LIBOR Replacement - Update 1

If your firm or company provides debt funding, receives debt funding or has entered into derivative transactions linked to such debt funding then it is likely that amounts payable under some of those contracts will be determined by reference to LIBOR.

1. What is happening to LIBOR? Currently LIBOR is calculated by reference to quotes provided by panel banks. However, on 27 July 2017, the Financial Conduct Authority's chief executive published a speech stating that by the end of 2021 it would no longer persuade or compel banks to submit LIBOR quotes. In the absence of being 'persuaded or compelled', panel banks have indicated that they will no longer provide LIBOR quotes after the end 2021.
2. What will replace LIBOR? The current market consensus is that LIBOR will be replaced by overnight risk-free rates (“RFRs”). These are rates calculated by reference to historic transaction data and published on an overnight basis. The RFR for transactions denominated in sterling will be, in all likelihood, Sterling Overnight Index Average (“SONIA”). SONIA is published by the Bank of England and measures the rate of interest paid by banks on overnight unsecured sterling deposits made to other financial institutions. There are two key differences between LIBOR and SONIA (and other RFRs) which are:

• SONIA is a backward looking rate whereas LIBOR is a forward looking rate; and
• LIBOR takes into account other factors such as credit risk and market liquidity not reflected in SONIA.

Consequently RFRs are typically lower than LIBOR rates. This may result in a positive or negative impact on the amounts payable under a funding arrangement and will impact all existing transactions that use LIBOR to calculate such amounts. The switch from LIBOR to SONIA will be particularly relevant to the derivatives market where enormous volumes of LIBOR linked transactions are completed on a daily basis. A working group for the derivatives industry body 'ISDA' has consulted widely with the market to establish a methodology that will, as far as possible, minimise the impact on pricing. The current thinking seems to be that a credit adjustment spread will be included in SONIA to account for any pricing discrepancy and this amount will be calculated using a median average of LIBOR over a 5 year lookback period. It is worth noting that discussions and work are still ongoing so it is difficult to say definitively how the industry will address this point. Once a settled position is reached in the derivatives market then it is likely this will be adopted in the syndicated and bilateral lending market.

3. How will this impact loan documents? In 2018 the LMA produced a Replacement of Screen Rate Clause which has been included in facility agreements by the majority of the market since such date. Although the clause is helpful it only really sets out a more detailed method for agreeing the replacement benchmark at a future time. In essence it is an agreement to agree. As a result, those market participants with legacy loans (whether their documentation contains the LMA clause or not) should consider a number of things when deciding how important it is for them to address the issue of LIBOR transitioning. Who is their counterparty? Are they likely to take an approach which broadly follows the market? Are their positions hedged and do the documents currently consider LIBOR transitioning in a manner which offers some guidance as to how and when the transition will be agreed?*Further notes will be available in the coming weeks. Any queries please contact us.