Current background
Following the 2008 financial crisis, liquidity in the interbank loan market fell significantly to the point where over seventy percent of the bank quotations on which LIBOR is set were based on judgements by the panel banks as to their own costs of credit, rather than being based on the interest rates for actual interbank loan transactions. Not surprisingly, as came to light in 2012, the LIBOR market became subject to manipulation by bank participants. While UK bank regulators undertook various reforms to address the problem, because liquidity has not returned to the market, concern over the reliability of LIBOR persists. Consequently, the UK Financial Conduct Authority (FCA), which began regulating LIBOR in 2013, has promoted the phase-out of LIBOR in favour of reference rates based on verifiable market transactions. The FCA has targeted the end of 2021, a little over three years from now, for the phase-in of new risk-free reference rates (RFR) to be completed. While it remains possible that LIBOR also will continue to be quoted after 2021, given the uncertainty, floating rate debt, as well as swaps and derivatives, with tenors extending beyond 2021 should include appropriate LIBOR fallback and replacement provisions.Alternative RFRs
Various currency-specific industry working groups, in coordination with their relevant regulators and central banks, are developing the new RFRs expected to replace LIBOR. In the U.S., with respect to the dollar, the effort is led by the Alternative Reference Rates Committee (ARRC). ARRC is an ad hoc committee convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York and is comprised of representatives from leading U.S. banks, industry groups, and regulators, including the U.S. Treasury, Federal Deposit Insurance Corporation, Commodity Futures Trading Commission and Securities Exchange Commission. ARRC has identified the so-called Secured Overnight Financing Rate (SOFR) as the reference basis for a U.S. dollar RFR. SOFR is a volume-weighted median of rates on overnight repos collateralised by U.S. Treasury securities. The New York Fed began publishing SOFR in April 2018, and overnight indexed swaps and futures in SOFR already have begun trading. Once sufficient liquidity develops, ARRC intends to fashion term reference rates based on SOFR derivatives.In the UK, the effort is led by the Working Group on Sterling Risk-Free Rates operating under the auspices of the Bank of England. This Working Group has identified the Sterling Overnight Index Average (SONIA) as the RFR basis for pounds sterling. SONIA, which is administered by the Bank of England, has long served as the reference rate for sterling overnight indexed swaps. It represents the mean of interest rates paid on overnight wholesale deposits, where credit and liquidity risks are minimal.
The challenge posed by SOFR, SONIA, and equivalent RFRs being developed for the euro, yen and Swiss franc is that they all are backward-looking overnight rates and so do not compensate for the forward risk and time value of term lending, whether it be one week, one month, or longer. LIBOR, by contrast, is forward-looking over several different maturities. LIBOR compensates for term risk and provides lenders and borrowers certainty as to the cash flows during each interest rate period. In addition, SOFR is secured by U.S. treasuries and so nearly risk-free, while LIBOR is unsecured and responsive to bank risk generally. SONIA is similarly low risk. SOFR and SONIA, therefore, are likely in most circumstances to be lower, less volatile rates than LIBOR, implying that different margins will be required to achieve equivalent effective interest rates. At this point, while under development, the mechanics, timing and ultimate availability of forward-looking term rates based on the new RFRs remain uncertain.
Implications for current floating rate debt
Although the phase-in of RFRs is not targeted to be completed until the end of 2021, floating rate notes and syndicated loans with tenors beyond that date are already being placed in the market. It is important, therefore, that new debt instruments include provisions which, as best they can at this point, anticipate the replacement of LIBOR.While the ultimate nature of the RFRs to be implemented by the end of 2021 is not yet known, it is likely that they will not be economically interchangeable with their corresponding LIBOR rates, and so it is unlikely that the new RFRs can be slotted into existing loans with their margins as currently priced without resulting in unintended value transfers to either lenders or borrowers. Consequently, it appears the best that can achieved at the moment in new loan documentation to address the risk that LIBOR will become unavailable, unreliable or non-standard during the term of a loan is to include provisions which facilitate amendments undertaken specifically to reset the interest rate reference and margin to accommodate the mechanics and economic metrics of the new RFR.
In the syndicated loan market, the general rule has always been that the unanimous consent of all lenders and the agreement of the borrower is required in order to change the rate of interest. In the case of conversion to new RFRs, however, because the new metrics will be well established and understood by the time replacement is necessary, and the transition will be undertaken on a market-wide basis, lenders and industry groups appear comfortable with relaxing the lender consent requirement, generally to a majority in interest of the lenders.
In the UK market, the Loan Market Association (LMA), which works to standardise documentation for English law-governed credit agreements, has published a set of provisions addressing the replacement of LIBOR. These provisions (i) identify the changes in LIBOR or the market, including but not limited to the cessation of LIBOR quotations, which would trigger the relaxed lender consent threshold for interest rate amendments and (ii) delineate the nature and scope of amendments that qualify for such treatment, including the prerequisite characteristics of qualifying RFR benchmarks.
In the New York law-governed syndicated loan market, similar though varied clauses have begun to appear in recent floating rate credit agreements, without any dominant market standards having yet taken hold. In addition, on 24 September 2018, ARRC published for comment proposed LIBOR replacement provisions for floating rate notes and syndicated loans. These are similar in format to the LMA provisions, although ARRC also includes provisions which, in addition to replacing the benchmark, would adjust the credit spread in certain cases.
