LIBOR transition in the Loans and Derivatives Markets – a mid-2021 round up

Worldwide, regulators and industry associations have established working groups to identify and recommend risk-free rates (RFRs) to serve as alternatives to LIBOR and other benchmarks used in financial instruments. In Europe, the European Central Bank, European Commission and others have recommended the euro short-term rate (€STR) as the RFR for the euro area. In the US, the Alternative Reference Rates Committee (ARRC) has recommended the use of the Secured Overnight Financing Rate (SOFR) for dollars. On 2 June 2021, the Financial Stability Board published a helpful global transition roadmap summarising the high-level steps financial and non-financial firms should take over the course of 2021 to complete their transition. 

In the UK, the recommended RFR for sterling is SONIA.  During the first few months of 2021, the Bank of England's Sterling Risk Free Rate Working Group (SRFRWG) published further guidance on the implementation of recommended replacement rates for LIBOR in cash and derivatives markets.

• In February, the SRFRWG published guidance papers for new GBP SONIA referencing loans (including refinancing and renewals) and for the transition of legacy GBP LIBOR bilateral and syndicated loans.
  
  
• Following that, the SRFRWG published a proposed potential methodology using compounded SONIA rates which could form a replacement for the GBP LIBOR ICE Swap Rate, to provide a fallback where swaptions are to be cash-settled using the LIBOR swap rate or cleared-settled when cleared LIBOR swaps are no longer provided by the clearing houses.
  
  
• A further SRFRWG paper outlining how a sterling structured products and repackaging market could operate on the basis of compounded SONIA was published in April.
  
  
• Finally, in May, the SRFRWG confirmed the use of SONIA compounded in arrears as the recommended rate for the bond markets, but left approaches to calculation to be tailored by participants on a case-by-case basis.

This means the SRFRWG has now recommended the use of compounded SONIA across all major sterling markets. It has stated that use of SONIA compounded in arrears should be operationally achievable for approximately 90% by value of the GBP LIBOR loan market. The SRFRWG has acknowledged that alternative rates may be more appropriate in other cases, such as the use of the Bank of England's bank rate for lower-value loans to smaller borrowers. Forward-looking term SONIA reference rates ("TSRRs") are now available for a range of tenors and published by three benchmark administrators (for a summary click here), but the Bank of England and the FCA have stressed that use of TSRRs by regulated entities should be limited to cases in which compounded in arrears SONIA cannot be used.

Lending banks in the US have been advocating the use of credit-sensitive rates, arguing that these better hedge their cost of funds in stressed market conditions such as those which arose at the start of the pandemic in March 2020. However the Governor of the Bank of England, Andrew Bailey, has made it clear that the Bank considers credit-sensitive rates to be inappropriate in the sterling markets, owing to their reliance on transactions in commercial paper and certificate of deposit markets that have proven precarious in stressed conditions when liquidity drops.

It is therefore expected that rates based on SONIA compounded in arrears will be used in the vast majority of cash and derivative market instruments as the replacement for sterling LIBOR.

Despite the guidance from SRFRWG, there remains no legal requirement for UK-regulated firms to transition to risk-free rates or other LIBOR replacements, although the messaging from the Bank of England, the Prudential Regulation Authority (PRA) and the FCA has been consistent and is becoming louder. On 26 March, the FCA and PRA wrote a joint "Dear CEO" letter, reiterating the expectation that no new LIBOR business be written following key dates throughout 2021. The letter stated:

“Firms should have robust processes in place to ensure that all new sterling LIBOR business is closely controlled and the use of the linear derivative risk management exemption is consistent with its express purpose of facilitating the risk management of existing positions. Any incident of sterling LIBOR-referencing loan, bond or securitisation issuance from Thursday 1 April onwards that expires beyond end- 2021 would potentially be viewed as indicative of poor risk management and poor governance of transition.” 

The FCA and PRA also highlighted the need for "active transition", i.e. agreeing to rate switches before the actual cessation date of the rate – in other words, reliance only on fallbacks which come into effect on cessation is discouraged, although the regulators have welcomed the widespread incorporation of such fallbacks into legacy derivatives contracts via the ISDA 2020 IBOR Fallbacks Protocol.

The SRFRWG has also stepped up its push for firms actively to transition contracts onto RFR rates prior to LIBOR cessation. It recently published a further paper recommending that counterparties move now to active transition rather than incorporating fallbacks in legacy bonds and loan transactions. Parties are encouraged to prioritise the transition of instruments with long lead-times for amendment, such as bonds which require consent solicitations to be conducted. Even where contractual fallbacks are included in financial contracts, the SRFRWG encourages an active rate switch ahead of the 31 December cessation. Whilst the SRFRWG views the ISDA Fallbacks Supplement mechanism as a robust safety-net, it nevertheless specifically encourages counterparties to consider where it may be preferable to transition to the RFR now rather than rely on the fallbacks, and suggests that this would be the case for example with derivatives instruments hedging LIBOR exposure in loans.

This means that as of the end of Q2 2021, there should be no new loans made, derivatives business transacted or bonds issued on the basis of LIBOR, except for risk-management of existing positions, in the following circumstances:

• (i) transactions that reduce or hedge the firm’s, or any client of the firm’s, GBP LIBOR exposure on contracts;
  
  
• (ii) market making in support of client activity related to existing GBP LIBOR contracts, including streaming of prices to support such activity and to support other benchmarks;
  
  
• (iii) novations of GBP LIBOR transactions;
  
  
• (iv) transactions executed for purposes of required participation in a central counterparty auction procedure in the case of a member default, including transactions to hedge the resulting GBP LIBOR exposure; and
  
  
• (v) transactions in GBP LIBOR-linked exchange traded futures and options executed before end-Q2 2021, or otherwise in line with the relevant exceptions set out above.

In the absence of a mandatory fallback or active rate-switch requirement, some firms have been hesitant to switch customers to RFRs while LIBOR has continued to be published and markets have been some way from a consistent approach to the adoption of replacement rates. In early May, the Governor of the Bank of England warned that firms who persist in "lazy" behaviour in unnecessarily sustaining LIBOR-linked products will be treated by their supervisors as demonstrating failures in governance and risk management. That said, the Governor also noted that billions of pounds of GBP facilities and bonds are now linked to compounded SONIA in arrears. To support a substantial move in trading volumes from GBP LIBOR to SONIA, the Bank has also encouraged a change in interdealer quoting conventions for linear and non-linear sterling derivatives from LIBOR to SONIA pricing, a switch which has now gone ahead with the broad support of the markets.

However the sterling markets are still using a variety of approaches to SONIA-based rates and the application of compounding conventions and credit adjustments. As discussed in our earlier briefing, the ISDA 2020 IBOR Fallbacks Protocol relied for rate-switches on a manufactured rate published by Bloomberg, which compounds SONIA over a backward-looking period corresponding to the replaced LIBOR tenor. This created a certain degree of fallback uniformity in the OTC derivatives markets, but "day one" compounded SONIA instruments reflecting cash market approaches were still required to be developed. Where there is not a uniform fallback mechanism across the derivatives, loan, bond and repo markets, mismatches and gaps will appear, for example where a party has entered into a derivative to hedge a risk arising under another financial arrangement, such as a loan. On 14th June, ISDA published its new 2021 Interest Rate Definitions booklet, allowing counterparties various options to tailor the compounded SONIA floating rate option and apply various shift, lookback and lockout approaches to match those used in the cash markets.

Initial progress towards SONIA adoption in sterling loan markets was slow. Publication of market conventions for a compounded rate by the SRFRWG in September 2020 was swiftly followed by the launch of RFR-priced "exposure draft" facility agreement templates published by the Loan Market Association ("LMA"). This significantly facilitated the documentation of new SONIA-priced loans. However these templates went through a number of iterations and were not published in "recommended form" until the end of March 2021, by which time parties were expected to cease writing new GBP LIBOR-linked facilities.

Challenges in the way of transition have included education of market participants on the fine detail of the new documentation, which include complex mathematical formulae for calculating compounded SONIA. Some firms have also struggled to make the necessary IT changes to facilitate the adoption of new loan pricing.

In many cases, SONIA-based pricing has been adopted through the amendment of existing documentation. This presents multiple challenges because there is no "one size fits all" approach and changes have to be made to multiple parts of the document, often with a dual pricing structure in place for existing vs. new interest periods. In recent years attempts were made to "future proof" loan documents, to allow for RFR re-pricing decisions to be made via lower consent thresholds. In many cases this wording was bespoke and so the pre-existing documentation requires consideration to see whether amendments are feasible. Another challenge is that multicurrency facilities have seen a divergence of approach between currencies, such that some currencies (e.g. euro) continue to be priced off a forward-looking screen rate whilst others (e.g. sterling) adopt a compounded RFR rate.

The LMA documents do not address definitively the consequences of SONIA re-pricing in many areas for which a consistent market practice has yet to emerge. These include the management of prepayment and other intra-period events, the use of fallbacks (e.g. cost of funds) and the impact on financial covenants. Instead the LMA has published discussion papers detailing considerations which firms need to focus on, for instance when documenting RFR-priced leveraged finance or real estate finance transactions. The larger banks were quick to publish their policies on some of these issues. Smaller lenders have taken longer to adopt policies and some lenders that fall outside the FCA regulatory framework have sought to delay adoption of RFR pricing or pursue other options. This presents challenges when lenders are unable to agree on a common approach, requiring "re-tranching" of existing facilities in some cases.

In summary, banks and investment firms are finally making progress to transitioning away from LIBOR in the face of confirmation of its upcoming cessation. While movement is in the right direction, there is uncertainty in some key areas, including: (i) which compounding conventions and credit adjustments will be used across different products when calculating the compounded SONIA rate (and how this will affect pricing and market liquidity); and (ii) how market participants will deal with any potential mismatches in methodology (e.g. when using derivatives that are linked to cash products). 

In addition, HM Treasury has proposed a legislative "safe harbour" which, if enacted, is expected to prevent frustration or termination of contracts for LIBOR discontinuance. The FCA has also recently consulted on the possible designation of LIBOR as an "Article 23A Benchmark" under its new powers pursuant to the UK Benchmark Regulation granted by the Financial Services Act 2021. If so designated, the FCA would have certain powers to compel the continuation of LIBOR via a synthetic methodology and allow its use in limited circumstances for what have been termed "tough legacy" contracts. We expect to publish a further briefing on both of these proposals, including which contracts may be included within the scope of "tough legacy", once draft rules are available.

If you would like to discuss this further, please contact us.

For commentary on the impact of LIBOR discontinuation on other commercial contracts which reference LIBOR (for instance in late payment clauses), see our earlier briefing here.