With news reports unceasingly filled with the ups and downs of the UK’s exit from the EU, are we potentially ignoring an even larger threat? With outstanding transactions having notional values in the hundreds of trillions; is LIBOR risk bigger than Brexit risk?
What is LIBOR?
Lenders and borrowers alike will be familiar with LIBOR – the London Inter Bank Offered Rate. It is intended to reflect the average rate at which major banks can obtain unsecured funding in a specified currency for a particular time in the London Interbank Market.
In syndicated lending in particular, LIBOR is used to simplify the calculation of interest where lenders seek to pass on their funding costs to borrowers and to ensure that borrowers are not exposed to changes in an individual lender’s financial stability.
LIBOR is calculated using the data contributed by a panel of contributor banks. Historically, this data was simply the rate indicated by each contributor as the rate at which it could borrow by asking for and accepting reasonable offers in a reasonable market size. Each contributor used its own methodology in making its submissions.
Concerns that LIBOR rates were open to manipulation led to review of its calculation and the process for making submissions. ICE Benchmark Administration Limited (IBA) then took over from the British Bankers Association as administrator of the rate and panel banks were required to apply a standard methodology to their rate submissions.
Whilst the Wheatley Review did not conclude that LIBOR should be replaced, it recommended the provision of information in respect of and the administration and governance of LIBOR should be regulated by the FCA. These became ‘regulated activities’ in April 2013. The manipulation of benchmarks was made a criminal offence at the same time.
These increased potential liabilities have discouraged banks from participating on submitting panels.
The FCA announced that it would no longer compel LIBOR submissions to be made after 2021 and that, after this date, the market should no longer rely on LIBOR being available. This, coupled with the fact that a lack of underlying transactions has increasingly made LIBOR unrepresentative of its underlying market, has resulted in a move toward an alternative.
Risk Free Rates?
Alternative nearly risk-free reference rates (RFRs) are overnight rates which can be used as alternatives to interbank offered rates (IBOR). They are anchored in active, liquid underlying markets and are therefore perceived to be more robust than IBOR.
In April 2017, the Sterling Working Group of the Bank of England (the Sterling Working Group) recommended SONIA (the Sterling Overnight Index Average) as its preferred alternative to LIBOR.
SONIA measures the rate at which interest is paid on Sterling short-term wholesale funds in circumstances where credit, liquidity and other risks are minimal. It is the trimmed mean of interest rates paid on eligible Sterling denominated deposit transactions. It has been administered by the Bank of England since April 2016.
SONIA – Reference Rates and Conventions
LIBOR is a forward-looking term rate, allowing borrowers the certainty of knowing the interest which will be payable at the end of their interest period and allowing them to plan their cashflows accordingly. The RSRs being proposed as alternatives are historic, overnight rates.
The practical and operational difficulties posed by this to both lenders and borrowers have been highlighted and the possibility of RFR-derived term rates is being explored.
A forward-looking SONIA rate could be based on derivatives that reference SONIA, such as futures or overnight index swaps as these reflect market expectations of the rate for a forward-looking period. IBA plans to publish preliminary rates for one, three and six month SONIA based on futures contracts information.
Conventions for referencing SONIA directly (rather than as a term SONIA reference rate) are being explored for use in the loan markets. This would require aggregating SONIA rates (whether by compounding daily rates or calculating a simple average) in order to determine interest over a certain period.
The difference between averaging and compounding is typically quite small over short periods of time. Averaging is the simpler method and is therefore easier to administer. Compounding incorporates interest which accumulates during the relevant period and ensures that there is no potential loss of interest (when compared to daily interest payment) for the lender. As other markets use the compounding method, it is more likely that loans will be easier to hedge if calculated using the compounding convention.
A further consideration is whether the conventions should be calculated in advance (as is the case with most contracts which reference LIBOR) or in arrears.
Advance payments would reference a single RFR or an average of the rate for a period before the current interest period. This would give borrowers ample notice of the amount of their next interest payment but presents questions as to the length of the sample period and protection against shifts in the rate over the period.
Visibility for borrowers is an issue for rates calculated in arrears, particularly when the publication times for selected rates differ. To allow for timing issues, various methodologies have been proposed. ‘Lag’ (where the reference period would start, for example, five days before the start of the interest period and end five days before the end of the interest period) or ‘Lock’ (where a rate from a few days prior to the end of the interest period is used instead of the actual rate for those days) mechanisms could be utilised to allow some cashflow certainty.
Hybrid mechanisms that combine elements of each of advance and arrears methods have also been discussed. These might require an initial instalment interest payment, followed by payment of an adjustment.
The Sterling Working Group’s August 2019 statement indicated a preference for a compounded in arrear approach with a five day lag. Any margin applicable to the loan would be added after compounding the rate.
Transitioning from LIBOR
Given the unsettled nature of the approach to new rates, it is perhaps not surprising that there has been little impetus to write new loans off of alternative reference rates such as SONIA.
Whilst the LMA has reported seeing the first bilateral loan linked to SONIA (a NatWest transaction with National Express), at the time of writing there are no reports of syndicated loans based on SONIA. To the extent that there has been movement toward replacement rates, this has been reflected in ‘fallback’ provisions to cater for amendment once LIBOR is no longer available or, in some cases once there is a market consensus on a new approach.
The pricing, documentation and administration of most existing loans depend on the current features of LIBOR. Many existing facility agreements contain a fallback to a reference rate provided by a group of ‘Reference Banks’. The regulatory regimes discussed above in relation to LIBOR have resulted in many banks no longer wishing to act as ‘Reference Banks’.
The LMA has published various iterations of a ‘Replacement of Screen Rate’ provision in order to legislate for changing trends in fallback positions. Originally, two options were given, which provided for differing fallback waterfalls when a screen rate was unavailable; the ultimate fallback being to cost of funds. These are likely to be included in existing documentation dating from 2014 onwards.
The fallback wording was intended to be an interim measure and most parties are agreed that it is not sufficient to be relied upon in the event that LIBOR is permanently replaced or ceases to be the rate generally used in the market. There will therefore need to be amendments to any facility which is priced in accordance with LIBOR and matures after 2021.
A revised version of the ‘Replacement of Screen Rate’ clause was published by the LMA in 2018. The clause applies where a replacement or additional rate is formally selected or is generally accepted by the market as the appropriate successor to LIBOR.
Rather than hard-wiring a new rate into documents, the clause makes provision for appropriate amendments to be agreed between the parties at a time in the future. It remains open for the parties to agree the trigger events for amendments and the level of lender consent that should be required. Documents drafted using this wording should be easier to amend, but will ultimately need to be re-opened.
Documents drafted before the updated wording was made available (or using non-LMA templates) may well be more difficult to deal with.
Considerations for Existing Facilities
Lenders and borrowers would be well advised to check existing facility agreements to see what, if any, fallback wording is included. Where fallback wording is included, consideration should be given to whether this will apply if LIBOR ceases to be published and whether it would extend to the situation where LIBOR rates were still available but ceased to be the most widely-used rate in the market.
Procedure for amendment should be checked (particularly in relation to the level of lender consent required for syndicated facilities) and the types of amendment required should also be considered. For example, where a replacement rate is not equivalent to LIBOR, there may need to be an adjustment to the margin. Other provisions such as financial covenants may also be impacted.
Intercreditor arrangements should be borne in mind when changes to interest provisions are in contemplation. The effect of changes on any related interest rate hedging products should also be considered.
Considerations for New Facilities
It would be prudent for parties entering into new facilities to make transition to a new rate in the future as simple as possible.
Inclusion of wording such as the LMA updated ‘Replacement of Screen Rate’ provision should be considered and, indeed, has become a standard requirement for several lenders active in the UK market. The parties should also consider who should select the replacement rate (i.e. the borrower and the agent, or just the agent or the agent following consultation with the borrower); the trigger(s) for applying the new rate and whether an adjustment spread needs to be added to give economic equivalence to the LIBOR position.
Even once there is clarity in relation to a new rate, there are likely to be challenges for both borrowers and lenders in implementing changes.
Current financial and accounting infrastructure is set up for LIBOR and will have to be amended to reflect the workings of a new rate. This is likely to have substantial cost implications.
RFRs for different currencies are calculated in different ways and are likely to be published at different times. This may cause difficulties in particular for borrowers borrowing in more than one currency. Consideration will have to be given to whether different pricing will need to apply to different currencies. In addition, changes to the RFRs for different currencies are being progressed at different rates, meaning facilities may have to be amended more than once to cater for new rates.
Parties may also wish to consider tax and accounting implications and the effects on any intra-group financing or cash-pooling.
It is likely that SONIA will be adopted as the successor rate to LIBOR. Whilst the specifics are by no means settled, borrowers and lenders should keep abreast of developments and prepare themselves for the 2021 deadline by reviewing their loan documentation and considering what changes may be required.