The transition away from LIBOR: state of play - Commodities/Derivatives/Stock Exchanges

The Financial Conduct Authority (FCA) has recently reiterated that '2021 is the critical year for firms to complete their transition away from LIBOR'.¹

This transition was first announced in 2017, and in 2019 we saw regulators and industry bodies expressing a greater sense of urgency in calling on market participants to avoid delaying preparations. Since then, and notwithstanding any disruption as a result of the COVID-19 pandemic, there have been ongoing developments to support the transition away from the London Interbank Offered Rate (LIBOR).

In this article, we discuss the current state of play and the measures governments and institutions are taking to aid this transition, including the development of overnight risk-free rates (RFRs), recommended transition milestones and proposed legislative reform.

Development of RFRs

The European Central Bank commenced publishing the Euro Short Term Rate on 2 October 2019, and since then RFRs for all LIBOR currencies have been available.

Each LIBOR jurisdiction except Switzerland is also progressing with the development of a forward-looking RFR term rate (the National Working Group on CHF Reference Rates is not developing or recommending the use of such a rate with respect to Swiss Average Rate Overnight (SARON)). Government authorities are also clearly messaging that market participants should be actively negotiating loan documents to minimise legacy LIBOR exposures, notwithstanding that forward-looking RFR term rates are not yet available.

Several RFR-based loans have now been executed, and the Loan Market Association (LMA) has published a list of the RFR-based loans that have been executed based on publicly available information. The majority of these loans utilise a 'compounding in arrears with a lookback' approach to manage payment obligations. We anticipate this may become the new norm in the absence of forward-looking term rates.

Users of multiple currencies will need to understand the approach taken to each currency as each RFR has unique characteristics that reflect its local market. This will likely result in some level of variation, meaning that it is therefore possible that multi-currency loans will require the rate sources and conventions applicable to each RFR to be documented individually.

Documentation

Loan Market Association / Asia Pacific Loan Market Association

On 23 November 2020, the LMA published updated exposure drafts of facility agreement precedents incorporating rate switch provisions (Rate Switch Agreements). The Rate Switch Agreements allow market participants to, at the time of entering into a LIBOR-based facility, agree to a compounded RFR mechanism which is to replace the LIBOR-rate on either an agreed date or upon certain prescribed events (e.g. cessation of the LIBOR-rate). This materially differs from the 'Recommended Revised Form of Replacement Screen Rate Clause' published by the LMA in 2018 which required the parties to agree on a replacement RFR after the occurrence of a prescribed Screen Rate Replacement Event.

On 15 January 2021, the Asia Pacific Loan Market Association (APLMA) also published its exposure draft based on the LMA's Rate Switch Agreements for which the base currency is Australian dollars. However, further drafting will be required for parties wishing to incorporate switching mechanisms to replace the Australian or New Zealand benchmark rates with risk-free rates, as these are not contemplated in the current exposure draft.

Both the LMA and APLMA caution that the Rate Switch Agreements are exposure drafts only (i.e. not a recommended form) and that market participants should form their own view of the extent to which their respective documents are suitable for their use. Nonetheless, this is a significant step forward that should assist market participants to smoothly transition from LIBOR to RFRs in a single facility.

Alternative Reference Rate Committee

Similarly, the Alternative Reference Rates Committee (ARRC) has updated their recommended fallback language for syndicated and bilateral loans. They no longer appear to be pushing the 'amendment approach' (requiring parties to agree to a replacement RFR following a 'Benchmark Transition Event'), due to practical constraints (particularly for financial institutions required to amend thousands of facilities) and the risk of creating clear 'winners' and 'losers' (as market conditions may dictate parties' negotiating abilities). Instead, the ARRC is now recommending that parties adopt the 'hardwired approach' (offering certainty as to the successor rate and adjustment and preventing the need for future negotiation).

With respect to bilateral loans, the ARRC has also introduced a 'hedged approach' which provides for a fully or partially hedged loan to fall back to the rate and spread selected by the International Swaps and Derivatives Association (ISDA). This approach may be of interest to market participants who value consistency between the fallbacks for loans and swaps.

International Swaps and Derivatives Association

In relation to derivatives, the ISDA has published its 2020 IBOR Fallbacks Protocol (Protocol) and related Amendments to the 2006 ISDA Definitions (Amendments) which took effect on 25 January 2021. The Amendments ensure that all new derivatives contracts referencing ISDA's standard interest rate derivatives definition include suitable fallback provisions for the cessation of LIBOR. The amendments are also incorporated into legacy non-cleared derivatives if the counterparties have bilaterally agreed or have both adhered to the Protocol. The Protocol remains open for adherence and to date, more than 12,000 entities across nearly 80 jurisdictions have adhered.

Recommended milestones

In January 2021, the Working Group on Sterling Risk-Free Reference Rates (Working Group) published an update to its priorities and roadmap, which sets out recommended milestones for institutions in transitioning away from LIBOR.²

The Working Group recommends the timeline below to ensure a smooth transition.

Action	Date
Continue to enable and promote widespread use of RFR-based products.	Now
Cease initiation of new LIBOR-linked loans, bonds, securitisations and linear derivatives (other than risk management of existing positions) that expire after the end of 2021. Complete identification of all legacy LIBOR contracts expiring after 2021 that can be actively converted, and progress active conversion where viable.	By end-Q1 2021
Cease initiation of new LIBOR-linked non-linear derivatives (other than risk management of existing positions) that expire after the end of 2021.	By end-Q2 2021
Complete active conversion of all legacy LIBOR contracts expiring after 2021 where viable.	By end-Q3 2021
Be fully prepared for LIBOR to cease.	End of 2021

Legislative updates

Bodies in the UK, EU and US are lobbying for legislative reforms to ease the transition away from LIBOR. Below is a summary of the proposed legislative reforms in each jurisdiction.

Jurisdiction	Key features/purpose	Stage of development
UK	Enable the FCA to direct a methodology change for a critical benchmark in circumstances where the regulator of that benchmark has found that the benchmark's representativeness will not be restored and where action is necessary to protect consumers or to ensure market integrity. Prohibit the use of a critical benchmark where its representativeness will not be restored, while allowing the regulator of the benchmark discretion to specify limited use of the benchmark in certain 'legacy contracts'. Ensure that administrators have adequate plans in place for the winding down of a critical benchmark.	The Financial Services Bill was introduced to the lower house of the UK Parliament on 21 October 2020. At the time of publication, the Bill was at its second reading in the upper house.
EU	Allow the European Commission to designate a replacement benchmark that covers all references to a widely-used reference rate that is phased out when it is necessary to avoid disruption to the financial markets in the EU. Replacement rate is only to be available for those financial contracts that reference a benchmark rate at the time when that benchmark ceases to be published. The replacement rate to be a matter of law to avoid any contractual conflicts over this issue.	On 22 January 2021, the European Parliament and the Council of the European Union adopted the regulation. The regulation will enter into force on the day following its publication in the Official Journal of the European Union (pending at the time of publication).
US	Prohibit a party from refusing to perform its contractual obligations or declaring a breach of contract as a result of the discontinuance of LIBOR or the use of the statute's recommended benchmark replacement. Establish that the recommended benchmark replacement is a commercially reasonable substitute for and a commercially substantial equivalent to LIBOR. Provide a safe harbour from litigation for the use of the recommended benchmark replacement.	Senate Bill S9070 was introduced in the New York State Senate in October 2020 largely reflecting the 'Legislation solution' published by the ARRC.

Australia

For those of us dealing in Australian dollar transactions, a wholesale replacement of our local credit-based benchmark, the Bank Bill Swap Rate (BBSW), is not presently contemplated. The Reserve Bank of Australia (RBA) considers that the calculation methodology, supporting infrastructure and market practices have been sufficiently strengthened so as to allow the BBSW to continue.

Nonetheless, parties remain free to transact in the cash rate (our local risk-free rate, also known as AONIA), and the RBA suggests that this option should be considered in particular where, as for the one-month tenor, the market underlying the BBSW calculation lacks liquidity and as a result the BBSW is less robust.³

Final thoughts

The transition away from LIBOR is full steam ahead, and market participants should be actively negotiating to minimise their legacy LIBOR exposures to ensure that they have financial certainty before the transition completes, while also keeping a look out for any legislative updates.

Footnotes

¹ Financial Conduct Authority, 'The final countdown: Completing sterling LIBOR transition by end-2021' (11 January 2021) Financial Conduct Authority, available here.
² Bank of England, 'Working Group on Sterling Risk-Free Reference Rates (RFRWG) Top Level Priorities - 2021' (Web Page, January 2021), available here.
³ Christopher Kent, 'Benchmark Reforms' (Speech, Reserve Bank of Australia, 17 November 2020), available here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.