LIBOR, the benchmark rate used in trillions of USD of transactions, will cease to be available to a very large extent after the end of 2021. While the Covid-19 pandemic has led to some delays to the transition timetable, it has not delayed this end date. In fact, the volatility in the markets caused by the pandemic has only emphasised the need to move away from LIBOR. The way the benchmark is constructed exposed borrowers to rising interest payments as economic conditions worsened globally.
The replacement alternative benchmark rates do not provide a like-for-like replacement of LIBOR. Transition does not involve a simple replacing of one rate with another so there is work to be done. This article reviews the task ahead for businesses in moving away from LIBOR.
The first task for businesses is to identify where they have exposure to LIBOR.
LIBOR is used as the interest rate benchmark to price or value a wide range of financial products including but not limited to:
The rate is not just referenced in the main interest clauses for the above products but can also be found in late payment fee clauses and working capital adjustments. Once businesses have identified LIBOR-linked contracts there should be a more granular review. For example, there may be linked products such as where an interest rate hedging product has been taken out for a loan or loans. For that product to continue to operate as an effective hedge of interest rate risk, a transition away from LIBOR to a replacement rate should apply across both products. It is also advisable to check for existing so-called fallback provisions, ie the provisions that deal with temporary unavailability of LIBOR.
As has been widely publicised, the transition from LIBOR in most currencies is to what are known as risk-free rates (RFRs). There are different RFRs for different currencies:
While the currency of the facility or other product will, to a large extent, dictate the choice of a replacement rate, other alternatives are available including central bank rate, fixed rates or - for a smaller portion of the sterling market - a variation on the RFR, a SONIA term rate.
Which rate is appropriate will depend on the needs of the business. As RFRs are backward looking overnight rates, a straight switch to an RFR may not be appropriate for a business that needs advance certainty of interest payments. On the other hand, there are benefits to moving away from LIBOR, including removing exposure to bank credit risk that is present in the pricing of LIBOR products.
Although banks and other institutions have been encouraged by regulators to engage with their customers over the transition, it is clear that some institutions are more advanced in this process than others. Businesses should not wait until refinancing is required or to be contacted but should proactively contact their lending institutions.
Dealing effectively with the discontinuance of LIBOR can provide better financial outcomes. Some regulators are pressuring institutions to replace LIBOR with RFRs to produce a 'fair' replacement rate of interest for customers. LIBOR plus margin is to be replaced by an RFR plus spread adjustment plus margin.
A key issue is over how the spread adjustment is calculated. Institutions will prefer one method of calculation and offer that to customers. This may involve using five years of historic data and then applying the median rather than a trimmed average to that data. This may produce a more favourable result for institutions than, say, 10-year data and a trimmed average.
However, as there is no contractual basis for this choice nor for the method of calculation, it is for the parties to decide. Only those customers who appreciate the impact of different calculation methods will know if they are being offered a fair deal by the institutions.
If nothing is agreed ahead of time, the fallback provisions in the facilities and instruments, including loans and SWAPS if any, will be triggered. These usually provide for the cost of funds plus a possible margin or, indeed, the last published LIBOR rate.
The 'cost of funds' refers to the cost to the lender of funding its participation in the loan from whatever source it may reasonably select, expressed as a percentage rate per annum. Institutions hope to borrow at less than they lend and the cost of funds is significantly less than LIBOR.
This means that a shift from LIBOR to cost of funds will, without adjustment, represent a substantial saving in interest for customers. However, most businesses will need expert support to know what the cost of funds is for their lender and to know whether they are being treated fairly when the fallback provisions are applied.
If the last published LIBOR rate is to be used (and this is questionable where LIBOR ceases to exist) then that will fix the interest rate. Whether that is good or bad for customers will depend on market conditions at the time. If there are no fallback provisions in any given contract then the contracts may become frustrated. This may leave the losses where they fall but predicting the legal and financial outcome can be complex.
At a late stage close to the LIBOR cessation date, the only alternative to accepting the institution’s calculation for the RFR is to reject it and this may put the loan into default with full repayment required.
Any of the above may cause significant cash flow and other issues. It is for this reason that an early consideration of the position and a proactive approach to the institutions is essential to obtain the best possible result for the ongoing cost of borrowing. There is not a standard approach to transition and, as such, businesses can require bespoke arrangements.
The extent to which bonds can readily move away from LIBOR will generally depend on when the bonds were issued. For example, for GBP LIBOR-linked bonds issued prior to 2017, the terms are unlikely to adequately address a permanent end to LIBOR. This could result in a bond fixing to the last LIBOR rate becoming a fixed rate instrument.
The permanent end of LIBOR is more likely to be considered in GBP LIBOR-linked bonds issued between 2017-2019 although not the risks of LIBOR becoming unrepresentative or volatile in the event that panel banks begin to withdraw before LIBOR ends.
GBP LIBOR-linked bonds issued after 2019 are more likely to consider a successor rate for the permanent cessation of LIBOR and if LIBOR becomes unrepresentative. Through a process called consent solicitation, markets have seen bondholders vote to convert the floating rate in existing bonds and securitisations from LIBOR to SONIA. This represents bonds that have actively converted away from LIBOR to avoid the risks resulting from an abrupt end to LIBOR or the event that LIBOR becomes unrepresentative.
Covid-19 and its impact on businesses have compressed the time for transitioning away from LIBOR. In the year or so remaining until the rate is no longer readily available, there is much to be done from a business, legal and compliance perspective.
Once a replacement rate has been agreed, transactions will need re-papering and systems will need updating. An RFR compounded in arrears (the emerging standard in sterling markets) will need systems that can work with the compounding calculation.
However, there are also opportunities to benefit from the transition, particularly for businesses which actively engage with institutions. It is worth remembering that, with scandals over LIBOR manipulation following the 2007-2008 financial crises and the trading that used to underpin LIBOR (term unsecured lending between banks) having more or less dried up, LIBOR is no longer regarded as an appropriate benchmark rate. Something more fitting for today’s markets is required and to be welcomed.