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25 October 201810 minute read

Preparing for benchmark reform and the end of IBORs

Considerations for the future
In brief…

Regulators have made it clear that markets need to moveaway from financial contracts that reference interbankoffered rates (IBORs) as soon as possible and well inadvance of the end of mandatory LIBOR submissions atthe end of 2021. Regulated firms are already expected tohave a plan for this transition, including in relation to theirlegacy book. It is particularly important that this isaddressed in relation to any new financial contracts, inparticular those that are not easy to amend in the future.

Alternative near-risk free rates have been identified,including SOFR for US dollar markets, SONIA for sterlingmarkets, ESTER for euro markets, TONA for yen marketsand SARON for Swiss franc markets. These are notforward-looking term rates but are overnight rates (and insome cases are secured rates) so are not directreplacements for existing IBORs in the term markets,which will mean that markets have to adjust. Thisadjustment is already taking place as we are already seeingexamples of new bond issues referencing SOFR andSONIA, with public institutions including the EuropeanInvestment Bank and the World Bank leading the way andfinancial institutions such as Lloyds Banking Group andSantander recently also issuing SONIA-linked bonds.

Going forward, with new contracts and products,consideration must be given to including transitionlanguage in new loans, bonds and derivatives. The LMA inrelation to the loan market, ICMA in relation to the bondmarket, AFME in relation to the securitization market andISDA in relation to the derivatives market have allintroduced new language suggestions to introduce fallbacksto deal with amendments following discontinuation of ratesor rates ceasing to meet the requirements of regulators(particularly the requirements of the EU BenchmarksRegulation) or to include appropriate risk factors anddisclosure in capital markets documentation.

The legacy book presents its own challenges, particularly inthe cash bond markets as amendments to something asfundamental as the basis for interest calculation require theconsent of a high proportion of bondholders (and mayrequire unanimous consent). Liability managementexercises may be necessary, particularly for long-datedPreparing for benchmark reform and the end ofIBORsConsiderations for the futurefloating rate debt, and issuers should be alert to this ifconducting any other form of consent exercise on thoseliabilities prior to 2021.

Background

Andrew Bailey, chief executive of the Financial ConductAuthority in the United Kingdom made it clear in July 2017that the market needs to transition away from LIBOR bythe end of 2021. He returned to the topic again in a speechdelivered at Bloomberg, London on 12 July 20181andspecifically said that:

"I hope it is already clear that the discontinuation of LIBOR shouldnot be considered a remote probability ‘black swan’ event. Firmsshould treat it is as something that will happen and which they mustbe prepared for. Ensuring that the transition from LIBOR toalternative interest rate benchmarks is orderly will contribute tofinancial stability. Misplaced confidence in LIBOR’s survival will dothe opposite, by discouraging transition."

The background to the transition is that the internationalinterbank funding market has substantially decreased andregulators have become increasingly concerned aboutusing IBORs (including LIBOR) as the basis for trillions ofdollars of financial and other contracts when the base datafeeding into the rate relates to transactions with volumesonly in the hundreds of millions of dollars, making IBORsintrinsically less representative of the market andpotentially vulnerable to manipulation. In the EuropeanUnion, the advent of the EU Benchmarks Regulation’s fulleffectiveness on 1 January 2020 may hasten the change asit is a regulatory requirement that a benchmark rate mustbe sufficiently representative of the economic reality itintends to measure. Once panel banks are no longerrequired to submit LIBOR rates after 2021, it is likely thatthe number of banks submitting a rate will reduce furtherdiminishing the representative nature of the LIBOR rates.

In the UK, Andrew Bailey has made it clear that Firms thatthe FCA supervises will need to be able to demonstrate toFCA supervisors and their PRA counterparts that theyhave plans in place to mitigate the risks, and to reducedependencies on LIBOR. His speech listed a range ofrequirements that the FCA will expect are dealt withwhich merit repeating in full, where he pointed out that:

"Some firms will also have obligations to disclose and consider risksto investors when they sell LIBOR-related instruments. Issuers ofLIBOR-related listed securities, for example, owe duties ofdisclosure under prospectus requirements, and need to ensurethese have been fulfilled. Banks and investment firms also need toconsider the design and risks of any new LIBOR-referencinginstruments as part of their product governance obligations,considering and describing the impact of LIBOR discontinuation onthose instruments. And they will need to provide all appropriateinformation to all distributors of those financial instruments.

Those acting on behalf of investors will need to ensure they haveconsidered and understand what will happen to LIBOR-referencinginstruments in the event of LIBOR discontinuation. Investmentadvisors and portfolio managers may need to be able to show thatthey have considered whether such investments remain suitable fora particular client or portfolio if there is no clear and appropriateplan on what will happen in the event of discontinuation. Brokers orplatforms offering non-advised services need to disclose to clientsin an understandable way information on the key features and risksof financial instruments they make available. For an instrumentrelying on LIBOR “beyond end-2021”, the risk of discontinuationwill need to be covered."

Replacement rates

Significant work has been undertaken around the globe bya series of working groups to identify robust replacementrates. Work continues in a number of working groups todevelop possible forward looking term rates as true LIBORterm replacements but the market is being encouraged toadapt to using overnight rates. The Working Group onSterling Risk-Free Reference Rates launched a consultationon term SONIA reference rates in July 2018 which closedat the end of September 2018 and has yet to report.However, overnight near risk-free rates have found favor asthey are likely to be the most robust interest ratebenchmarks available since they are firmly grounded intransactions.

Accordingly, in the US dollar market, a new overnightsecured rate (SOFR - the Secured Overnight FinancingRate) has been developed and has been published sinceApril 2018 by the New York Federal Reserve based ontransactions in the Treasury repurchase (repo) market. InLondon, SONIA (the sterling overnight index average) hasbeen reformed and since 23 April 2018 has beenadministered by the Bank of England based on overnightunsecured transactions in sterling. In the EU, the EuropeanCentral Bank will administer a new rate, ESTER (the euroshort term rate), as the risk-free rate for transactions ineuro, reflecting euro area banks’ borrowing costs in thewholesale unsecured overnight market and the ECB hascommitted to publishing the rate no later than October2019. In Switzerland, the Swiss National Bank incooperation with SIS Swiss Exchange has developedSARON (the Swiss Average Rate Overnight) whichrepresents the overnight interest rate of the securedfunding market for Swiss franc (CHF), based ontransactions and quotes posted in the Swiss repo market.In Japan, the new risk-free rate benchmark will be TONA(the Tokyo Overnight Average), administered by the Bankof Japan and based on money-market rates.

SONIA and SOFR have started to be used in capitalmarkets transactions with public institutions and financialinstitutions leading the way. In June 2018, the EuropeanInvestment Bank issued a £1 billion SONIA-linked bond,followed by a £750 million SONIA-linked bond issue byLloyds Banking Group, a £1 billion SONIA-linked bondissue by Santander and a £1.25 billion SONIA-linked bondissue by the World Bank in September 2018. Similarly inthe US dollar market, at the end of July 2018, Fannie Mae(the US mortgage finance agency) issued three tranches ofbonds with SOFR-linked rates for a total of US$6 billion,followed by a US$1 billion SOFR-linked bond issue by theWorld Bank, a US$100 million SOFR-linked note issue byCredit Suisse and a US$1billion SOFR-linked bond issue byMetLife Inc. in August 2018.

Amendments to documentation

The main industry bodies have published fallback languageto deal with transition and are regularly supplementing thatlanguage. The loan market already uses fallback language sothe majority of floating rate loans documented on industrystandard terms are likely to survive a cessation inpublication of rates. However, the fallback may be tolender cost of funds rather than a replacement rate ifreference banks are not willing to provide reference rateswhich is likely to be administratively unworkable on anongoing basis so amendments bilaterally are still likely to berequired. The Loan Market Association (LMA) in Londonhas published a Revised Replacement of Screen RateClause which was developed in order to facilitate furtherflexibility with lower consent thresholds than the existingclause would allow in light of uncertainty over the future ofLIBOR and other benchmark rates.

The derivatives market is likely to adapt to replacementrates by using the common industry approach ofintroducing a new protocol for participants to adhere tothat would amend all transactions between adheringparties. Although this facilitates changes, it is not a panaceaas it may lead to imbalances in hedging positions if not all ofa participant’s counterparties adhere to the relevantprotocol. It may also lead to loss of regulatory grandfathering, for example in relation to reporting and clearingunder the European Market Infrastructure Regulation(EMIR). For non-financial counterparties using derivativesfor hedge accounting purposes, this approach may causemismatches and may lead to failures of hedges, introducingbalance sheet volatility, unless the same amendments aremade to both sides of their hedge positions. Simplechanges to rate methodology, such as the updates to SONIA, have been adopted through the usual method ofsupplements to the ISDA definitions and require nofurther documentation changes in the majority of cases.

ISDA is amending its standard documentation toimplement fallbacks for certain key interbank offered rates(IBORs). The fallbacks will apply if the relevant IBOR ispermanently discontinued, based on defined triggers. Thefallbacks will be to alternative risk-free rates (RFRs) thathave been identified for the relevant IBORs as part ofrecent global benchmark reform work. ISDA is alsocurrently consulting on certain technical elements of thefallbacks with its “Consultation on Certain Aspects ofFallbacks for Derivatives Referencing GBP LIBOR, CHFLIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW”open for responses until 12 October 2018.

In the capital markets, there are now examples of newtransactions referencing SONIA and SOFR which can beused for new floating rate transactions. Some transactionshave fallbacks to the last available rate which would ineffect turn transactions into fixed rate transactionsfollowing rate discontinuation. The US AlternativeReference Rates Committee (ARRC) has publishednon-binding guiding principles for consideration whendrafting LIBOR fallback language for US dollar cashproducts which relate to usage of successor rates, spreadadjustments, and trigger events and encourage consistencyof terms and conditions across asset classes andjurisdictions. The Working Group on Sterling Risk-FreeReference Rates has published a paper entitled "Newissuance of Sterling bonds referencing Libor"3setting outsome considerations for market participants in relation tothe issue, offering and purchase of long-dated floating ratebonds referencing LIBOR on the basis of current marketstandard bond documentation. ICMA has also developednew benchmark disclosure language to be included in newfloating rate transactions. The securitization market hasalso developed amendment language to facilitate changesto the rates if required in the context of securitizationtransactions by means of ‘negative consent’ involving thebond trustee.

Practical considerations

Due diligence should be conducted by issuers on theirlegacy book in the run-up to 2021 to identify agreementswhere rate cessation would cause difficulties, withparticular focus on the applicable fallback language and anylinked hedging arrangements.

It is possible that LIBOR and other IBORs will continue ona voluntary basis or even with a synthetic rate for legacycontracts post the end of 2021. Regulators have not ruledthis out but they are strongly discouraging reliance on this,not least as if the rate is not representative of anunderlying market it would not meet the requirements ofthe EU Benchmarks Regulation and so could not be usedby regulated parties for new transactions.

Going forward, if a new transaction is not alreadyreferencing one of the new rates, for floating ratetransactions that will last beyond 2021, consideration mustbe given to including specific amendment language andfallback wording to facilitate a transition to a replacementrate without unanimous consent from all investors.Appropriate risk factors and disclosure should be includedin all sales documentation to mitigate future regulatory andlitigation risk.

Liability management exercises may be necessary forfloating rate long-dated debt so if any consent solicitationsor other liability management exercises are beingconducted by issuers in advance of 2021, considerationshould be given to using the opportunity to also introducereplacement rate language.


1 https://www.fca.org.uk/news/speeches/interest-rate-benchmark-reform-transition-world-without-libor
2 Available at https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/risk-free-reference-rates-new-issuance-of-sterling-bonds-referencing-libor.pdf

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