The impending demise of the London Inter-bank Offered Rate has been consecutively, and publicly, forecast by regulators since Andrew Bailey, as chief executive of the Financial Conduct Authority, spoke on the matter in July 2017.

Other interbank offered rates, including EURIBOR, also face challenges. The search for alternative benchmarks, if not yet frenetic, is being more energetically pursued and by a greater number of interested parties than was the case even at the tail-end of 2019. The end of 2021 remains the ‘official’ target for discontinuing LIBOR, and an international community of national and supra-national regulators have bought into this timeframe.

Where does this leave lenders in what the Bank of England has deemed to be a critical year for the transition away from LIBOR? They are being told that “the time to act is now”. But what are the consequences if there is a lack of ways or will to amend legacy LIBOR-based loan transactions and eschew the benchmark in documenting new deals?

Choosing a successor

On 16 January, the Working Group on Sterling Risk-Free Reference Rates, Bank of England and the FCA jointly published a set of documents outlining priorities and milestones for this year in relation to the transition away from LIBOR.

For the sterling markets with which it is concerned, the working group made clear its view that the use of an alternative benchmark, the Sterling Overnight Index Average, ‘compounded in arrears’ will and should become the norm in most derivatives, bonds and bilateral and syndicated loan markets. The working group also stressed the benefits of consistent use of benchmarks across markets and the robust nature of SONIA as an overnight and virtually risk-free rate.

The working group stated that there may be a need for something different from SONIA compounded in arrears. This need might be driven by the type of product a firm is offering or the capabilities of its clients. However, before that stirs hope in those holding out for forward-looking term rates – derived from SONIA – to replace LIBOR, there is seemingly nothing that will shift the group from promoting its default alternative for all “large corporate” loan transactions worth £25m or more, including those that are sponsor-driven.

By the group’s calculations, this segment accounts for about 50% of the sterling LIBOR-based loan market by value. The concern is that, should the use of yet-to-be-developed forward-looking term rates become widespread here, it might reintroduce structural vulnerabilities similar to those associated with LIBOR.

Speculation about whether and how these vulnerabilities would actually compare with those associated with LIBOR is probably fruitless. As has been widely reported, attempts at market manipulation by banks responsible for submitting rates for calculating interbank offered rates, together with a decline in interbank borrowing following the global financial crisis, undermined the reliability and robustness of these rates as benchmarks.

A term rate built on a highly liquid overnight indexed swap market could be quite a different prospect to the maligned sterling LIBOR. However, such a rate could not escape its status as a derivative of the transactions underlying SONIA or its labelling by the regulators as a less robust alternative to compounded SONIA looking back across the same period.

If the working group’s preferred position takes hold as expected, ‘large corporate’ deals, ‘mid to large corporate’ transactions of between £10m and £25m and ‘specialist’ real estate and project finance (there are other segments too – in total, approximately 90% of the market by value) will soon be using SONIA compounded in arrears as the alternative to sterling LIBOR. The idiosyncrasies that come with specific products or clients would not be taken into account. The Loan Market Association’s compounded SONIA-based facilities agreement, published as an exposure draft, shows how the new benchmark might be documented.

Potential mismatches

To be effective, the hedging of floating rate bonds and loans will require derivatives that are sufficiently aligned in their referencing of the floating rate – hence the Working Group’s desire for consistent use of SONIA across products. It is certainly not a given that the risk-free rate-referencing cash and derivatives markets will develop in this way: sufficient alignment will require not just the common referencing of SONIA compounded in arrears, but also common conventions for doing so.

Perhaps the most acute example is that too long a ‘lag’ or ‘lock-out’ period aimed at providing cashflow certainty to a borrower, or to the issuer of a bond, could unacceptably reduce the effectiveness of an associated interest rate swap without the same feature.

In this regard, the FCA’s and the Bank of England’s encouragement of market makers to move most new sterling swaps from LIBOR to SONIA by 2 March is potentially significant. Should this happen, borrowers of floating-rate loans that wish – or are required – to swap some or all of their floating-rate exposure for fixed rates will increasingly press for a loan product that allows them to access the most liquid and tightly priced part of the swaps market.

If acceptably priced fixed-rate loans cannot be offered as an alternative – thereby obviating the need for interest rate hedging – this could catalyse the loan markets’ transition from LIBOR to SONIA and the cross-product alignment of referencing conventions, at least in relation to hedging derivatives.

Looking beyond sterling, the move to risk-free rates has also disrupted the broadly equivalent basis on which LIBOR, in its multiple currencies, and similar forward-looking term rates, including EURIBOR, are referenced in multi-currency loan documentation. With a risk-free rate being developed for each major currency, there is the potential for complicating mismatches. This may be thought of more as an operational than a commercial concern, but it will require thought and coordination if it is to be adequately addressed during this phase in which new market standards are being set.

Living in the past

Another area of concern are those legacy loans in which – even with the help of the LMA’s recommended clause for lowering the threshold for lender consent in syndicated deals – the parties are unable or unwilling to replace IBORs with prevailing risk-free rates.

Jumping straight to the endgame for European IBOR-based loans documented on LMA terms: where the relevant IBOR has been discontinued, its contractual replacement will, in most cases, be the cost to each lender of funding its participation in the loan for successive interest periods from “whatever source it may reasonably select” (its ‘cost of funds’).

Putting to one side the operational objections to invoking a cost of funds fallback (which are made most forcefully by borrowers and facility agents), it is worth focusing on the commercial implications. First, such a fallback requires an annualised rate. This follows from LIBOR being an annualised rate, and the underlying assumption that the lenders are banks and building societies that access wholesale funding of various types, but all of which is fixed income-like.

Second, the cost should relate to the lender’s participation in the relevant loan. How ‘matched’ the funding must be to the loan, and how that is proven, are not tested. The paradigm is banks funding in interbank markets.

Third, notwithstanding the assumed source of funding mentioned above, the actual source may be any that the lender reasonably selects. This confers some discretion on the lender. However, the lender is still required to act reasonably and to identify a cost associated with that funding which satisfies the other elements of the clause. With a private debt fund looking primarily to raise equity capital from investors, some thought would be required as to how to apply these points.

Overlaying this is the question of whether a wider market shift to an alternative rate on discontinuation of an IBOR would affect a lender’s right to insist on strict adherence to contractual fallbacks without regard to that rate. That context might have a bearing on the contractual interpretation of what constitutes a reasonable fallback rate, or it might bring regulatory scrutiny as to whether such conduct is in line with that expected of lenders.

Looking to the future

The regulatory pressure to make the transition from LIBOR to alternative rates is intensifying. Yet beyond this, there would be good commercial reasons for switching if the fallback position on any permanent cessation of LIBOR led to unacceptable uncertainty in determining the applicable interest rate – or, even before that, if it were necessary to access the most liquid and tightly priced part of the swaps market.

However, for the large number of debt investors hoping for consensus over referencing and the documenting of LIBOR alternatives, there remains some way to go. Leveraged private debt funds will be contemplating these matters as borrowers as well as lenders.

Article by Jamie Macpherson originally published by Private Debt Investor on 25 February 2020 and reproduced with permission. Copyright Private Debt Investor. For information on further use, please visit privatedebtinvestor.com.