Background: Why is it possible that LIBOR may cease to be published?
On July 27, 2017, Andrew Bailey, the Chief Executive of the UK Financial Conduct Authority (the FCA) announced that the FCA would no longer compel or persuade banks to make submissions to LIBOR as from the end of 2021. This announcement came as a result of longstanding concerns regarding the robustness of LIBOR as a benchmark.
LIBOR was originally a survey-based benchmark, compiled by panels of banks answering the question “at what rate could you borrow funds were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?” In the wake of the LIBOR manipulation scandal, regulators found that there were very few transactions taking place to support some of the currencies and tenors for which LIBOR was published. As such, LIBOR submissions were largely based upon expert judgement rather than transaction data. This led to concerns that LIBOR was unrepresentative and vulnerable to manipulation.
Given the lack of underlying transactions supporting LIBOR, banks have become increasingly reluctant to make submissions to the benchmark, prompting regulators to take steps to persuade panel banks to contribute in order to support its continued publication. However the situation is increasingly unsustainable. There is a real risk that when banks cease to be compelled by the FCA to submit to LIBOR, the benchmark will become more volatile and may no longer pass regulatory tests of representativeness. As such, the announcement by the FCA represents an attempt by the regulator to conduct an orderly transition away from LIBOR to more robust benchmarks and prevent market disruption.
What will replace LIBOR?
So called “risk-free rates” have been designated for each currency for which LIBOR is currently published. Risk-free rates are benchmarks generally based on overnight deposit rates. They are considered to be more robust as they are based upon a larger volume of observable transactions.
However risk-free rates differ from LIBOR in several important ways:
- LIBOR is a term rate and so is set prior to the commencement of the interest period to which it relates. This enables a borrower to budget. The borrower will be able to calculate at the outset of the interest period the amount of interest which will be payable. Most risk-free rates such as SOFR are backwards looking and are published the day after the period to which they relate. This can make budgeting difficult as, depending on the calculation method chosen, the borrower may only know on the interest payment date itself how much interest it owes.
- They do not build in the same kind of premium for term liquidity or bank credit risk as LIBOR. As a forward looking rate, LIBOR contains an element of pricing based on the notion that one bank is taking credit risk on the other for the relevant tenor. This is not the case with risk-free rates. As such, interest calculated over a period using a risk-free rate will be lower than interest calculated over the equivalent period at LIBOR.
- LIBOR is administered in London and published on or about 11 am London time for a number of different currencies. Risk-free rates are each administered locally in each currency jurisdiction and published at different times.
What is the risk-free rate for US dollars?
The risk-free rate for US dollars is SOFR (Secured Overnight Financing Rate). It is a broad measure of the cost of borrowing cash overnight collateralized with US Treasury securities and is compiled using data from numerous sources including (i) tri-party repo transactions, (ii) General Collateral Finance repo transactions and (iii) bilateral Treasury repo transactions cleared through Fixed Income Clearing Corporation. It is published at 8 am Eastern Time with respect to transactions occurring on the previous day. SOFR is a relatively new risk-free rate and was published for the first time in April 2018. It is administered by the Federal Reserve Bank of New York.
Will existing loan agreements and other financing documents with a term extending beyond the end of 2021 need to transition from LIBOR to a risk-free rate?
It is prudent for market participants to transition away from LIBOR to risk-free rates prior to the end of 2021. However from a documentary perspective, this is not a simple matter of amending references to LIBOR to SOFR or another suitable risk-free rate. Due to the inherent differences between LIBOR and risk-free rates, this change will also impact the mechanics of the loan agreement or financing document. The following points will need to be considered:
- What method of calculation should apply? Borrowers and lessees will need some notice of the interest payment which is due. One suggested approach would be to calculate the interest payment on a compounded basis over a reference period commencing five days in advance of the relevant interest period and ending five days prior to the relevant interest payment date. In this way a borrower would have five days’ notice of the interest payment due. Borrowers and financiers will however want to model how such a calculation will work in practice and compare this to LIBOR over an equivalent period.
- What spread adjustment should apply? As noted above, risk-free rates do not reflect term risk or bank credit risk and as such are lower than LIBOR over the equivalent period. Upon transitioning to a risk-free rate and to mitigate the risk of the transition giving rise to an economic benefit for one party over another (rather than preserving the status quo), borrowers and financiers may need to agree some kind of a spread adjustment to reflect this difference. However the calculation of a suitable spread adjustment is unlikely to be straightforward.
- What consents are required? Recent loan documentation may contemplate that the consent threshold among lenders for a change in benchmark is reduced from all lender consent to majority lenders; however this will not always be the case. In addition, the consent of other parties, such as providers of third-party security, guarantors and hedging providers, may also be required.
- Impact on Hedging Where obligations under loan and lease documentation are hedged, it will be necessary to ensure that transition to a risk-free rate is managed in a way which avoids basis risk. For example, the timing of the transition and the method of calculation adopted with respect to the risk-free rate will need to match in both the hedging derivative and in the underlying loan or lease. The possible impact on hedge accounting treatment will also need to be considered.
- Who bears the cost of transition to a risk-free rate? This will depend on the existing provisions of the loan or lease agreement with respect to amendments – however it may be the subject of negotiation.
What is the consequence if no change in benchmark is agreed?
Most finance documentation will contain a mechanism for determining the rate of interest if LIBOR ceases to be published. For example in the vast majority of Loan Market Association-based documentation, if LIBOR ceases to be published, then ultimately financiers would be able to charge interest based upon their cost of funds from whatever sources they may reasonably select. Such provisions were only intended to address short term interruptions to the publication of LIBOR rather than a complete cessation. They are unlikely to lead to a desirable future basis for the continuation of the transaction.
However some aviation finance documentation referencing LIBOR may not contemplate LIBOR cessation at all. This is most likely to be the case in operating leases which reference LIBOR either as a means of calculating floating rate lease rentals or as a means of calculating a default rate. As such, any change to an alternative benchmark would require the parties to agree to amend the relevant document and a failure to do so would lead to uncertainty and, in some transactions, possible disputes.
What about new loan or lease agreements?
At the time of writing, LIBOR is still commonly referenced as a benchmark in aircraft finance documentation. At present, the majority of lenders and financiers are not in a position where they are able to offer financing using a risk-free rate as systems are not yet in place to do so. It is likely that this position will start to change, most likely for bilateral transactions at first, as the market moves towards a consensus for the method of calculating interest referencing a risk-free rate.
Recently the Loan Market Association published a form of compounded SOFR referencing loan agreement as an exposure draft for discussion purposes. This is a helpful development, however it is by no means a final form of precedent and will require careful review by industry participants.
As such, in new transactions which reference LIBOR it is best to build in a mechanism for agreeing a future change to a risk-free rate. Ideally this would contemplate a change in benchmark prior to the actual cessation of LIBOR given that LIBOR may become more volatile and unrepresentative before publication of the rate ceases. Parties may also want to discuss who should bear the cost of required changes to documentation and borrowers and lessees may want to consider what should happen if they disagree with a proposed change in benchmark and whether they would want to have the right to terminate or prepay in such circumstances.
Parties should also bear in mind whether some references to LIBOR in aviation finance documentation are needed at all. An example of this is the use of LIBOR in an operating lease default rate where LIBOR is being used as a benchmark without any relationship to underlying financing arrangements. In such circumstances it may be easier to use another benchmark, such as a risk-free rate or a central bank base rate, instead of LIBOR to avoid future amendments being required.
Although the use of risk-free rates is not yet common in aviation finance transactions, market participants should prepare themselves for a transition away from LIBOR. We would recommend the following steps are taken:
- Review your transactions: Which transactions would be affected by the possible cessation of LIBOR? What consents are required for a change in benchmark? Map any linked transactions to ensure that changes are properly coordinated. If you are a borrower or lessee, do you have the right to terminate or prepay (and at what cost) if you disagree with a change in benchmark?
- Draft for LIBOR replacement: Include mechanisms in your agreements to agree a change in benchmark or what should happen if there is no such agreement. Consider that you may want to agree a change in benchmark ahead of actual LIBOR cessation.
- Is LIBOR necessary?: Consider whether your use of LIBOR is necessary in new transactions. If LIBOR is just being used to determine a default rate, can you replace this with an alternative?
- Monitor developments: Engage with consultations and monitor developments. Start to look at SOFR and SONIA and other relevant risk-free rates and how these might compare to LIBOR. The New York Fed and the Bank of England are looking at whether they can develop tools to calculate compounded SOFR and SONIA.