The Future of LIBOR

by Pillsbury Winthrop Shaw Pittman LLP
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A London seminar considers what may become of the long-time benchmark interest rate as it faces possible obsolescence—and what might take its place.

Takeaways

  • Although the 2021 deadline, after which LIBOR will not be supported by the FCA, has been set, it is still far from certain whether LIBOR will continue on (in the same or some diminished fashion) after this date.
  • The Risk Free Rate (RFR), which is meant to replace LIBOR, remains a work-in-progress as an interest rate at present.
  • Transitioning to the RFR will be fraught with challenges involving rate calculation, loan documentation, currency variations, regulatory regime revisions and more.

On 9 January 2018, the Loan Market Association (LMA) presented a seminar on the future of the London Inter-Bank Offering Rate (LIBOR). The UK Financial Conduct Authority announced in July 2017 that market participants should not rely on the benchmark rate being available after 2021.

Discussions at the seminar included these observations:

  • The reasons why the move away from LIBOR are well known (not least the various scandals in the setting of LIBOR and the political pressure to move away from it), and the view is that the Risk Free Rate being the sterling overnight index rate (SONIA) in the case of sterling, a rate administered by the Bank of England, will replace it. The panel noted that banks do not actively fund using LIBOR and it therefore does not reflect the true cost of funding of banks (even though it is held out to do so). SONIA is thought to reflect more accurately the cost of capital and is based on far more transactions than LIBOR. In calculating the RFR, the credit and liquidity risk element is stripped out of the rate, thereby making the rate inherently lower (as an interest rate) than the LIBOR rate. The RFR is still being refined as an interest rate; a new methodology for SONIA was introduced in April 2017. The RFR is preferred as an alternative to LIBOR as it is stable, easy to understand and already widely used in the wholesale markets.
  • Borrowers appear to be reasonably relaxed around the change from LIBOR to the RFR and have not really engaged in the process. The view of borrowers appears to be that the market (and market participants) will sort out the new rate and its implementation in due course and therefore they do not need to be involved—i.e. they just expect that a new benchmark rate will be adopted by the market in the future.
  • A number of significant issues arise in the transition from LIBOR to the RFR:

1) Given that the RFR is lower (as a rate of interest) than LIBOR, the calculation of the components making up the rate will need to be considered and agreed by market participants. The rate of interest on loans currently comprises of LIBOR and the applicable margin. Lenders are currently considering whether it will be possible to introduce a third element (in the way that MLA costs were once included) to increase the rate, or whether an additional amount can be added to the margin. In the case of increasing margin, this may be a difficult sell to borrowers who are likely to take the view that the margin which they currently pay (and which reflects the current credit risk associated with that borrower) should not increase (given that the credit risk applicable to that borrower has not changed).

2) The current LMA documentation does not deal with the transition to the RFR. Many loan agreements contain the optional language of the replacement of the screen rate language but this is not universally the case—and even if this language is included, LIBOR may still be quoted but not be the generally accepted market rate (therefore meaning that loan agreements would not reflect the market position). Once the RFR methodology has been settled and language has been agreed for the purposes of documenting new loan agreements going forward, consideration needs to be given to amending existing loan documentation being used in the market—see below.

3) RFRs in different currencies are calculated on a local basis. This will lead to time zone issues when undertaking transactions in different parts of the world. For example, the US dollar RFR will be set in New York; this will cause issues for US dollar transactions being undertaken in, say, the Far East.

4) Unlike LIBOR, RFRs are calculated on a look back historic basis. Methodology needs to be created in order for RFRs to be calculated in a look forward basis.

5) RFRs are not calculated on the same basis in all parts of the global market and use different criteria and methodologies in their calculation. For example, the RFR in Japan (the Tokyo Overnight Average Rate (TONA)) is the uncollateralised overnight call rate calculated by the Bank of Japan, whereas the Alternative Reference Rates Committee in the U.S. has selected the Secured Overnight Financing Rate (SOFR) as the U.S. RFR, such rate being based on the overnight lending collateralised by the transfer of U.S. treasury securities as published by the Federal Reserve Bank of New York. By contrast, SONIA, administered by the Bank of England (and currently being reformed in order to increase its stability and resilience to market fluctuation), is the main benchmark for overnight unsecured money market transactions in the London market.

6) The implementation of the RFR needs to be considered across markets and products (for example in the loan market, the derivatives market etc.). Clearly there is a significant degree of interaction between both markets and products and all issues need to be dealt with on a consistent basis. For example, a loan may require interest rate hedging to be undertaken by the borrower; both the loan agreement and the hedging will need to be considered (and amended) when the RFR is adopted.

7) Market regulation will need to be considered prior to the implementation of the RFR. This, in itself, is no small task.

  • Currently, LMA loan documentation does not deal with the transition to the RFR. As noted above, some loans contain the optional language dealing with the replacement of the screen rate although this is not the case in all loan agreements. A simple substitution from LIBOR to the RFR will not work for investors given that RFR is an inherently lower rate of interest (and an added component to increase the RFR to a similar rate to LIBOR is not envisaged in the current interest rate calculation). There have been some attempts to deal with a change in the calculation of the interest rate in the future although none have been particular well received by investors. The main issue in this respect is that a change in the calculation of the interest rate is a unanimous decision for lenders—attempts to change this to a majority lender decision or a decision of the Facility Agent are extremely controversial given the sensitivity that a change of interest rates would have for investors. The fall-back position under loan documents is for the interest rate to reflect the lenders’ cost of funds, but if a high number of loans reverted to this if LIBOR was no longer quoted, a melt-down of the market would be a likely result.
  • Given that the 2021 date is largely “written in stone,” and financial institutions that are currently required to provide rate are keen to no longer do so, it seems likely that the change to the RFR will go ahead on this date. The Bank of England set up a focus group some time ago to look at the implementation of the RFR and discussions are progressing. Various sub-groups have been established more recently to consider all of the issues around implementation. One such RFR working group, chaired by the LMA, has been tasked with the development of documentation (and transitional documentation). Disappointingly, when the LMA was asked what progress had been made in this regard, the response was that it was way too early to say anything.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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