As is now well known, in July 2017, the UK's Financial Conduct Authority (FCA) announced that after the end of 2021 it will no longer use its influence to persuade LIBOR panel banks to provide quotes and will not exercise its powers to compel them to do so. This announcement was a wake-up call to the debt and derivatives markets, forcing participants in those markets to address the likelihood that LIBOR will cease after 2021. Market participants have begun to address the transition from LIBOR to alternative benchmark rates and the development of more robust contractual fallbacks in contracts that go beyond 2021 if publication of LIBOR were to cease. Significant steps toward identifying alternative benchmark rates have been made since the FCA's announcement.
Potential Replacement Benchmark Rates for LIBOR
Many jurisdictions are currently considering moving away from their relevant currency IBOR to an overnight risk-free rate. In the US, the Alternative Reference Rates Committee (ARRC) has recommended the Secured Overnight Financing Rate (SOFR) as the LIBOR replacement for derivatives. SOFR is the combination of three overnight treasury repo rates. According to the Loan Syndications and Trading Association (LSTA), SOFR may become the replacement rate for cash products, like syndicated loans and CLOs. In the UK, Reformed SONIA (Sterling Overnight Index Average) has been identified as the appropriate replacement for GBP LIBOR. In Switzerland, SARON (Swiss Average Overnight Rate) has replaced the TOIS benchmark. In Japan, TONA (Tokyo Overnight Average Rate) has been selected as the alternative to yen LIBOR. Finally, the European Central Bank has decided that its new unsecured overnight rate would be called ESTER (Euro Short-Term Rate).
Some of these risk-free rates, such as SONIA, are unsecured while others, such as SOFR, are secured. Whether the potential replacement rates are secured or unsecured, they may behave differently to LIBOR, which has always been intended to reflect prime bank credit risk. For example, the spread differential between SOFR and USD LIBOR has not been stable during periods of stress, in that USD LIBOR (and bank cost of funds) spiked during the financial crisis, while SOFR remained relatively stable.1
The ARRC is considering whether it would be appropriate to provide for a credit spread adjustment to be added to SOFR in certain cases to reflect bank credit risk and cost of funds. In the US, SOFR began to be published by the Federal Reserve Bank of New York in April 2018.2 In October 2017, the ARRC proposed a six-part staged transition plan to SOFR.3
For bank lending, however, a key question remains unanswered - whether a term structure can be built around these overnight rates to give borrowers the ability to fix rates over terms comparable to the traditional LIBOR maturities. In its transition plan, the ARRC stated that it expected that a term structure would be developed before the end of 2021.
Different currencies may transition to alternative rates at different times and the different alternative rates may require different adjustments.
Impact on Legacy Agreements and New Agreements
At this stage, it is impossible to definitively state whether LIBOR will cease to exist after the end of 2021. However, cessation is possible.
There are many agreements currently in force that refer to LIBOR and will remain in effect after 2021. While the potential replacement benchmark rates for LIBOR are being considered, it is impossible to draft wording identifying the new rates that might apply after then. However, what is possible is to provide additional flexibility so as to ease the process of amending documents at the appropriate time in the future.
Generally, all existing agreements using LIBOR should be reviewed to determine whether there is any fallback language and amendment flexibility and, if so, whether such language is adequate. Furthermore, all new documents and documents currently in the process of being amended should address the transition to a new benchmark in the event such transition takes place.
Many legacy debt agreements currently have fallback mechanisms in the event that LIBOR ceases to be quoted or is unavailable. In most cases, these credit agreement fallbacks are intended to address temporary disruptions in the LIBOR market. In the event that LIBOR were to cease permanently, the fallbacks currently provided for would be unworkable.
a. The loan market
In most debt agreements, the fallback in the case of a temporary unavailability of LIBOR is the lender's cost of funding. Not many facility agreements specifically address the issue of a permanent replacement for LIBOR and, therefore, any such replacement will, by default, be a majority-lender decision. However, as a reduction in the amount of interest payable is typically an all-lender decision, a replacement benchmark rate that results in such a reduction in interest will be an all-lender decision.
Some agreements provide for an eventuality where LIBOR ceases to exist by including the LMA's version of the optional "Replacement of Screen Rate" clause. The clause, which has been part of the LMA's Primary Documents and the Leveraged Documents since November 2014, allows the benchmark rate to be replaced with the consent of a two-thirds majority of the lenders. By making the replacement a majority-lender decision in all circumstances, the LMA could have been seeking to avoid a dissenting lender from potentially holding up the syndicate decision.
The LMA has recently published an updated version of the optional "Replacement of Screen Rate" clause. The updated clause permits amendments to be made to documents in a wider range of circumstances than the existing clause permits, and the LMA acknowledges that, while requiring the consent of the majority of lenders for a replacement of the Screen rate may be an appropriate threshold, there might be circumstances where replacement of Screen Rate might need to be made with the consent of all the lenders. LMA members can see this clause here.
In Asia, the APLMA's Asian facility agreements (other than the secured facility agreement) include the earlier version of the LMA clause on "Replacement of Screen Rate". However, the manner in which it has been adopted produces a slightly different effect to that in the LMA documents. While replacing a benchmark rate is a majority-lender decision in the APLMA documents as well, if it results in a reduction in the amount of interest payable, it becomes an all-lender decision.
In the US, the loan market has not agreed on a single common provision. However, we have seen market participants implement several provisions with some frequency. These provisions allow for a loan agreement to be amended upon a determination by the lender or the facility agent that LIBOR has ceased permanently. These amendments could be effected unilaterally or (in a syndicated deal) subject to a consent or negative consent mechanism that called for less than a 100% vote of the lenders. Some borrowers have attempted either to get a say in the imposition of a substitute rate or to impose limitations on such rate (such as a most favoured nations clause). The situation remains in flux4.
In the US, many loan agreements revert to the prime rate if LIBOR is unavailable. As this rate is normally higher than LIBOR, borrowers will likely find this an unattractive solution.
ISDA has announced that it expects to launch a market-wide consultation on the credit spread methodology and term fixing adjustments that would apply to derivatives fallbacks. Once agreed, ISDA will incorporate these fallbacks into ISDA's 2006 interest rate definitions such that new trades that refer to the definitions will get the benefit of such provisions. ISDA has also announced that it expects to publish a protocol to allow market participants to incorporate the fallbacks into existing trades.
c. Capital markets transactions; CLOs; securitizations
For floating rate notes in the US, the Credit Roundtable, an industry group formed by institutional investors, has proposed some standard language to apply in the event that LIBOR becomes unavailable.5 It remains to be seen whether this (or other) language will be broadly accepted.6 Legacy floating rate note transactions that mature after 2021 face a significant issue in that interest rate amendments require a 100% noteholder vote. In many cases, in the event of a LIBOR discontinuance, thenceforward the applicable rate may be LIBOR on the date last quoted. The ARRC has observed that "[b]uy-backs or renegotiation may be difficult depending on the rate environment (if note holders believe that converting to a fixed rate is in their interest at a point when LIBOR is discontinued, they will be reluctant to renegotiate for other terms)."7
For CLO indentures, the interest payable is often based on LIBOR in order to correlate with the loan portfolio of the particular CLO issuer. In the event of any transition from LIBOR, the CLO would be at risk if there was a mismatch between its floating rate revenues and its floating rate obligations. In the US, an ARRC working group has expressed the view that the CLO market was beginning to settle on standard language in new issuances allowing for the issuer or the collateral manager to name a market standard rate as a successor to LIBOR.8 With respect to legacy transactions, CLO notes tend to be issued with relatively short maturities, which may mitigate the risk in that many legacy CLOs may be refinanced before 2021.
With respect to securitizations, in the US ARRC working group members have reported seeing new fallback language incorporated in most new CMBS transactions, and in fewer new RMBS transactions.9 Securitization market participants also face the issue of legacy transactions.
What is Next?
One of the problems with LIBOR that concerned the FCA was that the lack of liquidity in the interbank lending market rendered LIBOR unstable. There is evidence that this lack of liquidity has got worse since the FCA's announcement, increasing LIBOR's instability and making the need to address potential LIBOR discontinuance more urgent.10
While significant work has been undertaken by market participants since the FCA's announcement, much work remains to be done. At this point, market participants seem to be waiting to see whether the recommended alternative reference rates are practicable substitutes for LIBOR, and whether sufficient liquidity will develop in contracts that refer to these rates. In a white paper, BlackRock identified what it referred to as a "chicken and egg" problem with transitioning to alternative reference rates: investors will not adopt ARRs if liquidity is insufficient, but sufficient liquidity will not develop if investors do not adopt ARRs.11 Also, anti-competitive issues around the sharing of pricing information make it more difficult for banks to sit down together to consider the options.
Much still depends on the development of replacement alternative reference rates. If such a rate were to be more fully developed, understood and broadly accepted, it might be possible to prepare more concrete fallback language for contracts, with a reference to a specific rate as a replacement for LIBOR, and a mechanism for specific adjustments for credit spread and forward term, to the extent necessary.
The problem remains complex and unresolved, and shows no sign of going away. Market awareness of the issue appears to have increased since the FCA's announcement, and work continues by public and private sector actors to address the many issues confronting the market.
1 While SOFR was not published during the financial crisis, publicly available US Treasury repo rate information extends back more than 10 years. The ARRC has expressed the view that such information provides a reasonable proxy for modelling how SOFR would have behaved during this period. Market participants may thus use such information to compare SOFR and USD LIBOR over time.
3 See ARRC Second Report, March 2018, available at https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report.
4 At the ARRC meeting held on 22 March 2018, several ARRC working groups presented information on recent trends and issues in contract language for certain cash products. See https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2018/ARRC-Minutes-for-March-22-2018.pdf (Attachment 4). including business loans, floating rate notes, and securitized products.
5 See Letter from the Credit Roundtable, "Industry standard for LIBOR fallback language" 22 January 2018
6 PIMCO circulated alternative LIBOR language for floating rate notes at the 17 April 2018 ARRC meeting. See https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2018/ARRC-Minutes-April-17-2018.pdf (Attachment 3).
7 See supra note iv.
8 See supra note iv.
9 See supra note iv.
10 Compare, e.g., The ICE LIBOR quarterly volume reports for Q2 2017 and Q1 2018, available at https://www.theice.com/publicdocs/ICE_LIBOR_Quarterly_Volume_Report_Q2_2017.pdf. and https://www.theice.com/publicdocs/ICE_Libor_Quarterly_Volume_Report_Q1_2018.pdf, respectively. For many currency/tenor combinations, the percentage of trades based on market data (ie., judgment) had increased.
11 BlackRock, LIBOR: The Next Chapter, available at https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-libor-the-next-chapter-april-2018.pdf.