Preparing for the End of LIBOR
The end of LIBOR is in sight. Working groups in different industry sectors and geographic regions are developing protocols to transition to new benchmark rates. Identifying the most appropriate benchmark in a given credit market requires consideration of how it will be calculated, how it will integrate with new benchmarks adopted in other credit markets and the extent to which it may cause dislocation for market participants. Firms that participate in LIBOR-based markets would be well served to take stock of their existing agreements and consider whether there are steps they should be taking in anticipation of the coming transition.
The Need for Alternate Rate(s) of Interest – Why Care?
The London Interbank Offered Rate (LIBOR), which has been a primary benchmark rate for loans, derivatives and other credit exposures for decades, is based on transactions in the unsecured wholesale interbank lending market. Few such transactions occur in today's market place, and as a result, the ability to determine LIBOR is dependent on quotes from banks in the interbank market. In addition to concerns regarding manipulation of LIBOR, this process introduces an element of bank credit risk into determinations of LIBOR, which in turn may cause LIBOR to reflect a higher-than-actual cost of funds for market participants. These and other concerns have led to a global effort to discontinue the use of LIBOR entirely by the end of 2021.
With the window on LIBOR closing in less than three years, market participants have been forced to adopt new contractual "fallback provisions" that address the question of how to identify an alternative benchmark once LIBOR is permanently unavailable. Although there are differences among the provisions that have been adopted by market participants, each of them provides a framework for the permanent replacement of LIBOR. These "fallback provisions" are being included in new agreements today regardless of stated maturities since the possibility exists that markets will move away from LIBOR in advance of LIBOR's contemplated end date. For the same reason, they are also being included in existing agreements that are being amended or otherwise modified, regardless of the reason for the modification.
What are the alternate rates being considered?
Regulators in various jurisdictions have convened currency-based working groups to identify robust alternatives for use as risk-free reference rates (RFRs) in each of the five LIBOR jurisdictions. As reflected below in Table 1, overnight RFRs have been identified in each of the five jurisdictions. In the United States, SOFR (Secured Overnight Financing Rate) has been identified as the preferred overnight RFR to replace LIBOR.
SOFR represents a broad measure of the daily cost of borrowing cash overnight collateralized by US Treasury securities. It is derived from actual transactions occurring daily in the market for repurchase agreements (repos), a robust market with an estimated volume of $750 - $800 billion in transactions each day. These factors have made SOFR an attractive overnight RFR, and the Federal Reserve Bank of New York began quoting overnight SOFR in April 2018.
Transitioning from LIBOR to SOFR
Unfortunately, the transition from LIBOR to SOFR will not be as simple as amending existing agreements to reference SOFR in place of LIBOR. LIBOR is generally quoted as a forward-looking term rate (a rate applicable for a specified interest period, such as one, three or six months). By its very nature, a term rate provides parties with certainty as to interest expense over a given interest period. In contrast, SOFR is a daily overnight rate. As such, it does not provide parties with certainty as to interest expense over a given interest period. Although it is not generally considered as a serious issue for the derivatives market, where many participants are focused more generally on hedging interest rates, it is of potential concern to participants in the syndicated loan market and other cash markets where parties are more concerned about knowing and/or fixing their interest expense for specified periods.
There are a host of considerations that must be addressed in order to develop robust term alternatives to LIBOR, and each of the five working groups is in the process of developing methodologies to identify such alternatives. Three methodologies that are frequently mentioned:
- A forward-looking rate based on derivatives of the overnight rate applicable in the relevant market. This approach would provide parties certainty of interest expense for the contemplated interest period.
- A "compounded setting in advance" rate. This approach would provide parties certainty of interest expense for the contemplated interest period. A given interest rate would be set based on the applicable RFR as in effect a specified number of days prior to the beginning of the contemplated interest period, compounded on a daily basis. Whether to provide a credit spread adjustment to better account for bank credit risk and cost of funds in setting this type of term rate is something that is under consideration.
- A "compounded setting in arrears" rate. This approach involves setting an interest rate based on the applicable RFR in effect on each day during the contemplated interest period, compounded on a daily basis. Calculation of the rate would occur a specified number of days prior to the end of the contemplated interest period. As such, it would more closely reflect movements in interest rates during the contemplated interest period, but would not provide parties certainty of interest expense for that period. Whether to provide a credit spread adjustment is also a part of the discussion regarding this alternative.
Minutes of the Federal Open Market Committee meeting on January 29-30 reveal that the Federal Reserve Bank of New York intends to begin publishing a series of backward-looking secured overnight financing rates in the first half of 2020.
The end of LIBOR is fast approaching. Firms need to take inventory of their financial and other arrangements to determine how the transition away from LIBOR will impact the organization and plan accordingly. Examples of things to consider include:
- Whether the adoption of a new RFR will affect interest expense under existing agreements, and where there is an effect, whether to seek modifications of those agreements to better reflect the original intent of the parties.
- Whether it is necessary to include the transition away from LIBOR as a risk factor in public filings or other disclosure documents.
- How the adoption of a new RFR in the syndicated loan markets may affect existing interest rate derivatives. The International Swaps and Derivatives Association is working to develop "fallback provisions" for the derivatives markets based on a "compounded setting in arrears" rate and the historical mean/median approach to provision of a credit spread adjustment. Where existing derivatives are intended to hedge interest expense under existing debt issuances, firms should monitor developments and review their existing agreements to determine whether modifications of existing agreements are required in order to reflect the original intent of the parties.
|Jurisdiction||RFR||Overnight Rate Available?||Term Rate Available?||Working Group|
|Yes||Expected in the first half of 2020||Alternative Reference Rates Committee (ARRC)|
Working Group on Sterling Risk-Free Rates
|Yes||No||National Working Group on Swiss Franc Reference Rates|
|Yes||No||Study Group on Risk-Free Reference Rates|
|Available as of October 2019||No||Working Group on Euro Risk-Free Rates|
© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.