The Financial Conduct Authority (FCA) recently announced that all 35 LIBOR benchmarks "will either cease to be provided by any administrator or no longer be representative" from certain dates, the relevant date for most of those benchmarks being 31 December 2021.
This should come as no surprise, the FCA having long signalled that the expectation should be that LIBOR would cease to be available after the end of 2021. Nonetheless, the announcement throws into sharp focus the need for market participants to continue and to heighten their efforts to transition their transactions to alternative benchmark rates.
As they continue to work to adopt alternatives to LIBOR, firms may find it helpful to refer to the best practice guide for the transition of GBP loans recently published by the Working Group on Sterling Risk-Free Rates (RFRWG). This guide helpfully consolidates a series of previous publications recommending conventions that should be adopted when referencing daily compounded SONIA in loan products. The guide also makes reference to key milestones that the RFRWG recommends market participants meet (originally set out by the RFRWG in its updated priorities and roadmap published earlier in the year). In particular they should by "end-Q1, cease initiation of new GBP LIBOR linked loans that expire after the end of 2021" and "by end-Q3, complete active conversion of all legacy GBP LIBOR contracts expiring after end 2021 where viable".
These milestones make it clear that while the current priority for many lenders will be to finalise their arrangements for providing non-LIBOR based products by the end of March, the start of Q2 is unlikely to offer much breathing room, given the imperative to transition existing LIBOR-referencing transactions by the end of September.
Significant strides forward have been made on this issue in recent months. We have worked with a number of our clients to close transactions referencing risk-free rates, and continue to work with others on the development of their policies and documentation preferences. While the number of loan transactions that reference risk-free rates remains a relatively low proportion of the number of outstanding loan transactions overall, some early trends in lenders' preferences for how risk-free rates are to be adopted are becoming apparent. In particular:
- we have seen an almost universal preference for compounded SONIA to be calculated on the basis of a five banking day lag, without employing an "observation shift";
- there is broad support for credit adjustment spreads to be calculated by reference to the median difference between LIBOR and compounded SONIA, each for the length of the applicable interest period, over a five year look-back period, in line with the methodology adopted by the International Swaps and Derivatives Association;
- generally, lenders prefer compounded SONIA to be calculated on a daily, non-cumulative basis, although a notable minority of lenders have expressed a preference for the simplicity afforded by calculating on a cumulative basis.
It is encouraging that there is a degree of convergence in lenders' preferences on a range of key issues but a stronger consensus is required among lenders on a number of conventions. This will facilitate the smoother execution of club transactions referencing risk-free rates, which have so far been fewer in number than single-bank deals. Consensus will also strengthen the syndicated market, in which there may remain for some time secondary lenders who lack the operational flexibility to adapt to divergent approaches among primary, originating lenders.
There are also challenges to be addressed in the markets for loan products which are conventionally required by lenders to be hedged, such as those in the real estate finance space.
To date, some of our borrower and sponsor clients have reported less liquidity for certain hedging products referencing risk-free rates than there is for their LIBOR-referencing equivalents, with consequential pricing implications. Improvements in liquidity for these products across the remainder of this year would hopefully address this issue, and alleviate any potential concerns on the demand-side of the market that are limiting the pace of transition.
Divergences in the details of the conventions reflected in Loan Market Association and International Swaps and Derivatives Association documents, such as the length of the suggested lag period, may also need to be addressed in order to minimise basis risk, whether by those trade organisations or, perhaps initially, by parties to individual transactions.
Publication of forward-looking term rates
Away from loan transactions, 2021 has brought positive news from benchmark administrators. On 11 January 2021, ICE Benchmark Administration and Refinitiv each announced the launch of forward-looking SONIA term rates (Term Rates), each having previously been operating those rates in a "beta" test phase since the summer of 2020. Both administrators are publishing rates available for one, three, six and 12 month tenors. FTSE Russell is expected to publish similar Term Rates once it has completed its own "beta" testing.
The publication of these Term Rates is a welcome development but market participants should not see this as heralding a move away from the use of SONIA compounded in arrears On the contrary, the RFRWG has, in a paper published recently, expressed a preference for "a broad-based transition to SONIA compounded in arrears for new transactions, with use of [Term Rates] being more limited than the current use of LIBOR". The RFRWG goes on to say that use cases for Term Rates are likely to be confined to relatively specialist market segments, such as those for supply chain, receivables and trade finance, which rely on the discounting of asset values by reference to forward-looking benchmark rates.
Although the RFRWG and regulators have clearly taken the view that Term Rates should not be widely adopted to calculate interest rates on debt products, participants in markets outside of the limited number identified by the RFRWG may find other uses for them. There is, for example, potential for Term Rates to be used to project finance costs, supported by the logic underlying the RFRWG's analysis. This could be useful in product lines on which it is customary to size the debt quantum, or monitor borrower or asset performance, by reference to a projected debt service cover metric.
The wholesale move away from LIBOR is a major undertaking for all market participants. With the sheer volume of documentation that needs changing presenting its own risks, the emergence of consensus on some issues and the publication of forward-looking rates are important developments (although the utility of the latter remains to be seen). Nevertheless, much work remains to be done this year and certain markets and market participants are likely to find the switch to risk-free rates more challenging than others.