A year has now passed since the FCA announced that LIBOR would be discontinued after 2021. In this update we examine the key developments in the transition away from LIBOR over the last 12 months.
On 12 July 2018, Andrew Bailey, Chief Executive of the FCA, gave a speech emphasising the need for firms to end their reliance on LIBOR by the end of 2021. He stated that LIBOR discontinuation should not be considered a remote possibility, but rather something that will happen and which firms must be prepared for. Although progress has been made, in his view the pace of transition was not yet fast enough to ensure financial stability.
In his speech, Bailey highlighted the advantages of so-called "risk-free rates" over LIBOR. These included the switch in bank funding away from the interbank market upon which LIBOR is based. Several jurisdictions have now identified risk-free rates as alternatives to LIBOR:
- SONIA (the Sterling Overnight Index Average) in the UK
- SOFR (the Secured Overnight Financing Rate) in the US
- SARON (the Swiss Average Rate Overnight) in Switzerland
- TONA (the Tokyo Overnight Average Rate) in Japan.
The European Central Bank is also considering what its preferred risk-free rate should be, and has announced that it will begin publishing an unsecured overnight rate called ESTER (the Euro Short Term Rate) in 2019.
In April, the Bank of England began publishing a reformed version of SONIA. Bailey reported that SONIA is now supported by an average of 370 transactions per day, compared with 80 before the reform. In some areas of the financial markets, SONIA is being adopted already. The volume of SONIA-referencing swaps and derivatives is increasing, and in June the European Investment Bank issued a £1 billion SONIA-linked bond. However, significant progress is still needed in order to make SONIA work for the loan market.
As noted in our previous update, one of the key differences between LIBOR and SONIA is that SONIA is backward looking and is published each morning in respect of the previous business day, unlike LIBOR which is forward looking and reflects the duration of the relevant interest period. This gives lenders and borrowers the certainty of knowing what rate will be applied to any given interest period for their loan. Another issue is that LIBOR reflects banks' credit risks, whereas SONIA (being a risk-free rate) does not; this means SONIA is lower than LIBOR and this pricing differential would need to be addressed as part of any transition.
The Bank of England Working Group on Sterling Risk-Free Rates has launched a consultation to explore the potential to create forward-looking term rates based on SONIA. Feedback can be provided to the consultation until 30 September 2018, with a view to term SONIA reference rates being made available in 2019. It seems unlikely that we will see any attempt in loan agreements to replace references to LIBOR with SONIA until we have more detail on the structure of these term rates.
In May, the Loan Market Association published a revised "Replacement of Screen Rate" clause which allows for amendments to reflect the discontinuation of LIBOR to be made to facilities agreements with a lower lender consent threshold and in a wider range of circumstances than the existing clause. The clause does not of itself effect the replacement of LIBOR in the facilities agreement, but merely permits amendments to be made to effect the replacement of LIBOR with less than all-lender consent. As such, it is only relevant to transactions documented on syndicated terms. The LMA has not incorporated the new clause into their facilities agreements, so if you are working on a syndicated transaction now or in the future you will need to consider whether these new provisions should be incorporated.
Although the new LMA wording does not implement the move from LIBOR to SONIA in the facilities agreement, it does shed some light on the sort of amendments we can expect to be made once we have more detail on the replacement benchmark. For example, as well as amendments to align the provisions of the documents to the replacement benchmark, it also allows for amendments to adjust the pricing to reduce or eliminate any transfer of economic value from one party to another as a result of the application of the replacement benchmark.
The revised LMA wording also contains some useful definitions, including:
- "Replacement Benchmark" - essentially a benchmark that is designated as the replacement for a screen rate by its administrator/regulator, that in the opinion of the Majority Lenders and the Obligors is generally accepted in the market as the appropriate successor to the screen rate, or that in the opinion of the Majority Lenders and the Obligors is an appropriate successor to a screen rate; and
- "Screen Rate Replacement Event" - optional triggers for amendments to replace the screen rate to be made, for example where the administrator of the screen rate or its supervisor publicly announces that such rate has been or will be discontinued or may no longer be used. In practice banks and borrowers may prefer the amendments to take effect when all Lenders/the Majority Lenders and the Obligors so agree, rather than rely on a pre-determined list of triggers.
In his speech, Andrew Bailey warned of the risks of continuing to rely on LIBOR. However, it is difficult to see how loan documentation can be amended to reflect SONIA term reference rates when the methodology behind these is still being developed. What we do now have, one year down the line from the original FCA announcement, is a consultation to facilitate the development of Sterling risk-free term reference rates, a timetable for such rates to be made available, and the emergence of drafting for loan documents to allow a transition to an alternative rate in due course.
- A year has now passed since the FCA announced that LIBOR would be discontinued after 2021
- The last 12 months has seen significant progress towards a transition from LIBOR to its preferred alternative SONIA, however much remains to be done
- Adoption of SONIA in the loan markets is problematic because it is a backward looking rate
- Forward-looking term SONIA rates are expected to be available in 2019, and it seems unlikely that we will see any drafting to implement the transition from LIBOR to SONIA in facility agreements before then
- The LMA has provided revised and extended fall-back language to cater for LIBOR ceasing to be available – we should consider including this in new facility agreements or when amending existing agreements.