Recent Developments in LIBOR Transition
Wednesday 30 September 2020
Despite the disruption to capital markets caused by the COVID-19 pandemic, regulators remain determined to keep the transition to alternative rates on track, with no plans to delay the end of LIBOR beyond the end of 2021. The necessity for the transition away from LIBOR has been reinforced by the spikes seen in the rate in March 2020 in response to COVID, due to the low levels of transaction based submissions for LIBOR. By comparison, the value of transactions for SONIA increased from £40 billion per day to over £60 billion in April.
Whilst there has been an impact on the timing of some aspects of the transition programmes for many firms, particularly within the loan market, some progress has been made which will be discussed below.
Credit Spread Adjustment
The Working Group on Sterling Risk-Free Reference Rates (RFRWG) recommends that robust contractual fallback terms should also include consideration of a credit spread adjustment to account for the differences between LIBOR and SONIA. In response to the Working Group’s consultation on credit spread adjustment methodologies for cash products, all market participants indicated their preference for the ISDA historical 5-year median approach for cessation fallbacks as well as 90% of respondents stating no other credit adjustment spread methodology should be considered. The majority of respondents also felt it beneficial to have an internationally consistent methodology.
The historical median approach is seen as the most robust methodology and is less susceptible to volatility and manipulation around the time the fallback is triggered because a long lookback period is used which addresses concerns about the alternative forward approach. However, it is understood that an approach which relies on historical data may not be representative of the future.
Tough Legacy Contracts
The predominant view remains that firms should proactively remove LIBOR dependencies from their contracts before the end of 2021, either through amending the contract to reference an alternative rate, or using a robust fallback allowing the contract to move to an alternative rate upon a triggering event. However, market participants have flagged to regulators that there will be legacy LIBOR referencing contracts without suitable fallbacks that will continue post 2021. The scale of the issue varies depending on the asset class.
Derivatives are considered the easiest to transition when compared with bonds and loans, largely due to ISDA’s IBOR Fallbacks Protocol expected to be published in Q4 2020. However, there will be a case for action in incidents where a derivative is used to hedge an exposure which is itself considered tough legacy. Non-linear products will also require additional contractual amendments to supplement those amendments made by the ISDA IBOR Fallback Protocol. The RFRWG announced plans for a new task force to progress and raise awareness of conventions for new risk-free, rate-based, non-linear products in July 2020.
Legacy bonds either do not contemplate permanent discontinuation of LIBOR, some involve the exercise of discretion, or contain no fallback provisions whatsoever. Remediation of the entire legacy bond market will not be possible as there will be instances where it may not be possible to obtain consent from bondholders; consent solicitations can be long and expensive; insufficient time available to transition; and more complex arrangements where there is no longer a decision maker, nor a party, willing to assume costs of amendment.
Both bilateral and syndicated loans are considered to be problematic. Whilst the use of a replacement of screen rate clause has become more prevalent in facility agreements allowing for majority consent, some older documentation does not contemplate such a replacement and requires all lenders and borrowers to consent to amendments to transition to an alternative rate. If the required consents are not obtained, the fallback in many syndicated agreements is to the lender’s cost of funds and so there will be difficulties in calculating relevant costs. Similarly, to legacy bonds, there are practical difficulties in that loans can be diverse in nature and renegotiation of all these contracts on an individual basis before LIBOR cessation will be difficult.
Considering the above issues, the Tough Legacy Taskforce has followed the ARRC in recommending proposals for legislative relief. The ARRC released a proposal for New York State Legislation in March 2020, which is primarily aimed at providing legal certainty and minimising adverse economic impact for those contracts that do not have fallback language addressing LIBOR cessation or have language that could alter the economics of the contractual terms. The proposed legislation is intended to be mandatory, however, parties will have the right to exercise discretion regarding the fallback rate and may mutually opt out of any mandatory application. The legislation will not override existing contracts that provide for a non-LIBOR rate as a fallback.
Off the back of the Tough Legacy Taskforce’s paper, the UK Government confirmed, in June 2020, that it intends to legislate to provide the FCA with enhanced powers to require the administrator of LIBOR to change its methodology, in circumstances where it is found that the benchmark’s representativeness will not be restored. This would allow LIBOR publication to continue in order to manage the transition of tough legacy contracts beyond the end of 2021.
Bloomberg has started publishing compounded in arrears RFRs, the spread adjustment and the ‘all in’ IBOR fallback rates, which will soon be implemented by ISDA for certain key IBORs.
As briefly mentioned, ISDA is expected to amend its 2006 ISDA Definitions, by publishing the IBOR Fallback Supplement, to include fallbacks which will apply either upon permanent cessation of LIBOR or upon a non-representative determination of LIBOR prior to cessation. ISDA will also be publishing a protocol, known as the IBOR Fallback Protocol, to facilitate multilateral amendments in legacy derivatives contracts. However, this protocol will be completely voluntary and will only amend contracts between two adhering parties.
Compounded in Arrears SONIA vs. Term SONIA
Refinitiv, IBA and FTSE Russell have all launched indicative forward-looking Term SONIA reference rates. All benchmark administrators have published 1-month, 3-month and 6-month tenors, with FTSE Russell also publishing a 12-month rate. A Term SONIA Reference Rate is an alternative to SONIA compounded in arrears and use of it will be limited. SONIA compounded in arrears is expected to be the primary vehicle for LIBOR transition for sterling markets and is seeing further transition progress across a broad range of market participants. The Loans Market Association has a dedicated list of loans referencing risk-free rates, outlining the key conventions used in these transactions – see here.
The RFRWG recently published a list of recommendations for referencing compounded in arrears SONIA for the sterling loan market. The working group has made clear that SONIA is to be implemented via a compounded in arrears methodology, using a five banking days lookback without observation shift – which aligns with the ARRC’s recommended approach. However, it should be noted that lenders can offer a lookback with an observation shift which remains a viable and robust alternative. The difference here being that an observation shift is where the SONIA rate is weighted according to the days in the observation period rather than in the interest period.
The transition from LIBOR remains both a challenging and essential task. It has been made clear that time is running out, and this, in itself, is causing practical difficulties for transitioning away from the continued dominance of LIBOR linked contracts. However, there is an orderly timeline in place and it is expected that those who can transition away from LIBOR should do so on terms agreed with their counterparties. All new LIBOR linked products are expected to cease between the first and third quarters of 2021. Completion of conversion processes will run alongside the ceased issuances, leaving plans in place to deal with legacy exposures.
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 Bank of England, UK Working Group on Sterling Risk-Free Reference Rates (RFRWG) 2020-21 Top Level Priorities, July 2020, https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/rfr-working-group-roadmap.pdf?la=en&hash=92D95DFA056D7475CE395B64AA1F6A099DA6AC5D
 Bailey, A, Libor: Entering the Endgame, 13 July 2020, https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/libor-entering-the-endgame---speech-by-andrew-bailey.pdf?la=en&hash=26FF64120E62077B52C879CE4BEAD13315101485
 The Working Group on Sterling Risk-Free Reference Rates, Consultation on credit adjustment spread methodologies for fallbacks in cash products referencing GBP LIBOR – Summary of Responses, March 2020, https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/summary-of-responses-on-consultation-credit-adjustment.pdf
 ISDA, Benchmark Reform and Transition from LIBOR, https://www.isda.org/2020/05/11/benchmark-reform-and-transition-from-libor/#press
 The Working Group on Sterling Risk-Free Reference Rates, Paper on the identification of Tough Legacy Issues, May 2020, https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/paper-on-the-identification-of-tough-legacy-issues.pdf
 Bank of England, Transition to sterling risk-free rates from LIBOR, https://www.bankofengland.co.uk/markets/transition-to-sterling-risk-free-rates-from-libor
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 Alternative Reference Rates Committee, ARRC Releases a Proposal for New York State Legislation for U.S. Dollar LIBOR Contracts, March 2020, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Press_Release_Proposed_Legislative_Solution.pdf
 Sunak, R, UK Parliament, Financial Services Regulation – Statement made on 23 June 2020, https://questions-statements.parliament.uk/written-statements/detail/2020-06-23/HCWS307
 ISDA, Bloomberg Begins Publishing Calculations Related to IBOR Fallbacks, 21 July 2020, https://www.isda.org/2020/07/21/bloomberg-begins-publishing-calculations-related-to-ibor-fallbacks/
 ISDA, ISDA Board Statement on Adherence to the IBOR Fallback Protocol, 29 July 2020, https://www.isda.org/2020/07/29/isda-board-statement-on-adherence-to-the-ibor-fallback-protocol/#:~:text=ISDA%20also%20expects%20to%20publish%20a%20protocol%20%28the,relevant%20IBOR%20and%20will%20therefore%20include%20the%20fallback.
 The Working Group on Sterling Risk-Free Reference Rates, Newsletter, July 2020, https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/newsletter/july-2020.pdf
 The Working Group on Sterling Risk-Free Reference Rates, Recommendations on conventions for referencing compounded in arrears SONIA in the sterling loan market, September 2020, https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/statement-on-behalf-of-rfrwg-recommendations-for-sonia-loan-market-conventions.pdf?la=en&hash=074583D7080993CE84B6A381B554BEFD6594C076
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