With only a year left on the clock before the retirement of LIBOR rates, the Bank of England estimates over $400 trillion of financial contracts worldwide still reference them. The urgency for financial markets to transition to alternative benchmarks has been exacerbated by the market volatility caused in the wake of COVID-19, reminding all market participants and observers of the need to adopt more reliable reference rates even before the impending 2021 deadline.
With new legislation proposed, new guidance advised and new protocols published, the final quarter of 2020 promises significant progress towards transition for many. Organised players in the market are already completing the cumbersome due diligence exercises needed to ascertain which of their contracts require review and amendment, whilst others have begun to offer new and refinanced non-LIBOR linked products.
UK Parliament and the Financial Services Bill
On October 21, the UK Government introduced the Financial Services Bill to Parliament. The Bill includes amendments to the UK Benchmarks Regulation that provide the Financial Conduct Authority (the FCA) with enhanced powers to oversee the transition from ‘critical benchmarks’ such as IBOR.
The Bill provides the FCA with powers to:
- Prohibit some or all new use of a benchmark by supervised entities by declaring the benchmark as being unrepresentative of the market.
- Require changes to methodology, rules or codes of conduct of benchmarks designated as unrepresentative. This could allow a change so that LIBOR is no longer reliant on panel bank submissions.
- Permit use of designated benchmarks in ‘tough legacy contracts’. The Treasury and the FCA consider ‘tough legacy contracts’ to only be those contracts “that genuinely have no realistic ability to be renegotiated or amended to transition”.1
- Extend the period over which the FCA can compel an administrator of a critical benchmark to continue publication to enable use in tough legacy contracts granted an exemption for a longer period.
The Bill reflects the Chancellor’s statement in June that the priority of all relevant market participants should be to prioritise active transition away from LIBOR well ahead of the end-2021 cessation.2
EU Parliament and the EU Benchmarks Regulation
Just as the UK Parliament is set to amend the UK Benchmarks Regulation, the Council of the European Union has this month agreed its opening negotiating position on the changes to be made to the EU Benchmarks Regulation.
The aim of the amendments will be to give the European Commission the power to designate a statutory replacement rate to assume the place of any benchmark whose cessation would disrupt the EU financial markets.
The upcoming points for negotiation between the EU Council and EU Parliament will likely revolve around the range of contracts and financial instruments that the new powers will apply to, as well as a possible extension to the 2021 deadline for EU supervised entities to make use of third-country benchmarks.
A topic that will no doubt be broached by the EU at some stage will be the plans for EURIBOR. The European Securities and Markets Authority has confirmed that whilst there are currently no plans to discontinue EURIBOR, it is still a regulatory requirement for EU supervised entities to incorporate fallback provisions into EURIBOR contracts. The Association for Financial Markets in Europe (AFME) published revised EURIBOR Benchmark Rate Modification Language for securitisation issues on October 5, 2020 and there will no doubt be further discussion and revisions for other markets to follow3.
International Swaps and Derivatives Association (ISDA) publications
Following announcements throughout September, on October 23, 2020, ISDA published the IBOR Fallbacks Protocol (the Protocol) and IBOR Fallbacks Supplement to the 2006 ISDA Definitions (the Supplement).4
The Supplement amends ISDA’s standard definitions for interest rate derivatives to incorporate fallback rates for each currency. For derivatives that reference LIBOR, SONIA will become the reference rate following either the permanent cessation of LIBOR or a determination by the FCA that LIBOR is no longer representative of the market.
The Protocol allows for parties to incorporate these revisions into their legacy derivative trades, provided all counterparties choose to adhere to the protocol. Market participants can adhere to the Protocol by submitting an Adherence Letter on the ISDA website.
The Supplement and the Protocol will come into effect on January 25, 2021. ISDA intends through the Protocol’s amendments to legacy derivatives contracts and the Supplement’s amendments to future derivatives contracts, to effect a smooth transition in the derivatives market.
The Working Group on Sterling Risk-Free Reference Rates and the FCA have issued a joint statement this month welcoming ISDA’s Protocol and Supplement, encouraging early adherence to the Protocol and reasserting the need for market participants to “accelerate efforts to transition from LIBOR in the time available.”5
Loan Market Association (LMA) publications
The LMA has released two major IBOR updates in two months.
In September the LMA published the first exposure draft term and revolving facilities documentation that incorporated ‘rate switch provisions’. The draft operates as a reflection of the most recent recommendations of the Working Group on Sterling Risk-Free Reference Rates.6 These recommendations include the use of SONIA as a Sterling LIBOR replacement, in addition to adopting a five banking day lookback methodology in place of the existing ‘Observation Lag’ convention found in other risk-free-rate transactions.
The LMA notes in their commentary on the draft that this documentation is not yet a recommended form, but instead will serve as a useful basis as the market moves towards more standardised documentation dealing with the issues raised by IBOR transition.
In October, the LMA released a note on the Revised Replacement of Screen Rate Clause and considerations relating to the inclusion of a specific pre-cessation trigger. The LMA’s earlier Replacement of Screen Rate clause is flexible as to what events trigger the change from using IBOR to an alternative benchmark. As the new Financial Services Bill will soon give the FCA the power to declare IBOR as no longer representative prior to the 2021 deadline, the LMA recommends parties consider including the additional pre-cessation trigger in the event of an FCA unrepresentative determination. The revised provisions are aligned with the ISDA Supplement discussed above and similar to the ARRC fallback language which has included since June 2020 a pre-cessation trigger where there is an announcement from the regulatory supervisor of a benchmark rate that all the available tenors are no longer representative. The European Commission has also published a proposal to amend the Benchmarks Regulation to include a power to designate a statutory replacement rate for a benchmark whose cessation would result in significant disruption to the functioning of financial markets in the EU. The proposal also contains a non-representativeness pre-cessation trigger for such benchmarks.
The Alternative Reference Rates Committee’s (ARRC) Requests for Proposals
The ARRC, the US committee assisting in the successful transition away from USD LIBOR, released two ‘requests for proposals’ in September. It is seeking to find a suitable administrator to publish daily forward-looking SOFR rates, as well as a suitable administrator to publish daily indicative spreads, and spread-adjusted fallback rates between SOFR and USD LIBOR for use in legacy contracts with the ARRC’s recommended hardwired fallback language.
ARRC will stop taking submissions from institutions at the end of October 2020, and will evaluate responses before publishing their recommendations. The successful entities will be those deemed capable of publishing these rates by June 30, 2021.
The European Central Bank (the ECB) publications
On October 7, the ECB published a summary of the public consultation that ran from July to September regarding the ECB’s publication of compounded term rates using the euro short-term rate (€STR)7. The ECB reported that a large majority of respondents expressed approval of the ECB publishing the proposed compounded term rates, and will use the feedback provided to finalise the proposed methodology.
- Clearing houses LCH, CMA and Eurex have issued Rate Change Notices to members, signalling the transition from using the Fed Funds Rate to using SOFR for the purpose of calculating Price Alignment Interest and Discounting Rate as of October 19, 2020.8
This change comes after LCH previously launched a consultation with their ‘SwapClear’ users on October 2, setting a deadline of October 30, 2020 to manage the process of the closure of outstanding EONIA contracts before the end-2021 deadline.
- In September 2020, GlaxoSmithKline completed the refinancing of two revolving credit facilities – a US$2.5bn 364-day facility and a £1.9bn multi-currency, three-year facility – replacing existing facilities to include fixed spread adjustment amounts for both SOFR and SONIA. The facilities involve 12 major banks all using identical documentation on a bilateral basis, with interest periods set at one month and a fixed spread adjustment reflecting the five-year historic median of spreads between the relevant LIBOR rates, SONIA and SOFR.
The refinancing is the first syndicated loan transaction to incorporate risk-free-rates and challenges other market participants to consider their own progress towards transitioning from LIBOR.
The Financial Stability Board (FSB) published its Global Transition Roadmap on October 16, 2020 that lays out the current timeline that prepared market participants should adhere to in order to be prepared for LIBOR to cease.9
- The FSB highlight that firms should already have identified and assessed all existing LIBOR exposures and have agreed project plans that allow the use of alternative reference rates in new contracts, as well as have a plan in place to communicate with clients about transitioning existing contracts.
- By the end of 2020, it is recommended that firms should be in a position to offer non-LIBOR linked loan products by providing borrowers a choice of reference rates, or by working with borrowers to include suitable conversion language.
- The FSB indicates that by mid-2021, firms should have begun the execution of formalised plans to amend legacy contracts where possible and have implemented a system to enable a full-scale transition.
- By end-2021, firms should be prepared for LIBOR to cease entirely. New business should be conducted using alternative rates or capable of switching rates at limited notice, legacy contracts should be amended and the effects of any tough legacy contracts should be understood by both parties.
For a comprehensive overview of IBOR transition, including background, timelines and video updates, see here.