Specific issues slowing transition
Participants in the loan markets have been notably much slower to take up RFRs as the base rate in their financing transactions, even where the facilities are contracted to mature beyond 2021. The reasons for this are mainly:
- The cash flow certainty that forward-looking term rates provide the initial focus from regulators on establishing forward looking term RFRs (based on overnight rates) has meant the loan markets delayed any significant market wide transition while awaiting further clarification and instruction from the regulator. However the difficulty in constructing markets based on term RFRs (remembering that the primary basis of the shift to RFRs from IBORs was that the RFRs were meant to be based on actual transaction data), has meant that the loan markets have begun to use base interest rates formed from historical overnight rates. The Sterling Working Group’s 2019 consultation (report issued in August 2019)1 on SONIA term rates found:
- a SONIA backed term rate is only required for the loan markets, and not necessary for the other cash markets;
- Overnight Index Swaps based on forward looking SONIA rates could form the basis of term RFRs but some significant development would be required before such term rates could be considered sufficiently reliable and meet the necessary criteria of regulators.
- The economic issues that arise due to the lack of any risk premium or credit spread being taken into account in such RFRs and how that may affect the way banks manage their assets and liabilities;
- The need for coordination across markets and jurisdictions. On the one hand, cash markets need deep liquidity in derivative markets in order to be able to hedge their interest rate exposures, but of course derivatives markets, in order to provide that liquidity, require products in the cash markets to support. IBOR has been described as a “Swiss Army Knife”2 solution - different products could use the same financial reference rate, meaning it worked across currencies, across jurisdictions and across markets. Given the multitude of alternative solutions proposed, there has been divergence of approach across markets, for example between SOFR and SONIA referenced bonds. This causes problems for:
- hedge accounting (where entries to adjust the fair value of the hedging instrument and the hedged item are treated as one)
- financial products that require cross currency basis swaps
- multicurrency facilities – how do lenders and borrowers operate and maintain a multicurrency facility where the base rate, and the calculation mechanics underlying that base rate vary depending on the currency used;
- The lack of underlying infrastructure to support any change in reference interest rates. In a slight chicken and egg scenario, users will only willingly move towards a market consensus on base rates when the necessary infrastructure and systems have been established. Understandably, infrastructure and systems providers had been reluctant to invest funds in developing and designing such new systems until it is clear which base rate and calculation methodology will become the norm. However, 2020 so far has seen a significant increase in progress and momentum on this front; and
- The simple practicality of amending contracts with a syndicate of lenders of potentially varying types and each with potentially a range of funding costs – banks and other financial institutions, securitisation vehicles and other types of credit funds, each with their own funding model and credit rating.
Progress was made during 2020, particularly following the Sterling Working Group's recommendation in its April 2020 statement on the impact of Coronavirus on the timeline for firms' LIBOR transition plans that:
- by the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
- after the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiations; and
- all new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.
As a result, Q2 and Q3 saw a marked increase in the number of RFR referenced loans issued in the market either using the RFR from the drawing of the loan or with a switch mechanism to convert from LIBOR to an RFR on a specified trigger date. The LMA published a list of syndicated and bilateral loans referencing RFRs.
Following on from the statement from the Sterling Working Group in April, from the start of Q4 this year, bilateral loans issued by UK banks have contained either a form of switch mechanism or an agreed process for renegotiation. Syndicated loans have largely (other than those referenced above) used the LMA’s Recommended Screen Rate Replacement Clause, which was updated in August 2020, in order to comply with the Sterling Working Group’s recommendations in its April Statement.
However the clause still broadly amounts to an “agreement to agree.”
LMA Exposure Drafts
In September 2019 in response to demand from loan market participants and regulators, the LMA issued exposure drafts of (a) a compounded SONIA based sterling facilities agreement and (b) a compounded SOFR based dollar facilities agreement (2019 Exposure Drafts) with accompanying commentary, using an internal rate calculated on the basis of the backward-looking RFRs.
To further focus attention, on 20th February 2020 the LMA issued a note outlining the outstanding requirements for finalising its Exposure Drafts, namely:
- the formula for calculating the Fallback Compounded Rate; and
- agreement on key conventions, including whether to compound the rate or the balance, and whether or not to use an observation shift, application of floors and rounding.
Sterling Working Group Recommendations – September 2020
There was limited visible progress on agreeing these conventions through the middle part of 2020, but since then significant progress has been made, with the catalyst being the Sterling Working Group publishing its Recommendations for SONIA Loan Market Conventions (Sterling Working Group Recommended Conventions). 3
LMA Rate Switching Agreement
Following on from the issuing of the Sterling Working Group Recommended Conventions, the LMA published an exposure draft of its multicurrency facilities agreement incorporating rate switch provisions (LMA Rate Switching Agreement). The LMA Rate Switching Agreement caters for facilities to be entered into initially referencing LIBOR, but then switching to SONIA or SOFR as applicable at a date in the future. The LMA Switching Agreement follows the conventions set out in the Sterling Working Group Recommended Conventions namely:
- Interest is calculated using the lookback without observation shift or lag method and the lookback period is 5 banking days.
- The compounded reference rate is calculated on using a non-cumulative methodology. A cumulative compound rate calculates the compound rate at the end of the interest period and it is applied to the whole period. A non-cumulative compound rate is derived from a cumulative compound rate. It is calculated as the cumulative rate as of the current day minus the cumulative rate as of the prior business day.
The Sterling Working Group recommend the non-cumulative methodology due to the need for the calculation of daily interest accruals in order to be able to calculate intra- interest period activity such as prepayments and secondary trading. Some market participants believe that the cumulative methodology is the correct approach, so it remains to be seen where the market will settle on this point.
- The rate is compounded rather than the balance. That is the rate itself is compounded and then applied to the loan at the end of the interest period whereas compounding the balance would involve applying the compounding rate to the principal and accrued interest on a daily basis.
Additionally, and contrary to some expectations, the LMA Rate Switching Agreement does not set out the streamlined method of formally adopting a screen rate service rather interest is calculated using a “manual” method/ formula approach.
Other elements of the LMA Rate Switching Agreement include:
- A credit adjustment spread as a separate component of the interest rate.
- A fallback to a central bank rate (e.g. such as the Bank of England Base Rate) if the chose RFR is not available on a particular day.
- A placeholder for “Break Costs”. Break costs are a standard provision in any LIBOR referenced loan agreement and are intended to compensate lenders for broken funding costs incurred if a loan is repaid in the middle of an interest period. The concept was based on the assumption that banks fund themselves on a matched term basis in the interbank market and consequently does not immediately reconcile with a RFR referenced loan. Again, it remains to be seen what market practice will emerge around break costs.
- Options regarding Market Disruption. As referenced above, given the nature of RFRs, arguably the concept of “cost of funds” is no longer relevant to RFR referenced loans and therefore, provisions for “Market Disruption” may no longer be necessary or appropriate where there is an RFR referenced loan.
So where now?
The issue of the Sterling Working Group Recommended Conventions and the LMA Rate Switching Agreement are significant steps forward in respect of the settling of loan market conventions. However, issues still remain:
- the varying status of participants in the syndicated loan market in their “readiness” for the end of LIBOR.
- the difference between banks in their approach to particular conventions and documentation.
- borrowers’ and non-bank lenders level of engagement and understanding of the issues involved.
- the complexity of documentation that arises as a result of the move to RFR methodologies.
The rest of 2020 and the beginning of 2021 will require significant work from regulators, trade associations and market participants before loan markets are fully prepared for the end of Q1 2021, when no new LIBOR referenced loans should be issued and the long road towards amending legacy contracts begins.
2 “Beyond IBOR: a primer on the new benchmark rates”; BIS Quarterly Review 05 March 2019 by Andreas Schrimpf and Vladyslav Sushko