically exclude them.
The fall-backs are intended to be a "one-size-fits-all safety net" to mitigate the systematic impact of IBOR cessation in the worst-case scenario. The fall-back rates will be triggered by an "Index Cessation Event," which essentially would mark the date on which it is announced by the relevant administrator that LIBOR or other IBOR has ceased or will cease to be provided by that administrator.
Consequently, the floating rate on new contracts will convert from LIBOR to ISDA's preferred replacement rate SOFR, which is based on compounded SOFR in arrears plus a fixed spread. This would happen automatically for contracts that incorporate the 2006 ISDA Definitions that are entered into on, or after 26 January 2021, or for contracts that parties have revisited and retro-actively incorporated the Definitions and Protocol.
On 5 March 2021, ISDA confirmed that the FCA’s announcement on the future cessation and loss of representativeness of the LIBOR benchmarks on the same day constituted an “Index Cessation Event”. Consequently, a “fallback spread adjustment” has been published by Bloomberg and fixed as of 5 March 2021 for all Euro, Sterling, Swiss Franc, USD, and Yen LIBOR settings.
5. Asia Update – New Timelines
The Hong Kong Monetary Authority (HKMA) issued a circular to banks to explain that new product issuance in LIBOR can cease by year-end 2021, instead of the original earlier end-June 2021 deadline. Despite this extension, banks should continue to press ahead with their transition preparations.
The later deadline is because some international banks have highlighted difficulties in offering products which reference alternative RFRs, as they are not yet widely available nor published in the APAC market. International banks are also concerned that restricting the issuance of LIBOR-linked contracts prematurely could result in a fragmentation of markets.
Singapore has also announced a new timeline for its transition to Singapore Overnight Rate Average (SORA) as the alternative interest rate benchmark for Singapore Swap Offer Rate (SOR). The SC-STS (Steering Committee for SOR and Singapore Interbank Offered Rate (SIBOR) Transition to SORA) has set a deadline of end September 2021 by which financial institutions and their customers should cease usage of SOR in new derivatives contracts and new financial products. The only exception to this rule is where the use of SOR is for a specific purpose relating to the risk management and transition of legacy SOR positions to SORA. The following deadlines remain:
- 6-month SIBOR will be discontinued by March 2022
- SOR will be discontinued in mid-2023
- Fallback Rate (SOR) will be published until end-2024
- 1-month and 3-month SIBOR benchmarks will be discontinued by end-2024