In this Ropes & Gray podcast, asset management attorneys Egan Cammack and Andy Des Rault discuss the LIBOR transition and the key differences between the approaches that are currently being taken in the U.S. loan and OTC derivatives markets.
Transcript:
Egan Cammack: Welcome everyone, and thank you for joining us today on this Ropes & Gray Podcast. I'm Egan Cammack, counsel in our asset management group, and I'm joined by my colleague, Andy Des Rault, who is a senior associate in our asset management group. In today's podcast, we're going to address a topic that will be of interest to any client that is hedging its exposure to U.S. Dollar LIBOR under a syndicated or direct loan. Specifically, we'll be addressing key differences between the approaches that are currently being taken in the U.S. loan and OTC derivatives markets with respect to the LIBOR transition that's underway.
At this point, we expect that the majority of our listeners are at least aware of the LIBOR transition, but just to make sure we're caught up, the "LIBOR transition" we're referring to describes the broad efforts of regulators, industry groups and market participants to adopt a replacement rate for the London Inter-bank Offered Rate (also known as "LIBOR"). These efforts have been developing over the past few years after the UK Financial Conduct Authority announced in 2017 that it will not compel panel banks to submit LIBOR quotes after 2021.
Andy, now that we're caught up on the basics, can you explain briefly to the audience what the general approach is for replacing LIBOR in both the U.S. loan and derivatives markets?
Andy Des Rault: Sure. The general approach is, for the most part, consistent between what has been recommended by the Alternative Reference Rate Committee (known as the "ARRC") for the U.S. loan market and that which is contemplated by the International Swaps and Derivatives Association (or "ISDA") for the OTC derivatives markets.
The gist under both approaches is that upon the occurrence of certain trigger events, LIBOR will be replaced with "SOFR" which is short for the Secured Overnight Financing Rate. SOFR is best described as the overnight rate for borrowing cash collateralized by U.S. Treasury Securities, and is published by the Federal Reserve Bank of New York based on information received from the repo market. The "trigger events" I referred to may, very generally, be summarized as either a public announcement by LIBOR's administrator, its regulatory supervisor, the relevant central bank or an applicable resolution authority that LIBOR will cease to be published or, if earlier, a public announcement by the administrator's regulatory supervisor that LIBOR will no longer be representative of the underlying market.
Both approaches also contemplate that a "spread adjustment" will need to be added to SOFR to minimize the difference between SOFR and LIBOR, as LIBOR is a historically higher unsecured lending rate. The method of calculating the spread under both approaches is the same and, in short, will be equal to the median of the difference between LIBOR and SOFR over a five-year lookback period.
That said, there are some key differences between the ARRC's recommended approach for cash products and ISDA's approach for derivatives which our listeners should be aware of.
Egan Cammack: That's right. One of the key differences is how SOFR itself is likely to be determined for loans and for OTC derivatives. You might recall that LIBOR is a forward-looking "term" rate, which is generally known at the beginning of an interest period and is available for several different maturities, including 1-month, 3-month, 6-month and 1-year maturities. This is not currently the case for SOFR, which is just an overnight rate for which there are no published "term" rates. As such, market participants transitioning to SOFR need a way to extrapolate SOFR into a term rate for the applicable interest period.
For OTC derivatives following the ISDA approach, SOFR will be calculated on a compounded basis "in arrears" at the end of the relevant interest period. In short, based upon several industry consultations, ISDA determined that this was the most intuitive way of determining SOFR for a particular period in the absence of a term rate.
The market for cash products, including loans, is taking a different approach. Because it is too difficult to calculate a compounded interest rate in the context of loans, where principal can vary daily due to things like prepayments, amortization and incremental borrowings, the ARRC has recommended instead that loan market participants calculate SOFR using a simple interest method, known as "daily simple SOFR."
So, you can see that following current approaches will likely result in a difference, or a "basis", between floating rate payments owed under a loan and those owed under a corresponding interest rate hedge where LIBOR is the relevant rate. While the ARRC acknowledges that the basis between SOFR calculated in arrears using a compounded versus simple interest methodology is not likely to be large, it is still a difference that parties should be aware of and consider whether and how such difference should be addressed, especially for larger loans.
I'll also note that under the ARRC's latest recommended language published in June, the Administrative Agent has broad discretion to make what it calls "conforming changes" to the terms of a loan in effecting the transition from LIBOR to SOFR – these changes can include the timing and frequency of payments. This may create further differences between a party's payment obligations under a loan and its corresponding hedge.
Andy Des Rault: Those are great points. Another potential timing issue clients should be focused on is potential gaps between the timing of the LIBOR transition itself under loans and their corresponding interest rate hedges.
Under the ISDA approach applicable to derivatives, the timing of the LIBOR transition is pretty straightforward. ISDA has published a supplement to the 2006 ISDA Definitions that includes the SOFR fallback mechanism we just discussed and, as of January 25, 2021, these terms will apply to all new trades referencing the Definitions. ISDA has also published, and will launch on October 23rd, a protocol enabling adhering parties to amend existing "legacy" swaps to incorporate the same SOFR fallback mechanism. The effective date of the Protocol will also be January 25, 2021 and is expected to be widely adopted in the derivatives market. In addition, and particularly relevant to this discussion, ISDA has published bilateral templates that may be used to customize the application of the changes covered by the Protocol. For example, there are template amendments, which we will talk about more shortly, that link interest rate swap hedges to the terms of related loans. In any event, it is fair to say that on the derivatives front, there is a relatively clear path forward for ensuring all documentation includes the prescribed SOFR fallback language.
The path is a little less clear on the loan side. For one, the vast majority of existing syndicated loans—tracking an earlier version of the ARRC's recommended language—require parties to "amend" the loan in order to transition from LIBOR to SOFR upon the occurrence of a trigger event. So, one can imagine a scenario—particularly in a lender-friendly market—where lenders do not consent to move to SOFR upon the occurrence of a trigger event so that they can take advantage of a higher, "alternative base rate" for some period of time. Meanwhile, if the corresponding hedge to such a loan has been amended by the standard Protocol or Supplement terms, it would automatically transition to SOFR upon the occurrence of a trigger event, resulting in a mismatch.
Furthermore, many loan agreements—also following recommendations by the ARRC—allow the parties to opt in to SOFR before a trigger event occurs. As we've noted, the ISDA Supplement and Protocol only contemplate a transition to SOFR upon the occurrence of a trigger event. So, it is possible that parties to a loan agreement agree to move to SOFR before the corresponding interest rate hedge would move to SOFR under the standard terms of the Protocol and Supplement. This would have the perverse result of a SOFR-based loan being hedged by a LIBOR-based interest rate swap.
Egan Cammack: That's a good point; what should parties be doing to address these differences, as well as any others that may arise between contracts referencing LIBOR, in effecting this transition to SOFR?
Andy Des Rault: Well, for starters, if they have not already done so, clients should take an inventory of all contracts referencing LIBOR to which they are a party. This includes derivatives, loans, securitized products, securities lending and repo transactions, just to name a few. Next, they should understand what the available options are for amending the terms of these contracts to refer to SOFR in the event of LIBOR's discontinuation or, if earlier, a non-representativeness determination. Clients should then flag instances in which the approach to LIBOR transition for any hedge differs from that likely to be used for the hedged product and determine whether it is worth closing the gap and how to achieve that result.
For clients with LIBOR-based interest rate hedges, the most direct way to align the approaches is to include language in the swap documentation expressly stating that the hedge will use the same fallback rate specified in the underlying debt instrument, effective at the same time. As I mentioned earlier, ISDA has published bilateral template amendments that include language to achieve this consistency. Depending on the terms of the underlying loan instrument (which may require the consent of additional parties to make amendments to the hedge), the quantity and identity of the hedge counterparties, and other relevant considerations, we would generally expect that most clients seeking to link loan instruments with corresponding hedges will opt to use these bilateral templates or otherwise bilaterally amend their existing hedges as opposed to adhering to the standard terms of the Protocol.
Clients can also try to address any mismatch in approaches in the loan agreement itself. The ARRC has, for instance, provided sample language parties can include in loan agreements if the parties would rather use compounded SOFR in arrears to match ISDA's approach as opposed to using daily simple SOFR.
The key thing to remember, however, is that, whichever approach a client wishes to take to align the LIBOR fallback provisions of a hedge with that of the hedged product, it will need to be agreed to by the other party (and in the case of a loan, the Administrative Agent and potentially the Required Lenders). So, we encourage clients concerned about any hedging mismatch to reach out to their hedge counterparty and/or the Administrative Agent as soon as possible to discuss the best path forward.
Egan Cammack: Thanks, Andy. I think that covers it for today. To our listeners, we encourage you to keep an eye out for further developments relating to the impending LIBOR transition. Please do not hesitate to reach out to us if you need assistance reviewing swap or loan documentation and any related amendments or in answering any other questions in connection with the impending LIBOR transition. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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