On 27 July 2017, the Financial Conduct Authority (FCA) announced that it would encourage a phase out and replacement of LIBOR by 2021 and will cease to use its powers to compel panel banks to make expert judgement contributions to LIBOR after the end of 2021. This doesn’t necessarily signal the end for LIBOR, as should ICE Benchmark Administration choose to continue its administrative role and at least 5 panel banks continue to make submissions, then LIBOR could survive. It is unlikely however that banks will make those submissions without compulsion from the FCA and therefore an alternative will be adopted by the markets. Participants should be prepared for that.
How will that alternative rate operate?
That is the million (or trillion) dollar question. The scarcity of term unsecured deposit transactions in the wholesale bank borrowing markets (which underpin LIBOR) means that its sustainability as a reliable global benchmark is at risk. Step up Risk Free Rates (RFRs). RFRs are based on actual underlying transactions (rather than judgement calls) and are therefore considered more robust. The Sterling Overnight Index Average (SONIA) has emerged as the likely favourite RFR in the UK and the Bank of England is currently working on a reformed methodology, to be announced on 23 April 2018. Conceptually SONIA is similar to overnight LIBOR, but there are significant differences that corporate borrowers should be aware of:
- As noted above, LIBOR is based on bank submissions, SONIA will be based on actual underlying transactions;
- LIBOR is published over various tenors from 1 week to a year, with 3 and 6 months being the most popular. SONIA is an overnight rate.
- LIBOR is published at 11am each day for a forward looking period, SONIA is published at 9am each day for the previous day (and publication times for the various RFRs across the globe will vary); and
- LIBOR is quoted for several different currencies, SONIA is sterling only.
Overnight RFRs such as SONIA are popular in the derivatives market (where interest rates are being traded, rather than credit), but there is still much work to be done to tackle the issues that a RFR poses for the syndicated loan market. LIBOR is a forward looking rate which enables corporate borrowers to calculate with certainty an interest payment due on a future interest payment date. SONIA is a backward looking overnight rate, so a borrower only knows the interest rate for an interest period at the end of that period (and that period can only be overnight). So interest payments would need to be settled on the same day as determining the interest calculation. This creates a lack of certainty and poses clear cashflow and rate exposure issues for corporate borrowers.
What should corporate borrowers do now?
That’s another big question. The Loan Market Association (LMA) has not yet made any amendments to its template syndicated loan agreements, and for good reason. Attempting to provide a drafting solution for an alternative rate, the methodology of which is not yet settled and which the market has not yet fully adopted, sounds tricky, if not downright dangerous. The LMA loan agreement already provides ‘fallbacks’ in the event that LIBOR cannot be determined on a given date, but these fallbacks are really designed to cover a temporary unavailability of screen rate and certainly don’t provide for an automatic switch to a completely different rate as a long term alternative. The complex waterfall of fallbacks was included in the LMA template in November 2014, so loan arrangements entered into prior to that date are unlikely to include even these short term options. The LMA has said that it will start work on reviewing its template loan agreements after 23 April 2018 when the BoE has announced the revised methodology for SONIA.
In the meantime, corporate borrowers could be thinking about their other contracts that extend beyond 2021 and which use LIBOR as a benchmark, such as intercompany loans and commercial contracts (which might use LIBOR for late payment mechanics or pricing adjustments). Consideration should be given to:
- how the parties might agree upon a new rate should LIBOR cease to exist;
- whether the parties should wait until LIBOR ceases to exist, or should the switch to a new rate occur sooner than that (what if LIBOR is still strictly available but has completely fallen out of market use?);
- what the parties will include instead. Right now that is very difficult to determine, are we just agreeing to co-operation/consultation in the future (and if so, is there a danger that it could be considered “an agreement to agree”, which English courts have traditionally considered unenforceable?)
- how that new rate will operate if it is backward looking? Again, this is very difficult to answer until we have seen the revised methodology.
- what should happen if that new rate is more expensive. Should there be a re-pricing mechanism, to put the parties back in the same economic position they were in when LIBOR was the chosen benchmark?
Clearly, there are a number of issues to consider now. But our message is not to panic. All corporate borrowers are in the same boat. There is a huge task of global co-operation to be undertaken before LIBOR can be replaced by SONIA, or some other alternative. The Bank of England is aware of the issues for the loan market, particularly around the difficulty posed to corporate borrowers by a rate that doesn’t offer longer forward looking interest periods.