The LIBOR benchmark is leaving us – so what’s happening with it?

The LIBOR benchmark is leaving us and the LMA and ACT have published a joint guide as an overview, which sets out the full details of what you need to know. You can find the Guide here.

Here is a short rundown.

Need for Reform

Amid allegations of manipulation, by 2012 it became clear that LIBOR needed reform. In 2014, ICE took over administration of LIBOR, but it still remained unclear whether LIBOR provided a reliable representation of economic reality So now, LIBOR panel banks will sustain LIBOR until end-2021 and work is being planned to transition to alternative rates based firmly on actual transactions.

The current alternatives are the “RFRs” or Risk Free Rates, which include:

1. Stirling £ - Sterling Overnight Index Average (SONIA), which is an unsecured rate;
2. Euro € - Euro Short-Term Rate (ESTER), also an unsecured rate;
3. US Dollar $ Secured Overnight Funding Rate (SOFR), which is a secured rate.

LIBOR versus RFRs

So, what are the key differences between LIBOR and the RFRs?

1. LIBOR is a forward-looking term rate published for 7 tenors (e.g. 1, 3, 6 months); RFRs are backward-looking overnight rates;
2. LIBOR includes term bank credit risk; RFRs are near risk-free;
3. LIBOR will include a premium paid on longer-dated funds; RFRs will not.

Because of this, there are some key commercial and operational issues to consider, which include:

1. The RFRs are overnight (and some are secured) rates, so they are lower rates than LIBOR. This potentially leaves a pricing gap, which needs a reimbursement mechanic.
2. LIBOR is quoted at the same time on the same basis for each currency – RFRs are currency specific rates published at different times to LIBOR and each other.
3. No term rate options are available for the RFRs. A forward-looking rate is needed for certainty of funding costs.
4. From a hedging perspective, different benchmark bases between loans and derivatives could lead to basis risk.

The key legal documentation implications for using RFRs are that:

1. Syndicated loans and bonds will require individual amendments to refer to an alternative rate (which will involve significant time and cost). Deals documented today which mature after 2021 are being based on LIBOR, which is compounding the number of legacy deals. LMA documentation currently contains interest rate fallback provisions, but these provisions are not designed to be used long-term or where LIBOR is permanently replaced by a different rate with a different calculation method. The ultimate fallback is to lenders’ cost of funds, which is also unworkable long-term.
2. For derivatives, ISDA already has a protocol system to implement amendments and is already updating its definitions to include its definitions to include the RFRs as fallbacks to LIBOR. It has engaged in an ongoing consultation process for this.

SONIA Working Group

A working group on Stirling £ RFRs has been established to catalyse a broad-based transition to SONIA by end-2021. The group includes the ACT, the LMA, banks and broker-dealers, among others (and similar working groups have also been established to transition to RFRs for the Euro and US$ as well as other currencies). This includes a sub-group working on establishing the feasibility of, and transition to, term SONIA reference rates (TSRRs) and best practice for referencing SONIA in syndicated loan markets (planned for later in 2018). Similar subgroups are being established for bond markets.