We have put together a timeline which can be read here and which sets out the FSB’s “prudent steps” alongside the different national working groups' aims and priorities and ISDA’s work in the derivatives space.
Whilst we have included information on the benchmarks relevant to the euro in the table, we do not focus on them in this article. This is because most euro-denominated financial transactions rely on EURIBOR which has been reformed to be compliant with the EU Benchmarks Regulation and is not currently expected to be discontinued, albeit that it is currently the subject of work to develop more robust fallback rates.
Financial institutions should be a long way along the road already
It is worth summarizing for the benefit of any non-regulated firms who have exposure to LIBOR, including debt funds, and who may not be as advanced in their planning as regulated firms what action should already have been taken:
- a full “drains up” review of all existing LIBOR exposures and impacted LIBOR products, both within financial contracts but also elsewhere across the business;
- development of a comprehensive transaction project plan, building in relevant industry and regulator recommended best practices and incorporating customer/investor communications explaining the impact of, and intended route to, transition; and
- consideration of what operational and accounting systems and processes will need to be updated to enable use of new risk-free rates (RFRs).
What is the impact of the ISDA 2020 IBOR Fallbacks Protocol on transition progress?
Adherence to the ISDA IBOR 2020 Fallbacks Protocol (the IBOR Fallbacks Protocol) is seen by regulators across the world as a key part of firms’ LIBOR transition plans and was described by Andrew Bailey, Governor of the Bank of England, as an important step in the LIBOR “endgame” and by the Board of Governors of the Federal Reserve System (the Fed) as playing an important role in an orderly transition away from LIBOR.
By adhering to the IBOR Fallbacks Protocol, derivatives counterparties would be incorporating the new robust fallback rates that would apply in the event of a permanent cessation of a key interbank offered rate (IBOR) and upon a nonrepresentative determination for LIBOR into legacy derivatives contracts with other adhering counterparties. The new fallback rates will be calculated by combining the relevant RFR compounded in arrears over the relevant IBOR period with a spread adjustment based on a five year historical median of the differences between the IBOR in the relevant tenor and the relevant RFR over the relevant corresponding period.
The FSB released a statement welcoming ISDA’s announcement and encouraging adherence:
“The FSB encourages adherence to the Protocol as a tangible step that can be taken by both financial and non-financial firms to avoid disruptions in covered derivatives contracts if the IBOR they currently reference is discontinued or, in the case of LIBOR, becomes non-representative.”
The IBOR Fallbacks Protocol takes effect on 25 January 2021 and although adherence is voluntary, regulators across the globe have said that they expect regulated entities to be adhering in a timely manner. Firms that are not regulated by a financial regulator, such as commercial end-users, can expect their dealer counterparties to contact them regarding adherence to the IBOR Fallbacks Protocol and commercial end-users should expect to be encouraged to adhere.
For more information please see our client alert: ISDA 2020 IBOR Fallbacks Protocol: What you need to know.
Firms should now be in a position to offer non-LIBOR linked cash market products to their customers
In the international bond market, there have been significant volumes of new SOFR and SONIA-linked Floating Rate Notes (FRNs); indeed public issuances of sterling LIBOR-linked FRNs and securitizations maturing after the end of 2021 has all but ceased. According to the recent newsletter from The Working Group on Sterling Risk-Free Reference Rates (£RFRWG), the cumulative subtotal of outstanding SONIA-linked FRNs is 149 deals, totalling around £64.7 billion.
The loans market is a little behind the international bond market, largely because of the additional structuring complexities created by loan mechanics. The FSB’s Roadmap states that “at a minimum” lenders should be in a position to offer non-LIBOR linked loan products to customers by the end of 2020.
The published timeframe of the £RFRWG set this goal a little earlier - at the end of Q3 this year - so this should already be in place for regulated lenders in the UK.
The £RFRWG’s publications in September of its recommendations based on market feedback to its consultation on preferred SONIA compounding methodology in the loans market and on credit spread adjustments in the cash markets should have helped institutions to meet this aim by enabling them to finalize necessary changes to their template documentation and operational systems to cater for lending in SONIA. It has been made clear by the working group that these methodologies are not the only viable options, however, and, in particular, some firms may instead prefer to adopt an observational lag with a shift compounding methodology. The work currently being done by various publishers of compounding calculation tools (as outlined in the £RFRWG’s summary also published in September) should also smooth transition progress by helping to make calculation of RFR compounded in arrears interest rates for particular interest periods simpler and more transparent.
If a borrower does not want to take an RFR linked product at this stage, firms are instead able to:
- provide products which are linked to alternative rates, such as to a central bank base rate or a fixed rate; or
- (in the words of the FSB) “work with borrowers to include language for conversion by end 2021 for any new, or refinanced, LIBOR referencing loans, for example, if systems are not currently ready”.
In the UK, the £RFRWG timetable provides for regulated lenders from 1 October 2020 to include contractual conversion mechanisms in all new or refinanced products. This can be done in various ways.
Hard-wiring a replacement rate: The method which delivers the most certainty for the parties is to “hardwire” into a LIBOR-linked loan transaction a move to the appropriate RFR (for example, for sterling that would be to SONIA) upon the occurrence of agreed trigger events. The Loan Market Association (LMA) recently published an exposure draft Rate Switch Agreement for market comments which documents such a hardwire mechanism.
In the US, the Alternative Reference Rates Committee (ARRC) also recommended SOFR in arrears rate conventions and this summer issued recommended hardwire benchmark replacement language for bilateral loans and syndicated business loans. The ARRC hardwiring language specifies a switch rate for USD LIBOR which is determined by a waterfall selection and a spread adjustment (also determined by a waterfall selection). At the top of that waterfall is a Term SOFR rate (being a forward-looking rate, which as yet does not exist) followed by daily simple SOFR in arrears for the interest period, although ARRC acknowledges that syndicated loans may be based on either compounded or simple interest. On a multi-currency loan which incorporates both SONIA and SOFR rates it is likely to be administratively easier to select compounded interest for both RFRs adopting the same compounding methodology. A hot topic in the U.S. at the moment is whether it should be possible for the parties after a trigger event has occurred to later “climb up the waterfall” in order to deselect simple SOFR in favor of a Term SOFR rate as and when that rate becomes available.
Amendment process: The alternative to a hardwire approach to meet the regulators’ requirements to include language for conversion, is to incorporate contractual provisions to amend the agreement away from LIBOR at a future date which falls before the end of 2021.
In the UK, this approach was the favored route until very recently, with the LMA’s “Replacement of Screen Rate” wording being the usual route to achieve this for syndicated loans. On 24 August 2020, the LMA issued guidance to include new detailed language within this provision to specify when the parties would start good faith negotiations to make these amendments. This change is to ensure that the language would be construed as an agreed contractual method of transition by the FCA. The LMA has said that they will also shortly be issuing a head of terms document which will further bolster that provision if the parties use it to document an outline of the basis of the agreed RFR replacement at the outset.
In order to make sure that this provision is compatible with the new ISDA IBOR fallbacks in cases where the loan is linked to a derivative which incorporates the new ISDA IBOR fallbacks, and to avoid potential interest rate mismatch, consideration should be given as to whether, in the case of any LIBOR rate, to include a so-called “pre-cessation” trigger event in this drafting. This would be in addition to the existing triggers which (broadly) occur upon an announcement by the benchmark administrator (or by that administrator’s regulator) that it has, or will cease to provide the benchmark permanently or a practice statement from the administrator’s regulator that the benchmark is no longer representative.
In the U.S., the ARRC amendment approach was initially the more popular approach compared to hardwiring, but recently with the market coalescing around SOFR calculation conventions following the ARRC recommendations, the hardwire approach is gaining traction and the working groups are proclaiming that the safer and more robust hardwire approach is best practice.
When should firms stop issuing new LIBOR linked loan products?
Whilst the FSB’s roadmap states that firms should “aim to use robust alternative reference rates to LIBOR in new contracts whatever possible” by mid-2021 (and this broadly matches the ARRC requirement), the £RFRWG timetable provides for lenders and borrowers to have taken necessary steps by the end of Q1 2021 to cease issuance of LIBOR-linked loan products that expire after the end of 2021.
The £RFRWG acknowledged at the start of this year that certain cash market products are not suited to a backwards-looking interest rate. These include lower value loans to a wide range of smaller borrowers, including SMEs with no dedicated treasury function and being less able to adapt to the technology/process changes required to accommodate SONIA compounded in arrears (and who value simplicity and payment certainty). Export finance, emerging markets, retail mortgages, trade and working capital products (including discounting/LCs/supply chain finance) and Islamic finance are also expected to require an alternative rate.
To the extent that a base rate or fixed rate is not commercially attractive, then these types of products may require a forward-looking “Term RFR” and such rates are currently in development in the UK, U.S. and in Europe.
The £RFRWG published a paper in October 2020 summarizing the key attributes of “Beta versions” of the term SONIA reference rates published by independent benchmark administrators. It is currently expected that discussions around the removal of the Beta tag will happen towards the end of this year. In the U.S., ARRC has said that it will seek to recommend a forward-looking SOFR term rate by the end of June next year. The FCA has been consistently clear that term RFRs are only appropriate for very limited types of cash market products (both new and legacy ones) and that outside of these categories it expects firms to move to the more robust and transparent compounded RFRs.
Starting to repaper legacy LIBOR products
The £RFRWG requires firms to have established a clear framework to manage the transition of legacy LIBOR products which will expire after 2021 and to have started to accelerate the reduction of sterling LIBOR referencing contracts by the end of March 2021. The FSB and the ARRC timetables set an aim of mid-2021 for this to commence. This should give firms sufficient time to finish the huge task of reviewing and sorting legacy product types and preparing template amendment agreements to enable the most efficient repapering mechanism possible. In all but the smallest of legacy back books, efficiency will demand the use of artificial intelligence, documentation automation and other and other legal tech products such as the Hogan Lovells LIBOR tool.
There is still a significant number of legacy LIBOR-referencing FRNs, capital securities and securitisations that are due to mature after the end of 2021, with many containing either no fallbacks at all or inadequate fallbacks which will need to be transitioned. The £RFRWG’s October paper on Active Transition of GBP LIBOR-Referencing Bonds sets out practical considerations in relation to consent solicitations and a recent International Capital Markets Services Association (ICMSA) bulletin contains a useful timeline of a consent solicitation.
The UK government has said:
“The active transition of legacy contracts remains of key importance and provides the best route to certainty for parties to contracts referencing LIBOR. Parties who rely on regulatory action, enabled by the legislation the Government plans to bring forward, will not have control over the economic terms of that action. Moreover, regulatory action may not be able to address all issues or be practicable in all circumstances, for example where a methodology change is not feasible, or would not protect consumers or market integrity”.
What about the “tough legacy” contracts?
It will not be possible to transition all legacy products. This is most likely to be the case for older, widely distributed syndicated loans which require unanimous lender consent to amend and in the case of certain bonds where a consent solicitation process is just not feasible. Firms are in the process of collating details of their impacted legacy contracts during the on-going due diligence phase of their transition projects.
The FSB roadmap mentions the need for parties to take into account the scope and impact of any steps taken by authorities to support tough legacy contracts.
The UK government has incorporated this type of legislation in its recent Financial Services Bill published on 23 October 2020. The application of the legislation is not limited to contracts governed by the law of a member country of the UK, although the FCA may also consider international aspects before exercising its new powers.
If it becomes law in its present form, in summary, in order to assist tough legacy contracts, the legislation will give to the FCA new powers to (as its supervisor):
- direct the administrator of LIBOR to change the methodology of LIBOR (and previous statements would indicate that this is likely to be made up of a forward-looking RFR plus the ISDA type credit spread adjustment, although this is not confirmed at this stage); and
- extend the period of publication of that rate for a set time (of up to 10 years).
Use of this ‘synthetic’ LIBOR by UK regulated entities will be prohibited except in the case of those specific tough legacy type exemptions prescribed by the FCA. The meaning of tough legacy contracts is not defined in the legislation, but the related policy statement confirms that the government and the FCA consider tough legacy contracts to be those which “genuinely have no realistic ability to be renegotiated or amended to transition to an alternative Benchmark”. Further information as to what will be included in the definition of tough legacy contracts will be provided when the FCA issues its expected policy statements. What those exemptions should be is likely to be the subject of hot debate.
The UK government’s approach is markedly different in nature to that being actively pursued in Europe where the European Commission is proposing a statutory override to LIBOR references in legacy contracts. A more limited statutory override has also been under discussion in New York. The UK government acknowledges in its policy statement that “as the home jurisdiction of LIBOR’s administrator, the UK has a distinct role to play in minimizing financial stability risks and disruption to financial systems from LIBOR wind-down in the UK and globally. Alongside the FCA and the Bank of England, the government stands ready to work with our international partners to coordinate respective legislative and regulatory approaches to support an orderly global wind-down of LIBOR.”
It is to be hoped that such coordination will result in a coherent international response to deal with the tough legacy issue.
What is clear is that firms should not rely on the future availability of any legislation which will only likely apply in narrow circumstances and should retain control of the economics of their returns on their investments and continue to take every step to actively transition their legacy books in good time before the end of next year. As Edwin Schooling Latter, Director, Markets and Wholesale Policy at the FCA said: “the only way for contractual counterparties to have certainty and control over the future of their obligations is to convert them by mutual agreement.”
This is a fast-moving area. The positions described in this piece are correct as of 9 November 2020. Please get in touch with your usual Hogan Lovells contact or any of the contacts named in this piece if you would like to discuss any of the issues raised in this piece further.
Authored by Susan Whitehead, Charlotte Bonsch, Hali Katz, Michelle Rich, Rebecca H. Umhofer, and Isobel Wright.
