The End of LIBOR – Considerations for Corporates | K&L Gates LLP
There has been a lot of news in recent months about the removal of the London Interbank Offered Rate (LIBOR) and what needs to replace it. Below is a summary of what happened and how it is likely to affect businesses.
Regulators have expressed concerns about the adequacy of the benchmark LIBOR as early as 2017 and the need for an alternative. While LIBOR will continue to be available until the end of 2021, thereafter representative LIBOR rates (i.e. rates that represent the underlying market) will no longer be available, except for day, month, three month, six month, and 12 month US dollar LIBOR rates, which will remain available until at least June 30, 2023.
The working groups (as the main coordinating bodies for the goal of achieving a market-driven transition) in each of the jurisdictions of the five LIBOR currencies (dollar, pound sterling, euro, Japanese yen and Swiss franc) have identified their preferred alternative to LIBOR. :
|Motto||Alternative benchmark rate|
|Dollar||Guaranteed overnight financing rate (SOFR)|
|Sterling||Day-to-day sterling average (SONIA)|
|euro||European short-term rate (ESTER)|
|Japanese yen||Average nightly rate in Tokyo (TONAR)|
|Swiss franc||Average price per night in Switzerland (SARON)|
How does this affect me?
As a first step, you need to identify which of your pre-existing agreements use LIBOR, will continue beyond the end of 2021 and will not include a mechanism for transitioning from LIBOR to an appropriate alternative benchmark rate (i.e. on a date specified before the end of 2021 (a switching mechanism) or following the termination or unavailability of representative LIBOR rates (a fallback mechanism).
LIBOR isn’t just limited to loan agreements. It may also appear in commercial contracts, for example, as a reference rate to determine the default interest due in the event of breach of this contract.
The next step is to identify what “fallback” (if any) is in agreements that do not include a switch mechanism or fallback mechanism. For example, in a loan agreement, which does not include a mechanism for transitioning to an appropriate alternative benchmark rate, the “fallback” may be the lender’s cost of funds, which may result in a cost of borrowing. higher.
If there is no “pullback” (as may be the case in a commercial contract where LIBOR is used to calculate the late interest rate) or if the “pullback” is not a rate alternative benchmark, the relevant agreement will ideally be amended before the representative LIBOR rate ceases to be available, so that control of economic conditions remains in the hands of the parties.
If so, you should enter into discussions with the counterparty to the contract to find out what changes need to be made to the arrangement and what an appropriate alternative benchmark rate would be.
Although, with the exception of the overnight, one-month, three-month, six-month and 12-month US dollar LIBOR rates, representative LIBOR rates will no longer be available after the end of 2021, it is not There are no plans to cease publication immediately. EURIBOR (Euro Interbank Offered Rate), and therefore, at least for the time being, no changes should be made to the references or mechanisms relating to EURIBOR in pre-existing agreements.
Given the impending termination of representative LIBOR rates, ideally any new agreement should not refer to LIBOR. Instead, an appropriate alternative benchmark rate should be used initially.
With respect to the pound-denominated facilities, the Pound Sterling Risk-Free Benchmark Working Group (the Working Group) (being the main coordinating body for the objective of achieving a sterling markets) recommended that from the end of March 2021 sterling LIBOR should no longer be used in new loans or other cash products maturing after the end of 2021.
What references to sterling LIBOR should be replaced?
As noted above, the Working Group preferred an alternative to sterling LIBOR is SONIA, although there are other alternatives in circumstances where this may not be appropriate, as explained in more detail below.
What should I know about SONIA?
One of the main differences between SONIA and LIBOR is that SONIA looks to the past, while LIBOR looks to the future. In addition, SONIA is an overnight rate and is not available for a fixed term. So, while with LIBOR, the rate is set at the start of the relevant interest period, and therefore a borrower will know what the interest amount will be for that period, with SONIA, the rate is measured every day over the period. interest, and therefore the total interest payable will not be known until the end of the interest period.
This lack of certainty at the start of an interest period can create problems for a borrower from a cash management perspective, and can also raise problems in loan agreements that include forward looking financial covenants, which take into account projected interest – for example, a projected interest coverage ratio – as can be found in real estate financing (because the amount of interest will not be known at the time the contract is tested).
Credit adjustment gap
LIBOR has an element of credit risk, unlike SONIA, and therefore SONIA is generally lower than LIBOR.
Therefore, when LIBOR is to be replaced by SONIA in an existing agreement, in order to ensure, as far as possible, that there is no transfer of economic benefits between the parties as a result of such replacement , a credit adjustment gap should be added. at the SONIA rate to take into account the difference between the two rates.
There are two preferred alternative methods of calculating the credit adjustment gap:
- the historical five-year median methodology (which has been adopted by the International Swaps and Derivatives Association (ISDA)) – examines past (i.e. historical) differences between sterling LIBOR and the rate derived from SONIA over a five-year retrospective period, then takes the median of these differences as the credit adjustment gap; and
- “The forward-looking approach” – this approach involves the calculation of the credit adjustment spread on the basis of the forward-looking swap market.
If the sterling LIBOR transition is based on the fallback mechanism, the task force’s recommendation is to use the historic five-year median methodology.
While the working group considered the above two methodologies where the transition from LIBOR is based on the mechanism of change or an active amendment before the end of LIBOR, it has so far not recommended a methodology rather than one. another to calculate the credit adjustment. broadcast.
Is there an alternative to SONIA?
Yes. Although SONIA is a suitable replacement in many cases, it will not be the case in all cases.
SONIA may not be suitable for business loans or commercial contracts, for example where simplicity and / or certainty of payment is key. In addition, when an agreement referring to LIBOR is made between two companies, it is likely that they will not have the capacity to calculate rates based on SONIA.
In such circumstances, the parties may consider using a fixed rate or the Bank of England discount rate instead.
Likewise, the working group found that SONIA (on a retrospective basis) is likely to create operational difficulties for certain types of loans, for example commercial and working capital products, export finance and Islamic facilities. . In such circumstances, it may be more appropriate to use a prospective SONIA rate. Although this rate is now available, the Working Group considers that it should only be used in very limited circumstances.
A decision will have to be made on a case-by-case basis.
Even when an alternative to SONIA is used, the comments above regarding the credit adjustment spread may be equally relevant.
Where a LIBOR loan is subject to interest rate hedging, it is likely that the hedging contract will need to be amended at the same time as the transitional provisions of the loan contract come into effect, in order to avoid a mismatch between the conditions set out in the loan contract and those defined in the hedging contract.
There will likely be frantic activity in the coming months, with contracting parties making the necessary changes to their contracts before the removal of representative LIBOR rates. When changes are necessary, we advise you to start discussions with the counterparties to the contract as soon as possible.