Preparing for a world without LIBOR: key considerations for loan market participants

It has been two years since the Financial Conduct Authority (UK) (FCA) announced that the London Interbank Offered Rate (LIBOR) would cease in 2021.

As that deadline approaches and the FCA continues to insist on the assumption that there will be no LIBOR release after the end of 2021, regulators and industry bodies around the world are urging market participants to prepare to the transition with increasing intensity.

FCA chief executive Andrew Bailey recently said companies that delay the transition are making a mistake. The CEO of the Asia Pacific Loan Market Association (APLMA) also pointed out that “time is running out now” and that members need to be aware of the “seismic shifts” to come.

In Australia, the Australian Securities and Investments Commission (ASICs) has written to major financial institutions imploring them to carry out a full risk assessment of their LIBOR exposure.

What will replace LIBOR?

Working groups in different jurisdictions have each identified an overnight risk-free rate (RFR) for their currency.

Each RFR is at a different stage of development, as shown in the table below. Unlike LIBOR, RFR is just an overnight rate, available in different terms. RFR, anchored in active and liquid market transactions, is inherently risk-free and therefore inferior to LIBOR (which takes into account credit and term risks).

How can loan market participants prepare for the transition to RFRs?

Due to the difficulty in reconciling the differences between RFRs and LIBOR, the lending market is lagging behind other financial markets in its transition to RFRs.

Since the RFR is only an overnight rate, interest amounts are determined at the end of a given interest period. This is troubling to both lenders and borrowers for cash flow management purposes.

There is a push for the development of RFR-based forward-looking forward interest rates, using derivative transactions that reference the RFR, provided there is sufficient liquidity. SONIA is the most advanced in the development of the Term Sonia Reference Rate.

There is great uncertainty about the viability and timing of RFR forward rates. The transition does not only concern new business, but also the conversion of old LIBOR contracts. Regulators stress that RFR term rates will not be the primary route to transition and urge market participants to pursue their RFR transition plans without waiting for RFR term rates to become available.

What else should loan market participants consider?

  1. Existing loan documents. Although many documents include a fallback mechanism if LIBOR is not available, this fallback was designed with temporary unavailability in mind, not permanent termination, which means that existing loan documents are not not equipped to deal with the transition.
  2. LMA proposed changes. In Europe, the Loan Market Association (AML) updated its Revised Recommended Replacement Screen Rate Clause Form and User Guide in May last year, extending the application of the ‘screen rate override’ clause to broader circumstances, including the benchmark administrator announcing that it will stop providing the interest rate of reference. The update also introduced a concept of an “alternate benchmark” that parties will transition to.
  3. The ARRC has proposed provisions for the new documents. In the United States, the ARRC has published two sets of contractual provisions called the “amendment” approach and the “hardwired” approach to prepare for a transition to SOFR. The “modification” approach does not prescribe a replacement rate, but provides a process for the parties to agree on a replacement benchmark. In contrast, the “hard-wired” approach prescribes the replacement options to be applied in cascade. Adoption of terms proposed by the LMA or ARRC is not automatic and must be voluntarily entered into by the parties. For existing loan documents, changes are required.

Next steps

Loan documents often do not exist in isolation, and along with changing the rate applicable to the loan, any hedging transactions must also be modified or alternatively terminated (which may incur breakage costs) and new hedges must be entered into .

As LIBOR is used in a wide range of commercial (i.e. non-financial) contracts, these contracts need to be modified.

Market participants are well advised to consider referencing RFRs for new contracts, identify contracts that include LIBOR clauses, assess their position, and be prepared to negotiate changes to documents. For complex cross-border transactions, negotiations may take longer than expected and time is running out.

Priscilla C. Carnegie