- It is unsafe to assume LIBOR will be available beyond 31 December 2021.
- To replace LIBOR, many loan market participants have called for the development of forward-looking term rates derived from the approved, overnight, near risk-free rates (RFRs) for each LIBOR currency. Like LIBOR, forward-looking term RFRs would make it possible to calculate the interest payable over an interest period at the beginning of that interest period.
- However, the UK and US regulators, in particular, have put pressure on the loan markets to switch from using LIBOR to using RFRs without waiting for the development of such forward-looking term RFRs, which may not be available by the end of 2021.
- the regulators instead suggest borrowing from recent sterling floating rate note practice and using backward-looking term RFRs derived from compounded averaging in arrear of all relevant daily RFR quotations relating to an interest period.
- In July 2019, NatWest announced that it had made such a loan to National Express Group plc under a committed revolving credit facility. Other RFR-based bilateral loans made using compounded averaging in arrear have followed.
The LMA Exposure Drafts
Against this background, the LMA released "exposure drafts" on 23 September 2019 of two single currency term and revolving facilities agreements (the Exposure Drafts) that:
- broadly indicate how such compounded averaged in arrear RFR term rates might be calculated and used in syndicated loan facilities; and
- are a vehicle to consult the market on a number of issues relating to the use of such term RFRs – there being insufficient loan market practice for the LMA to produce recommended forms at this stage.
One Exposure Draft is for sterling loans; the other works with US dollars. The floating rate under both Exposure Drafts is derived from the respective RFRs that are to replace sterling LIBOR (SONIA) and US dollar LIBOR (SOFR). As the RFR quotations relating to an interest period are compounded and averaged in arrear, if interest is to be paid on the last day of each interest period, it is necessary to find a way to compound and average all relevant quotations before the end of each interest period. This is done using a lagging "observation period".
The lag method
Broadly, under the lag method, all RFR quotations relating to an interest period are taken from a corresponding "observation period". Each observation period lags (i.e. begins and ends X banking days before the beginning and ending of) the interest period to which it relates. This lag enables all interest rate calculations and notifications to be done:
- in the final few days of the interest period; and
- in good time for the obligor to pay its interest bill on the last day of each interest period.
The usual lag period in the SONIA floating rate notes market is five banking days. In the loan markets, shorter lag periods may be adopted for short interest periods. By contrast, longer lag periods might be necessary, for example, for loans into those few developing markets whose exchange control regulations require significant advance notice of the amount of each interest payment.
The key pricing choice
Under the Exposure Drafts, the parties must choose between two pricing models. One such model (in this article, the Adjusted RFR Option) approximates the lenders' cost of funds using a credit adjustment spread known as the RR Adjustment Spread. This spread is separate from the credit margin and from the compounded and averaged RFR. Under the other model (in this article, the RFR Plus Margin Option), the lenders' cost of funds (if taken into account at all) is priced into the credit margin itself, which is thus likely to be higher than the margin would be on a LIBOR-based loan or under the Adjusted RFR Option in the Exposure Drafts.
While the Exposure Drafts anticipate that the RR Adjustment Spread will vary with the length of interest periods, there is no loan market consensus, or LMA recommendation, on how to calculate the spread between LIBOR and SONIA or SOFR, or how to calculate the RR Adjustment Spread itself. This currently makes the Adjusted RFR Option somewhat theoretical.
Neither pricing option under the Exposure Drafts seeks to compensate lenders for mandatory costs.
Which equation to use
While the Exposure Drafts are clear on the broad method of compounded averaging under the lag method, they do not specify the equation for doing so. The Financial Stability Board's June 2019 guide to using overnight RFRs provides sample equations and useful guidance on them. As with other features of the Exposure Drafts that are left for the parties to agree, this is because there is insufficient market consensus on the underlying issues. In relation to compounded averaging, for example, there is no consensus on how or whether RFR quotations should be compounded in relation to weekends.
The Primary Screen Rate and its fallback rates
The Exposure Drafts assume the default source of the compounded average RFR will be a trusted third party published screen rate (the Primary Screen Rate). No such screen rate currently exists.
During any observation period where this Primary Screen Rate is not available, the documents provide for the agent (or another willing finance party) to calculate the interest rate manually. This is known as the Fallback Compounded Rate. Without a Primary Screen Rate currently available, it is particularly important for the parties to agree an equation for compound averaging the RFR that the agent or other relevant finance party is comfortable calculating.
Once an appropriate candidate for the Primary Screen Rate comes into existence, the parties can stop using the Fallback Compounded Rate and instruct the agent to designate the candidate screen rate as the Primary Screen Rate without amending the facilities agreement.
Fallback from (initial) Fallback Compounded Rate
If the parties are compelled to use the Fallback Compounded Rate, rather than the Primary Screen Rate, but the necessary RFR quotations are not available for all or part of an observation period, there are respective fallback options for SONIA and SOFR-based transactions. If SONIA quotations are unavailable, the fallback is derived from the Bank of England Base Rate plus an adjustment spread. If SOFR quotations are unavailable, the fallback is derived from the US Open Market Committee's short-term interest rate target, plus an optional adjustment.
The fallback options do not include the use of reference bank rates, shortened interest periods or interpolated rates similar to those found in the current LMA recommended forms of LIBOR-based facilities agreements.
Cost of funds fallback
If the parties select the Adjusted RFR Option, rather than the simpler RFR Plus Margin Option (see The key pricing choice above) the Exposure Drafts include lenders' costs of funds as a fallback if none of the other fallbacks is available or there is "market disruption" i.e. in a broadly similar way to LIBOR-based facilities agreement.
Where lenders opt for the RFR Plus Margin Option, the LMA leaves it as an open question whether those lenders should be able to claim for an increase in their funding costs and, if so, what should trigger those claims and how they should be calculated.
Under either pricing option, whether or how to compensate lenders for break costs is left to the loan markets to determine. Issues here include:
- it is not clear that lenders under syndicated loans still match fund their participations in the wholesale markets from interest period to interest period as many did before 2008. This cuts across the traditional rationale for charging break costs on a floating rate loan;
- for most payments made before the last day of an interest period and its corresponding observation period, the interest rate applicable to that interest period will not then be known and so will not then be available to feed into the traditional floating rate break costs indemnity; and
- a simpler and more easily justified approach might be to charge obligors an administration fee for any mid-interest period payments. This would broadly be to compensate finance parties for the administrative burden mid-interest period payments produce and to discourage obligors from making these payments.
Amending existing facilities
Avoiding a transfer of value
As raw, daily, overnight RFRs do not price in bank credit risk or term risk they are lower than the LIBOR rates which they are to replace. When parties amend an existing facility to replace LIBOR with a term RFR, they will have to find a way to prevent this pricing differential from producing a transfer of value to or from the finance parties or the obligors. The financial markets have been working on how to prevent or mitigate this transfer of value over the last couple of years. The broadly favoured option for doing so is to use agreed credit spreads to quantify the relevant difference between LIBOR and the particular RFR. As noted above, however, at the time of writing, there is no consensus in the loan markets on how these sorts of spreads should be calculated.
The LMA Reference Rate Selection Agreement
On 25 October 2019, the LMA released another document in exposure draft form – the Reference Rate Selection Agreement (the RRSA). The purpose of the RRSA is to help streamline the process of replacing LIBOR with a term RFR in the many legacy transactions that have tenor going beyond 31 December 2021 (or any other date upon which it is necessary or desirable to replace LIBOR).
The scheme of the RRSA is that:
- all parties to the legacy LIBOR-based facilities agreement whose benchmark rate is to be replaced will execute the RRSA;
- in the RRSA, those parties will make high-level selections from a series of pre-determined key options for amending the legacy facilities agreement;
- the RRSA will authorise the agent and the obligors to enter into a separate amendment agreement amending the legacy facilities agreement; and
- that amendment agreement will bind all parties to the legacy facilities agreement and implement in detail the high-level key choices taken by all parties in the RRSA.
At the time of writing, the ECB has been publishing €STR (the RFR for euro) for just over two months. Despite this, there are no current plans to discontinue (reformed) EURIBOR.
Indeed, EURIBOR now appears to be so robust that the LMA plans to produce an exposure draft of a multicurrency facilities agreement where the benchmark interest rates will be SONIA, SOFR, SARON (the RFR for Swiss francs) – and for euro borrowings (not €STR but) EURIBOR.
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