Over the last few months there have been a number of significant developments for the use of risk free rates ("RFR") in the loan market and transitioning from IBOR-based facilities, both in the UK and in the US.
In this TechChat we highlight five areas of interest.
As Andrew Bailey made clear in a speech this week, "those who can transition away from LIBOR should do so on terms that they themselves agree with their counterparties" and to "[face] up to transition now". That said, some context is required as the banks adopt the necessary infrastructure and systems and finalise market conventions before being able to offer and service multiple RFR-based facilities.
- The Loan Market Association ("LMA") has published a list of RFR-based facilities. This list goes beyond SONIA-linked facilities and includes two deals that included automatic transition mechanics pursuant to which the interest rate switches from being calculated on an IBOR-basis to an RFR-basis (such facilities being described as Automatic Transition Loans or ATLs). The facility agreement relating to one of these deals (British American Tobacco) is available on the LMA's website. This is a welcome development, but we note there are certain elements in that deal that appear to have been negotiated on a bespoke basis and so are unlikely to form part of any market consensus on RFR-based or ATL-based deals. It is also worth commenting that the number of public deals remains very small, bearing in mind the first SONIA-based deal we worked on completed almost 12 months ago.
- One positive area of development is the interest that corporate borrowers are now taking in transitioning away from IBOR-based facilities. The statements published by the FCA, Bank of England and, most recently, the HM Treasury (see below) highlighting the cessation of LIBOR have raised the profile of needing to transition and, with most corporate facilities now terminating beyond 31 December 2021, finance teams within corporates are starting to enquire about what will be involved as part of the transition process and how RFR-based borrowing works mechanically, particularly as they are receiving communications regarding the same from their lenders. We have also had borrowers wanting to enter into, or amend, their finance documents to reference the relevant RFR.
- HM Treasury recently announced that the Benchmarks Regulation will be amended to give the FCA enhanced powers in respect of a benchmark that is no longer representative. In respect of LIBOR, the FCA would be able to direct the administrator of LIBOR to change the benchmark methodology which is expected to result in a form of synthetic LIBOR that can be used in "Tough Legacy" contracts that have not transitioned to an alternative rate and continue to reference LIBOR post-31 December 2021. This is not guaranteed and will only occur if such a rate is considered necessary to protect consumers or the integrity of the market. The FCA have also cautioned against any expectation that a synthetic LIBOR rate will be available for all existing currencies and tenors. Further, no new contract will be allowed to use a non-representative benchmark so this will only be a solution for tough legacy contracts.
This approach can be contrasted with the legislative solution recently proposed in the USA by the Alternative Reference Rates Committee ("ARRC").
ARRC's proposed legislation would apply to New York law contracts and is intended to reduce economic disruption and litigation by replacing unworkable fallback provisions in such contracts with a yet to–be–determined "Recommended Benchmark Replacement" (such as SOFR). This change would happen automatically by operation of law post-31 December 2021. This legislation, which is expected to be challenged on unconstitutional grounds, would only apply to contracts that reference USD LIBOR but either have no fallback provision or contain a fallback that includes LIBOR or requires polling lenders. The proposal would not affect existing contracts that specify a non-LIBOR fallback and allows the parties to opt out of the legislation's mandatory application. - Earlier this summer, the FCA updated the Q3 2020 deadline to the end of Q1 2021 for their requirement that no new facilities be entered into with a maturity post-2021 referencing £LIBOR. This was well received in light of the significant COVID-19 workload undertaken by financial institutions over recent months, and also the delays COVID-19 has had on the steps being taken to implement RFRs internally within the banks. This deadline is still an ambitious target based on the low volume of new facilities being issued on an RFR-basis, and the outstanding internal steps to be undertaken within financial institutions before they are ready to issue RFR-based facilities on a mass scale.
Other FCA targets include having embedded adjustment arrangements in all finance documents and to be offering non-LIBOR linked products in each case by Q3 2020. There is currently no market standard wording to accommodate the adjustment arrangements and no settled positions on certain aspects of RFR-based lending, so these remain significant short-term challenges for market participants. - In the USD market, the transition process has been moving at a slower pace. SOFR, a secured rate that tracks the US treasury repo markets, is the RFR recommended by the ARRC to replace USD LIBOR. But SOFR is facing its own challenges in being adopted as the accepted RFR for USD. Interested parties are highlighting operational inefficiencies, structural differences and a potential accounting problem. In the UK, SOFR is compliant with the Benchmark Regulations, but if an alternative USD RFR is selected by market participants, such a rate must comply with the Benchmark Regulations for an FCA-regulated financial institution to provide a facility whose interest rate is determined based on that rate.
The large number of deals that either include a USD facility or provide flexibility for the borrower to request a USD utilisation means that transitioning a large part of lenders' back-book requires the international solutions to be available alongside the GBP-based solutions. Solving for multicurrency facilities is one of the key challenges of the IBOR transition process given the complexities when compared to single currency arrangements, including there being different RFRs for different currencies and the fact that various markets around the world are not all transitioning away from IBOR at the same speed.
