Various working groups are busy trying to fit overnight risk free rates to the LIBOR term rate scenarios. This throws up a lot of industry talking points. Here are some insights and things to consider.
- The mood amongst borrowers continues to be "engaged but unfazed". They do expect any new benchmark to include a term rate - so that borrowers have an upfront view of interest outgoings. Easier said than done though; any shift from an overnight rate to a term rate brings in liquidity risk plus credit risk. That could look a lot like New LIBOR – which would be a silly place to end up.
- Given that any IBOR includes a term premium, which is absent from a near risk free rate (RFR), astute borrowers will want to ensure that any pass-on of the economic gap between an IBOR and a new benchmark will be calculated equitably. Most of the worry though will probably be on the lender side. After the LIBOR scandal, lenders will certainly aim to avoid any chance of a transition scandal; they may find themselves soaking up all or part of the transition costs as strong borrowers exert muscle.
- Transition economics are a big deal. The economic gap between LIBOR (or any other IBOR) and an RFR-based benchmark needs to be addressed. Ideally, the market (through the various working groups) will come up with a consensus on a fixed transition spread to preserve pricing economics. Once IBOR-based legacy deals have tailed off, any adjustment would be factored into the margin.
- Other jurisdictions are working on new or improved RFRs for various currencies. Not all will be on the same basis as SONIA (unsecured). For example, for US dollars, SOFR (secured overnight funding rate) is a secured rate. Because the RFRs won't all use the same methodology, there may be different transition spreads for different currencies – and potentially, going forward, different margins for different currencies.
- The operational/agency issues on transition are going to be challenging.
- In the ISDA universe, wholesale changes to ISDA terms are implemented via market participants agreeing to adhere to a published ISDA protocol. Any other market participant that agrees to adhere to that protocol automatically has the terms of its ISDA agreements with all other adhering parties amended as per the protocol. Market terms in the loan markets don't have the same level of standardisation that facilitate this method. Where loans have been hedged, the optimum position would be to change the loan and the hedge benchmark at the same time; maybe a short-lived mismatch will be tolerated.
- There needs to be a common approach to transition from IBORs to new benchmarks across all the major currencies – or things will get very messy.
- LIBOR is published (for all applicable currencies) at 11 am London time. RFRs are published in the local times of the applicable currencies. Tricky.
Can borrowers or lenders do anything to prepare?
- Loan documentation needs to facilitate transition to a new benchmark – that means giving control to the Majority Lenders (though some lenders will balk at this). The current last port-of-call LMA fallback, in the absence of a Screen Rate, is cost of funds certification by the lenders. That fallback is only workable as a short term measure.
- The LMA "Replacement of Screen Rate" optional wording does give some power to the Majority Lender group – but the wording needs to be broader. It needs to allow for transition even whilst LIBOR limps on, and it needs to acknowledge that the pricing economics may need some tweaking.
- Many deals will need routine amendments in the next few years before LIBOR is expected to fall away – and so it makes sense to review documents so that facilitative amendments can be made at the same time. There is no merit in referencing a substitute benchmark in loan documents at this point, but it is always smart to get prepared.
For a more in-depth conversation and help with transition, feel free to get in touch with our team.
