Goodbye LIBOR…..Hello Risk-Free-Rates

This article explains what the discontinuation of LIBOR (London Interbank Offered Rate) means for borrowers and lenders and their financing. The differences between LIBOR and RFRs (Risk-Free Rates) is explained. RFRs are used as a replacement for that discontinued inter-bank benchmark rate.

For many years, Interbank Offered Rates (or IBORs) have been used in financial transactions for determining floating interest rates in the loan, derivative, bond, and structured finance markets. Until recently, the London Interbank Offered Rate (LIBOR) was one of the most widely used IBOR benchmark rates in the world. The global financial crisis in 2007-2008 saw increased scrutiny of the integrity of the benchmark rate setting process; and the subsequent identification of manipulation of LIBOR by panel banks, which lead to the UK’s Financial Conduct Authority recommending that LIBOR screen rates be discontinued, and alternative risk-free rates (RFRs) developed. On 31 December 2021, after many years of recommendations and input from working groups, LIBOR for most currencies and tenors came to an end.

What does the discontinuation of LIBOR mean for borrowers and lenders and their existing or new financing transactions?

With the majority of LIBOR rates now unavailable, lenders and borrowers must agree which alternative benchmark rates will apply to new financing transactions and, where finance documents are already in place, which benchmark rates will replace the IBORs currently used. Borrowers and lenders with existing finance documents should first review their loan documents to determine whether there is any existing contractual fallback position applying from the date LIBOR became unavailable.

A lender presents an RFR as the benchmark rate for the calculation of interest, what does that mean?

The majority of syndicated loan agreements which existed in the market prior to the discontinuation of LIBOR applied a floating interest rate which was calculated by reference to a base rate of interest (calculated by reference to an internationally accepted inter-bank benchmark rate, like LIBOR) plus a margin. The discontinuation of LIBOR (and other accepted benchmark rates) requires the base rate portion of the interest calculation to be replaced. RFRs are used as a replacement for that discontinued inter-bank benchmark rate.

The new benchmark rates include overnight RFRs, such as SONIA (the Sterling Overnight Index Average) for loans in pound sterling and SOFR (the Secured Overnight Funding Rate) for loans in USD. Term RFRs have also been developed which are calculated on a forward-looking basis (similar to IBORs) by reference to derivatives.

What are the differences between LIBOR and RFRs?

LIBOR and RFRs (other than term RFRs, which have some similarities to LIBOR) are fundamentally different. LIBOR is calculated on a forward-looking basis and represents an average of the rates at which certain banks expect they could borrow money on the interbank market for a certain period/term (e.g. 1, 3, 6 months) rather than the actual cost of borrowing in the interbank market. LIBOR (and other IBOR benchmark rates) included an element of ‘term risk’ (or liquidity premium) on the part of the lenders, recognising that the LIBOR benchmark rate assumes funds are being committed to a borrower for a specific extended period (i.e. 1, 3 or 6 months) rather than overnight.

RFRs are ‘backward looking’, that is, they are calculated by reference to current overnight rates during the term of the loan, rather than forward-looking screen rates. RFRs (unlike IBORs) do not include inbuilt premium for term funding. To create a similar economic outcome and replace the base rate of a floating interest rate with an equivalent rate, the RFR benchmark rates require an element of term risk. This is achieved by aggregating RFR overnight rates and incorporating an element of term pricing into the calculation, which is done by compounding overnight rates over a specific period to achieve a rate that can be used for longer periods (e.g. 1, 3, 6 months). Credit adjustment spreads are also added to the rate of interest and are used to compensate lenders for an element of credit risk over and above their cost of funding (something that was indirectly captured in the cost of interbank lending and factored into IBORs).

Despite the differences between IBORs and RFRs set out above, the adjustments to RFRs which have been developed have the effect of creating, so far as is possible, a benchmark rate replacement for LIBOR which produces an economically similar outcome.

For further information or advice contact Wright Legal on +61 8 9327 0800.

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