LIBOR cessation: why you need to be interested
This briefing was updated on 3 March 2021.
The London Inter-Bank Offered Rate (LIBOR) is the reference rate of interest for a vast number of financial contracts including cash products, loans, debt securities and derivatives transactions.
It is an interbank interest rate which is calculated using data from a number of banks which are active in the London financial markets and represents a rate at which (theoretically at least) those banks are prepared to lend to one another. It therefore features a bank credit risk component, which caused LIBOR rates to spike during the 2008 financial crisis.
LIBOR is quoted as an annualised interest rate for fixed periods (e.g. one, three or six months) for a range of currencies (USD, GBP, EUR, CHF, JPY).
LIBOR came under increased public scrutiny after the LIBOR scandals of 2007-12, which centred upon the alleged manipulation of the rate by panel banks for their own ends.
After a comprehensive review of LIBOR, and whether it remains fit for purpose, the Financial Conduct Authority (FCA) announced on 27 July 2017 that market participants should not rely on LIBOR being available after 31 December 2021. The Bank of England (BoE) and the FCA remain committed to this deadline and have confirmed that there is no intention to extend it as a result of COVID-19.
LIBOR cessation, if improperly managed, may have adverse financial implications for market participants with LIBOR exposures.
These implications could range from an economic impact (if the fallback rate chosen to replace LIBOR is less favourable), basis risk (if there is a mismatch between the fallback rate of a loan and the fallback rate of any hedging of the interest-rate of that loan) or, at worst, potential defaults under arrangements that apply an interest rate linked to LIBOR.
The replacement of LIBOR interest rates will not be automatic, nor is there yet established market practice for moving to replacement rates. Different markets (e.g. the loan market and the derivatives market) may adopt different fallbacks. Moving to fallback rates will often require consultation or consent processes.
The process of identifying all exposures to LIBOR may be time consuming and resource intensive for some market participants. Identifying those exposures and developing a transition plan now is recommended.
While outside the scope of this note, the tax and accounting implications of LIBOR cessation, and the further implications of the adoption of certain fallback rates, will need careful consideration.
"Risk free" reference rates (often referred to as RFRs) are being developed to replace LIBOR. The BoE's Working Group on Sterling Risk-Free Reference Rates has recommended Sterling Overnight Index Average (SONIA) as its preferred replacement rate for LIBOR in sterling markets.
SONIA, administered and published by the BoE, is calculated as a trimmed mean of rates paid by banks on overnight unsecured wholesale funds. It is published for every London business day on a backward-looking T+1 basis. BoE maintains a comprehensive page explaining how SONIA works, here.
SONIA (a backward-looking overnight rate) is inherently different from LIBOR (a forward-looking term rate – 3 month LIBOR being the most prevalent tenor in loan markets). If SONIA is to be used as the successor rate to LIBOR, in many cases the daily rate will need to be compounded. Daily publication of a SONIA-compounded index by the Bank of England started in August 2020. Even then, further adjustments to SONIA are required - see 'Adjustments to SONIA' below.
The FCA has sent several "Dear CEO" letters relating to LIBOR cessation, mostly to sell-side financial institutions but also to asset managers (February 2020 letter available here), which stress the importance of engaging with LIBOR discontinuation as early as possible. It maintains a dedicated LIBOR transition page here. The FCA expects regulated market participants to be taking immediate action to develop and begin the execution of a LIBOR transition plan.
In its Discussion Paper on the UK implementation of the Investment Firms Regulation and Investment Firms Directive (also known as "IFR/IFD" and available here), the FCA has also clarified that investment firms should factor LIBOR transition into their "ICARA" process – in broad terms, ICARA will be the successor to the "ICAAP" and will require firms to look holistically at the risks inherent in their business and assess whether their capital and liquidity resources are sufficient.
Managers should be cognisant of the fact that the BoE and the FCA have increased pressure on market participants to transition away from LIBOR well in advance of the 2021 deadline. The BoE's Working Group on Sterling Risk-Free Reference Rates has set certain target milestones to manage the transition away from sterling LIBOR which include:
Managers should also note that despite support from market participants for sustaining LIBOR until the 31 December 2021 deadline, the FCA has not ruled out the possibility of deeming that LIBOR is not representative before 31 December 2021. Should the FCA make such a determination, Managers' LIBOR transition plans will need to be brought forward.
Managers should start scoping the universe of impacts that LIBOR cessation will have on their business and defining the steps they will take to manage those impacts and transition away from LIBOR to a risk-free rate. In September 2020, UK Finance published a helpful guide on LIBOR transition priorities for business customers (available here) and more detail is set out below.
To effectively assess what the impact of LIBOR cessation will be, managers will need to take a holistic view of the funds they manage. The specific arrangements that need to be considered will depend on the nature of each manager's business and the structure of the fund(s) they manage but consideration should be given to:
- fund finance facilities (such as bridge or NAV facilities);
- fund level hedging arrangements (including any collateral documentation);
- any credit lines made available directly to the manager;
- acquisition finance facilities at the asset level, and any interest rate hedging implemented in connection with those facilities;
- all LIBOR referencing credit investments (such as loans, bonds, notes, securitisations, etc.) and any cash products issued by the manager (which reference LIBOR and have a maturity beyond 31 December 2021);
- use of LIBOR as a benchmark or performance target (for example for fees);
- reference to LIBOR in late payment clauses (such as for capital contributions).
Once managers have established what the impact will be, the focus will be on preparing a LIBOR transition plan to ensure that a consistent approach is taken and that they are not exposed to mismatches in replacement rates, imperfect hedges that result in economic loss, disputes and/or defaults. Consideration should also be given to regulatory guidance on managing conduct and compliance risks relating to client communications during LIBOR transition.
The next step will be to engage with counterparties and commence the process of amending affected contracts. To assist with transition, industry bodies have been working on the amendments to their standard form documentation and calculations to adjust to RFRs (such as SONIA) though, as yet, there are not market-standard or automated processes for this.
The International Swaps and Derivatives Association, Inc. (ISDA) has taken the lead in respect of derivatives transactions and has published the ISDA Benchmarks Supplement (the Benchmarks Supplement) which creates a contractual framework for counterparties to agree a replacement rate. Banks now regularly require the Benchmarks Supplement to be included in their ISDA-based agreements2.
ISDA has further augmented its suite of LIBOR transition documents with:
- the 2020 ISDA IBOR Fallback Protocol (the Fallback Protocol) which offers parties that choose to adhere a means of 'bulk converting' legacy transactions that reference LIBOR; and
- a supplement to the 2006 ISDA Definitions (the Definitions Supplement) which, when incorporated into the documentation governing 'new' transactions, automatically embeds fallback risk free rates.
Both the Fallback Protocol and the Definitions Supplement incorporate certain "adjustments" which are applied when transition to the risk free rate occurs (i.e. upon a pre-cessation trigger or 31 December 2021). As risk free rates are overnight rates without a credit component (making them inherently different to LIBOR) the adjustments are incorporated with the intention of ensuring that the economics of a transaction post transition reflect (to the extent possible) the original agreement between the parties. Bloomberg Index Services Limited have been appointed by ISDA to make the adjustment calculations (being adjusted RFR (compounded in arrears), the credit spread adjustment and the 'all in' adjustment) and to publish the calculations on the Bloomberg website.
The Definitions Supplement and the Fallback Protocol were published on 9 October 2020 and will launch on 23 October 2020. Both the Definitions Supplement and the Fallback Protocol will take effect from 25 January 2021 (the Effective Date).
A summary of the timeline to the Effective Date is set out below.
- ISDA gave market participants two weeks' notice (on 9 October 2020) of the official launch of the Fallback Protocol and the Definitions Supplement (known as the "escrow period"). The official launch date of the Fallback Protocol and the Definitions Supplement was set for 23 October 2020.
- During the escrow period, firms will be able to adhere to the Fallback Protocol "in escrow" (meaning parties adhere on a binding but non-public basis). Parties that adhere during the escrow period will automatically adhere to the Fallback Protocol on the date that the Fallback Protocol is officially launched.
- The Fallback Protocol and the Definitions Supplement officially launch at the end of the escrow period on 23 October 2020 and will take effect approximately three months later, on 25 January 2021. Firms should be able to adhere to the Fallback Protocol for an indefinite period following the official launch.
- On the Effective Date, the fallback rates contained in the Fallback Protocol will apply to adhering parties' legacy transactions. In addition, "new" transactions (being those entered into after the Effective Date) which incorporate the 2006 Definitions (as updated by the Definitions Supplement) will incorporate the fallback rates included in the Definitions Supplement.
Managers looking to amend existing derivatives transactions which reference LIBOR may wish to consider incorporating the Benchmarks Supplement in their ISDAs and/or adhering to the Fallback Protocol, though the impact of doing so will need to be considered on a case-by-case basis.
Loans and bonds
Once LIBOR discontinuation hit the agenda, the market's first reaction was to adopt a form of "Replacement Screen Rate" clause published by the Loan Market Association (LMA) in May 2018. This essentially allows re-pricing decisions to be made by "Majority Lender" consent, once a "Screen Rate Replacement Event" has occurred. Without this provision, any agreement on re-pricing would require "all lender" consent, which is not feasible in many cases.
In April 2020, an announcement by the FCA urged parties to include "pre-agreed conversion terms" or an "agreed process for renegotiation" in new loans from the end of Q3 2020. Since then, market participants have typically supplemented the "Replacement of Screen Rate" clause such that a trigger event would also set the clock running on the agreed process towards transition. Generally speaking, this could amount to (a) a positive obligation to negotiate new terms; or (b) activation of a pre-agreed pricing structure linked to a risk-free rate (the so-called "hard-wired method"). Such clauses may not be entirely effective (some amount to an "agreement to agree" and others allow the lender unilaterally to select a new benchmark rate) and they may also conflict with fallback provisions elsewhere in the document (which point to historic LIBOR rates, reference bank rates and/or lenders' cost of funds). To further complicate the picture, the larger banks have each formulated different policies for transition and so the market has seen a range of approaches.
In parallel, since 2019 a succession of well publicised SONIA-priced bilateral loans have provided a template for further RFR-linked loans. The pricing structure of such loans is very different to LIBOR-linked loans, given the inherent differences between LIBOR and SONIA discussed in section 3 above. The LMA maintains a table on its website setting out publicly announced RFR-priced loans.
Over the past year, the LMA has published a proliferation of exposure drafts of syndicated loan agreements priced using SONIA and SOFR and also a Reference Rate Selection Agreement (designed to streamline the process of transition of widely syndicated loans from LIBOR to new rates by allowing market participants to use a familiar document on different transactions). Whilst such templates assume a simple "investment grade" loan transaction, they have enabled market participants to agree an ever-increasing number of RFR-priced loans. The templates will need to be further developed to fully reflect the impact of new pricing, particularly in the context of more sophisticated lending transactions. These include debt service projections in financial covenant ratios, rules on prepayments and various event-driven fees that are based on the calculation of yield.
The next milestone in the transition away from LIBOR will be formal announcements from the FCA and ICE Benchmark Administration (the administrator of LIBOR) as to the timing of discontinuance. The effects of these announcements for outstanding loans will depend entirely on the context, depending on when the documentation was agreed (or subsequently amended) and the consequences of a "Screen Rate Replacement Event".
Nevertheless, obstacles to widespread change include the need for some market participants to update back office systems and IT infrastructure and train key personnel on the use of compounded SONIA rates.
Since 2019 several consent solicitations have been issued to transition English law legacy bond contracts from LIBOR to SONIA. These processes typically require the passage of an extraordinary resolution of the bondholders and seek to amend LIBOR to daily compounded SONIA in arrear using the lag method, plus an adjusted margin (being the margin plus the applicable LIBOR-SONIA spread). In February 2021, the Investment Association published a "Dear CEO / CFO letter" (here) addressed to companies issuing LIBOR-linked sterling bonds, encouraging them to actively transition.
Adjustments to SONIA
In the derivatives markets, ISDA is working to implement certain adjustments to SONIA based on feedback received from its market consultations. The "Fallback Rate" to replace LIBOR will be calculated by adjusting SONIA by reference to compounded SONIA setting in arrears for each relevant term (to match the tenor of LIBOR it is replacing) and the historic 5 year spread between LIBOR and compounded SONIA. ISDA has appointed Bloomberg to calculate the Fallback Rate on a daily basis and to publish the adjusted rates on its LIBOR page.
In the loan markets it is unlikely that compounded SONIA alone would be a commercially acceptable replacement for LIBOR users as SONIA is almost always lower than LIBOR. It is not yet clear what approach will become the market standard, but it is possible that the interest rate calculations in loans will include an additional limb to reflect the spread between LIBOR and SONIA.
The FCA has made it clear that it expects lenders to treat their customers fairly when replacing LIBOR, which may nudge lenders towards a carefully calibrated "adjustment spread" when re-pricing existing debt.
Managers should also be mindful of so called "tough legacy" trades. These are financial arrangements which are incapable of being transitioned away from LIBOR (for example, commercial paper with a very large number of bondholders who are all required to consent to any amendment).
A standard approach to tough legacy trades is yet to be reached and the BoE's Working Group on Sterling Risk-Free Reference Rates issued a report in May 2020 considering potential solutions.
On 23 June 2020 Chancellor Rishi Sunak announced that the Government intends solve the problem of tough legacy contracts by giving the FCA new regulatory powers to change the methodology for calculating critical benchmarks and also by changing the law to enhance prohibitions on the use of non-representative benchmarks. It does not intend to use legislation to prescribe a replacement rate.
The FCA's September 2020 "five conduct questions" report reaffirms the FCA's focus on alleviating risks arising from LIBOR transition. Firms should be mindful that the FCA expects firms to actively engage with LIBOR transition and work to the LIBOR transition timetable set out by the FCA/BoE.
It is also clear (from the FCA's other communications on LIBOR) that the FCA expects LIBOR transition to be implemented in a way that does not prejudice the interests of clients (which includes giving clients sufficient time to consider the impact of LIBOR transition). Firms which fail to comply with these requirements may be open to challenge by the FCA.
- Working on LIBOR impact assessment and transition plans. We are currently working with a number of our clients to produce LIBOR impact assessments and creating LIBOR transition plans. We can help whether you are in the early stages of LIBOR cessation planning or are looking for specific advice on certain aspects of your LIBOR transition plan.
- Mapping exposure and level of preparedness. We are currently developing an AI tool which will allow our clients to quickly review their documentation and identify which contracts need to be considered in scope for the transition plans and any tough legacy trades.
- Amending existing contracts to add LIBOR fallback mechanics. Our experience working with loan, bond and derivatives documentation and close relationships with industry bodies such as ISDA, ICMA, the LMA, AIMA and BVCA mean that we are well placed to advise you on what needs to be done to amend contracts to incorporate LIBOR fallback mechanics.
- Considering any regulatory, and tax implications. Such implications might result from amending (or opting not to amend) existing contracts (for example, loss of regulatory grandfathering, significant accounting or tax gains or losses).
As the LIBOR transition deadline approaches, market participants should closely monitor liquidity in LIBOR-linked contracts to assess the timing for transition in relation to each asset class, as it is expected that liquidity will start to wane ahead of the 31 December 2021 deadline.
1 The FCA has acknowledged that the COVID-19 pandemic has caused significant disruption to the transition process insofar as it affects the loan markets and has stressed the importance of maintaining the smooth flow of credit to the real economy. In July 2020 the BoE's Working Group on Sterling Risk-Free Reference Rates published Q&As with more detail on compliance with the standards set out here. If you require further information or advice in relation to the credit lines developed by the UK government in response to the pandemic, please contact us.
2 In addition to the BoE and the FCA's communications on LIBOR cessation, the EU Benchmarks Regulation requires that "Supervised Entities" have "robust written plans" setting out the actions they would take in the event that a benchmark (such as LIBOR) ceases to be provided.