Since it was announced in 2017 that there would be a revision or replacement of LIBOR, a lot of water has flowed under the bridge. Treasury Today talks to Loan Market Association Chief Executive, Clare Dawson, about what happens next and what treasurers can do to ease the transition.
LIBOR is dead. Perhaps. After the furore that followed the LIBOR rate rigging scandal that broke in 2012, the benchmark for short-term interest rates – created from submissions by panel banks and currently administered by Intercontinental Exchange – is currently in transition.
It is getting ready to be something else by the end of 2021. That something is not yet known, and the cut-off may not technically be the end of LIBOR, even if after 2021 the LIBOR panel banks will no longer be encouraged or required by the UK’s Financial Conduct Authority (FCA) to provide quotes.
Whether that means it will be reformed or replaced is subject to ongoing debate. This debate involves the world’s leading authorities and central banks, as well as essential trade organisations such as the International Swaps and Derivatives Association (ISDA), the Securities Industry and Financial Markets Association (SIFMA) and the Loan Market Association (LMA). These bodies are seeking a fall-back for the transition of legacy contracts that would see the adoption of alternative risk-free rates (RFRs) should LIBOR be abandoned.
All participants understand that the deeply embedded nature of LIBOR (globally, it underpins $350trn of contracts – more than four times gross world product) means transition cannot be rushed. Indeed, according to Andrew Bailey, Chief Executive of the FCA: “The transition will be less risky and less expensive if it is planned and orderly rather than unexpected and rushed.”
To this end, September 2018 saw the FCA, and the Prudential Regulation Authority (PRA), write to the major banks and insurers supervised in the UK, asking for details of their preparations and actions in managing the transition. The aim was to seek assurance that not only do all understand the risks associated with transition, but also that all are now engaged in appropriate action to ensure their plans are effected smoothly by the end of 2021.
With 36 months to go, LMA Chief Executive, Clare Dawson, says progress depends on currency (LIBOR is currently quoted for USD, EUR, GBP, JPY and CHF) but the number of usable overnight RFRs is slowly rising, including Sterling Overnight Index Average (SONIA) and in the US, the Secured Overnight Financing Rate (SOFR). Meanwhile, the Euro Short-Term Rate (ESTER) will not be live until October 2019, at the latest, (leaving little time to build a functioning curve).
“Given that loans exist very much in a multi-currency world, the market is still waiting to see what will happen to the different currencies,” says Dawson. Even then, participants do not want to be working off a pure overnight rate; ideally, they will be looking for forward-looking term rates to be developed. The Bank of England consulted on a forward-looking term-rate for SONIA but, to date, the loans market still lacks a usable forward-looking RFR-based rate for any currency.
The alternative to finding a forward-looking rate is to work out how to compound or average overnight rates over a period. However, this ‘backward-looking’ approach presents issues for borrowers, says Dawson, not least that they would not know what their interest payment would be until on or very close to the payment date. There are also a number of operational concerns; neither bank systems nor loan documentation are geared to accommodating backward-looking rates.
Furthermore, LIBOR is a term-rate but it also incorporates a bank credit element; RFRs are specifically designed not to have that. “This means some form of adjustment spread is required so that if legacy deals are amended to work off one of the new benchmarks, the economics can be smoothed out to avoid any transfer of value,” notes Dawson.
ISDA’s consultation on adjustment spreads for certain currencies has concluded but this has been with the derivatives world very much in mind. For Dawson, “it’s probably too early to say if the conclusions of that consultation have produced an outcome that cash market participants would be happy to use”.
One approach to new loan documentation in this transitional period is to include provisions allowing more flexibility for amendments to legacy contracts. The LMA has been working on refining this method. For example, it produced its Revised Replacement of Screen Rate Clause in May of this year, facilitating the consideration of a lower consent threshold for agreeing amendments, offering a degree of contract flexibility on a per-transaction basis.
Meanwhile, in the US, the Alternative Reference Rates Committee (ARRC) consulted on fallbacks for new syndicated loans referencing LIBOR. The consultation, which is now closed, offered two options. One was an amendment approach, although this would mean each loan would need to be amended individually, which will be labour-intensive. The second option was a possible hard-wired approach, which set outs a specified ‘waterfall’ of alternative rates, although it envisages initially falling back to a rate that currently does not exist (a forward-looking term SOFR rate). The responses to the consultation have been published, and show mixed views among those who submitted responses.
In the UK/Europe, Dawson says the lack of certainty around the transition gives rise to the feeling that it is too early to hardwire change into new contracts. This leaves it with the amendment approach, for now. Accordingly, the LMA has been considering how to further standardise the process of legacy deal amendment. It has also been considering what the fall-backs would be, once contracts are being written off the new benchmark, if for any reason the figures (either derived from a new term rate or a compounded/averaged overnight rate) are not available.
Term rate preference
The market is taking a sensible and responsible view that LIBOR will at some point cease to be. The discussion to date has at least chosen a set of RFRs, even if not all are yet live. The need for term rates in the cash markets, something the LMA has been actively pursuing, has seen a lengthy debate, not least because many derivatives players appear quite comfortable with a compounded version of the overnight RFRs. Whilst there is work to be done on the derivatives side, some participants are starting to trade using RFRs, creating liquidity that can build much-needed term curves.
However, notes Dawson, not only does a LIBOR-like rate arguably make it easier to transition for all participants, but also, from a borrower perspective, it provides vital certainty of cash flow for internal modelling purposes.
“There is now acceptance, at a global regulatory level, that for certain products, term rates are a requirement,” she says. “This is a big step forward from where we were 18 months ago, when the thinking was that the markets should use pure RFRs. We are now engaged with the more practical issues of how to both economically and contractually construct a new formula that will work for the cash markets.”
At a purely practical level, systems changes will be driven by whether the market wants to stick with term rates and wait for these to be available (which would be a relatively easy technical transition) or if a significant number of borrowers accept the more technically challenging compound/average RFR approach (some floating rate notes have been issued on this basis but no loans to date).
As more certainty arises around the options, there may be a stronger will amongst greater numbers of participants to start hardwiring alternatives into their deals, rather than face the per-deal amendment process that may come post-2021.
At a more general level, whilst there are many large and sophisticated market players that are highly engaged with the process – and who see the transition as something that must be worked through – there is still a problem with “varying degrees of awareness”, especially amongst the corporate community, notes Dawson. Those that are not in the market at the moment either may not be focused on this point, given how much else they have to think about, or are perhaps thinking that it will all be sorted out for them.
Given the current uncertainty of the outcome of the transition, Dawson recommends that treasurers should now start making plans to tackle both legacy contracts and new transactions, mindful that the implementation of that plan will involve time, resources and cost, and that this should be budgeted for.
“Treasurers should be looking across their business, identifying where LIBOR is embedded, both externally and internally,” she advises. “By creating an audit of where LIBOR, or its possible replacement, will affect the business, it provides a vital first step to finding a solution.” It would be beneficial too to discuss the transition with the appropriate local borrower trade bodies and, once an audit has been prepared, to find out how the banks are approaching the topic and how they can offer potential solutions.
But there is a more community-based response required of treasurers too, says Dawson. “It’s important that the market stays engaged and talks to the different stakeholders so that every view is understood by the other participants. When consultations are called for, treasurers should try to respond and at least offer general assessments to ensure those running the process are aware of the widest range of views.”