London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which banks lend to one another. In 2017, the UK’s Financial Conduct Authority (FCA) announced its intention to stop compiling LIBOR by the end of 2021. This is due to the fact that the method by which LIBOR is calculated no longer complies with internationally accepted principles
The FCA, Bank of England and the Working Group on Sterling Risk-Free Reference Rates (the Working Group) jointly confirmed towards the end of April 2020 its earlier statement that firms cannot rely on LIBOR being published after 2021. Due to COVID-19, it extended to the end of Q1 2021 the deadline for the use of sterling LIBOR in new loans that expire after the end of 2021.
The currently planned replacement risk free reference rate (RFR) for sterling is SONIA (Sterling Overnight Index Average). SONIA measures the interest paid on overnight unsecured funds in the wholesale banking market.
The Working Group has recommended that by Q3 2020, lenders should be in a position to offer non-LIBOR linked products. After that, clear contractual arrangements should be included in all new and re-financed loan products to facilitate conversion before the end of 2021. This can be facilitated either through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other RFRs.
UK Chancellor of the Exchequer Rishi Sunak this week announced increased regulatory powers for the FCA to manage an orderly transition, but the best outcome remains that market participants negotiate their own solutions privately.
Changing to a backward-looking overnight rate creates challenges and it is not yet clear how the markets will adapt and react to the new conventions.
For example, since LIBOR includes a credit risk component, RFRs tend to be lower, particularly during a stressed period. With no certainty that forward-looking rates will be available after LIBOR ceases, this leaves a potential pricing gap. This presents certain challenges for risk models, valuation and hedging, as well as the potential for so-called “zombie” risk of LIBOR being referenced in legacy contracts without being available as a benchmark.
Loan agreements provide for fall-backs where LIBOR is not available. However these were generally designed for short-term disruptions such as an IT glitch, and not the permanent abolition of LIBOR. Traditionally, the fall-back rate was often the lender’s own cost of funds, which may prejudice a borrower.
Tentative industry developments
The LMA has encouraged discussion among market participants by circulating proposed new documentation. One such draft addresses compounded rates, which must be calculated manually in the absence of screen rates.
But while the bond market has largely completed a transition to SONIA, the loan market has been slower to adjust. Market standards have not yet emerged for the post-LIBOR world, with only tentative signs about the shape that contracts may take.
We are aware of one major syndicated transaction where the parties opted for a five year historical mean as a stable average, prioritising stability over a more dynamic metric. Break costs and fall-backs are another significant issue where it remains to be seen what new conventions will develop in the case of a prepayment during an interest period.
While COVID-19 has understandably slowed loan market LIBOR transition preparation, lenders and borrowers should not delay their transition efforts for existing loans or new loan issuances. Pragmatic solutions to documentation may be needed while the industry continues to develop.
For more information on how the LIBOR transition may ultimately affect your operations, contact a member of our Financial Services team.
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