LIBOR transition - where are we now?

On Friday 5 March 2021, the FCA announced that:

• The following 26 LIBOR settings will permanently cease: 
  • immediately after 31 December 2021: all 7 euro LIBOR settings, all 7 Swiss franc LIBOR settings, the Spot Next, 1-week, 2-month and 12-month Japanese yen LIBOR settings, the overnight, 1-week, 2-month and 12-month sterling LIBOR settings and the 1-week and 2-month US dollar LIBOR settings and
  • immediately after 30 June 2023 : the overnight and 12-month US dollar LIBOR settings
• The following LIBOR settings will no longer be representative and representativeness will not be restored: 
  • immediately after 31 December 2021: 1-month, 3-month and 6-month Japanese yen LIBOR settings, the overnight and 1-month, 3-month and 6-month sterling LIBOR settings and
  • immediately after 30 June 2023: 1-month, 3 month and 6-month US dollar LIBOR settings.

Whilst this is what the market was expecting in terms of timing, market participants will need consider the implications of this announcement on existing funding documentation which includes replacement of screen rate wording, rate switch wording, contractual fallback or similar provisions which may be triggered by this announcement. 

Taking the LMA recommended replacement of screen rate clause as an example, there have been several iterations of this clause since first introduced and so each deal would need to be checked individually to see if a "Screen Rate Replacement Event" has occurred. The latest iteration of the LMA provision published in 2020 contains provisions as to both cessation and non-representativeness that are triggered by this announcement. However, earlier versions (for example, those that do not refer to a screen rate being non-representative and only refer to cessation) may not have been triggered in respect of 1-month, 3-month and 6-month sterling and USD LIBOR. If such clause has been triggered this may, depending on what has been on agreed on each particular deal, allow amendments to be made to change the rate from LIBOR to a risk-free reference rate (RFR) on a majority lender rather than all lender basis. 

Under the LMA rate switch exposure drafts the announcement constitutes a "Rate Switch Trigger Event" for all tenors and currencies meaning that parties now have a fixed date for when the rate switch will take (being the day after the applicable date for the relevant screen rate set out above). 

The announcement also constitutes an "Index Cessation Event" for all tenors and currencies under the ISDA 2020 IBOR Fallbacks Protocol (Protocol) and the IBOR Fallbacks Supplement to the 2006 ISDA Definitions (Supplement). This means that parties who have adhered to the Protocol or whose derivatives contracts incorporate the Supplement (which took effect on 25 January 2021) now have a fixed date for when the automatic ISDA fallbacks will take effect (again, being the day after the applicable date for the relevant screen rate set out above). Further guidance on the impact of the announcement on ISDA documentation has been released by ISDA.

Market participants will of course need to be mindful of the fact that certain triggers may not have taken effect under loan documentation but may have done so under any related hedging documentation (or vice versa) and assess the implications of this (and take action) accordingly.

Although the announcement also refers to the FCA consulting with the IBA on publishing "synthetic LIBOR" (being a forward-looking version of the relevant RFR plus a credit adjustment spread) for certain currencies and tenors, the FCA have made it clear that use of any such "synthetic LIBOR" for sterling will only be permitted to transition "tough legacy" cases. Whilst we are still awaiting further detail (expected later this year) as to what will constitute "tough legacy," it is clear that the majority of corporate and real estate financings will not fall into such category and existing LIBOR-linked transactions should be actively transitioned to an RFR.

From 1 April 2021, the Working Group on Sterling Risk-Free Reference Rates (WG) has recommended that funders:

• cease to issue any new sterling LIBOR-linked loans, bonds, securitisations and certain linear derivatives maturing after the end of 2021 and
• have identified all legacy sterling LIBOR-linked contracts.

Since the last milestone at the end of Q3 2020 we have seen an increased use of day-one SONIA loans in readiness for this Q1 2021 deadline. However, the market has still been heavily reliant on the other ways to meet Q3 2020 requirements namely by including a pre-agreed process for renegotiation or by using a rate switch mechanism (for more details on these methods please see our previous briefing here). 

Best practice guidance from the WG makes it clear that this Q1 2021 deadline restricts the use of rate switch agreements or a pre-agreed process for renegotiation from 1 April 2021 meaning that new transactions should be, from this date, using a RFR from day-one rather than sterling LIBOR.

Rate switch agreements have had obvious benefits for funders to date in that they allow the use of LIBOR for now whilst including a mechanism whereby the rate automatically switches to SONIA (or other RFR) ahead of the end of 2021 thus allowing time for funders to ensure that are operationally ready to administer loans using SONIA (or other RFR).

The Q1 2021 deadline therefore means that funders need to be operationally ready ahead of 1 April 2021 in order to ensure all new transactions can be priced, issued and administered (and hedged) using an RFR. Whilst SONIA is likely to be used (particularly for larger corporate lending and real estate finance transactions) funders may use another RFR such as the Bank of England base rate (which we have already seen being used for smaller bilateral deals).

Significant progress has been made in the last few months with the market getting to grips with SONIA and how to calculate an interest rate over a particular interest period using SONIA. 

SONIA is fundamentally different to LIBOR in that it is a backward-looking daily rate unlike LIBOR which is forward-looking and set for different tenors that already align to typical interest periods. This difference has a number of implications under loan documentation which funders and borrowers alike will need to consider moving forwards.

It is important to note that, although certain providers are now publishing forward-looking "Term SONIA" rates, there are very limited cases where use of such rates is anticipated.  The WG has repeatedly confirmed that backward-looking SONIA compounded in arrears is the preferred alternative to LIBOR for the wholesale markets.  In general for corporate and real estate lending, market participants' calculation of the SONIA rate for a particular interest period on a backward-looking basis is fast becoming the market norm.  Term SONIA rates are broadly anticipated to be of limited application (for example to borrowers with straightforward lending requirements (single currency with no hedging requirement) and products (such as discounted trade finance products) that are offered on a discounted basis).

1. Calculation of an interest rate using SONIA

Methodology

The key issue for funders has been settling on their methodology for calculating an interest rate for a particular interest period based on SONIA and ensuring their systems are set up to be able to calculate the rate on that basis. 

Whilst there are different ways to calculate an interest rate for a particular interest period using SONIA, recommendations were published by the WG last year and funders in general are taking a similar (if not the same) approach. Our brief guide to the typically calculation methodolody can be found here.

Clearly it is important, particularly for club/syndicated lending and for those buying or selling in the secondary market, for funders to be aligned in their methodology. 

There are differences between the recommended approaches for the loan market and the derivatives markets which has led to some debate between lenders and hedge counterparties as to which methodology should be used on a particular transactions. However, with the LMA publishing an exposure draft which uses a similar method to that recommended for derivatives and ISDA expected to consider introducing options for methodology more similar to that recommended for the loan market in their upcoming 2021 Definitions, there will be more options available to the parties going forwards. 

Funders will of course need to ensure their operating systems are sufficiently flexible to cater for the different methodology they expect to encounter on their transactions.

Timing of confirmation of interest payment amounts

Whilst borrowers may not be too concerned about which methodology is used to calculate their interest rate (provided it be in line with what is being seen in the market), they do need to be aware that the interest rate for an interest period will no longer be known at the outset of that interest period. As the SONIA calculation can only be done at the end of an interest period (typically 5 business days before) borrowers will only receive confirmation of the interest payment amount once that calculation has been completed. 

2. Wider implications for loan documentation

It is important for funders and borrowers to note that the use of SONIA (or other RFR) in place of LIBOR has other implications under loan documentation. Areas where we have seen changes made include:

• the concept of "Break Costs" (which is no longer relevant in its previous form) being replaced by the inclusion of an administration or similar fee when a loan is prepaid and/or a restriction on the number of prepayments which can be made
• changes to the basis of projected interest-cover ratios given that the interest rate for a particular period can only be known at the end of an interest period and
• extensions to the time period for delivery of compliance certificates to ensure there will be sufficient time to obtain any necessary interest payments amounts and provide the required confirmation.

Market participants will therefore need to be aware that when documenting a loan using SONIA it is not just simply a case of changing the reference rate and should expect to see other consequential changes to such documentation. 

3.  Hedging alignment

Where derivatives contracts are used to hedge interest rate risks, parties will need to understand the triggers and fallbacks included in both the underlying loan instrument and the related derivative contract.  Where there is a lack of alignment between the two basis a risk may occur where the interest rate risk is not exactly offset by the hedge.  If a mismatch is identified, parties will then need to consider whether (a) the differences and their commercial/economic effects are minor or material and (b) any associated risks can be accepted or mitigated.  Where necessary, any resultant hedging concerns should be addressed by amending the transactions to ensure alignment before the fallbacks come into effect.

USD LIBOR

The FCA announcement confirmed the anticipated extension to certain USD LIBOR tenors after the end of 2021 with the 1-month, 3-month, 6-month and 12-month settings for USD LIBOR being published until 30 June 2023. Market participants should however be aware that this does not mean that funding documents can now continue to refer to USD LIBOR until such date. The recommended deadline that no new USD LIBOR-linked contracts should be issued following the end of Q2 2021 remains in place and the NY Fed has confirmed that the extension to the publication is only to assist with the run-off of legacy contracts.   

Market participants are therefore still required to take a proactive approach in switching from USD LIBOR to SOFR (or other RFR). The most recent LMA exposure drafts assume that SOFR will be used from day-one and will be calculated on the same basis as SONIA using the compounded in arrears method and so this approach to calculating SOFR is the most prevalent in the UK market. Funders should however be aware they may see different approaches to calculating SOFR as, in the US market, a simple averaging method is recommended. 

EURIBOR

EURIBOR is not being discontinued at this stage and will continue to be published. The focus therefore in the European market has been on switching any EONIA-linked contracts to ESTR. The most recent LMA exposure drafts assume that EURIBOR will be used on day-one but do contain a rate switch mechanism to allow the switch to ESTR at a later date. As with all currencies under the LMA documentation, the assumption is that ESTR will be calculated in the same way as SONIA using the compounded in arrears methodolody. 

The Working Group on Euro Risk Free Rates has also consulted on EURIBOR and ESTR fallback triggers. Whilst the summary of responses to this consultation have been published, recommendations for the fallback language are still awaited and expected later this year.

A lot of progress has been made in a short space of time considering where the market was just a few short months ago when we reached the Q3 2020 milestone. The Q1 2021 deadline is certainly a big step forward and funders will need to ensure they are operationally ready for this and able to accommodate the typical calculation methods they expect to encounter. Borrowers should expect to see other changes being made in documentation as a result of the transition to RFRs and we look forward to guiding out clients through these changes. 

As we look ahead to the rest of the year, whilst the focus especially for corporate and real estate finance lending will be on the active transition of existing LIBOR-linked loans, the market will look forward to getting more clarity on what will happen to "tough legacy" contracts which cannot be actively transitioned.