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As from December 31, 2021, banks will no longer be compelled to provide LIBOR quotations. This means that the market’s most common method of setting interest rates will be discontinued. This change will have broad implications, affecting loan agreements, bond agreements, leasing arrangements, derivative products and many more existing transactions.
In response to this deadline, working groups have been set up in respect of the five main IBOR currencies. These working groups have designated a preferred replacement rate and are working on the mechanics for making these available to the market in the next two years.
|Jurisdiction||Working Group Sponsor||LIBOR currency||Replacement RFR|
|United States||Federal Reserve Bank of New York||USD LIBOR||Secured Overnight Financing Rate (SOFR)|
|United Kingdom||Bank of England||GBP LIBOR||Reformed Sterling Overnight Index Average (SONIA)|
|Switzerland||Swiss National Bank||CHF LIBOR||Swiss Average Rate Overnight (SARON)|
|Japan||Bank of Japan||JPY LIBOR||Tokyo Overnight Average Rate (TONA)|
|European Union||European Central Bank||EUR LIBOR||Euro Short-Term Rate (ESTER) available as of October 2019|
The proposed replacement rates bring with them a number of challenges. SOFR, which is the proposed replacement for US dollar LIBOR is an overnight, secured nearly risk-free rate. In comparison, LIBOR is an unsecured rate which is published for future maturities. This immediately raises two issues. The first is practical in nature, as in most transactions floating interest rates are set in advance of the start of the interest period, and can be set for different fixed periods of time. Further developments need to be made to a backward-looking overnight rate in order that it can “replace” LIBOR effectively. The second relates to economics, as SOFR is designed to be as free of risk as possible, whereas LIBOR encapsulates an inherent element of credit risk on large banks and financial institutions.
These two issues are not insurmountable. The ICE Benchmark Administration (IBA) has developed the US Dollar ICE Bank Yield Index to establish a forward-looking rate which can be set, in advance, for certain fixed periods. This is done by taking a snapshot of transactions made in the last 24 hours for (1) primary market funding transactions, e.g. commercial paper and inter-bank deposits, and (2) secondary market bond transactions. This is then filtered by eligibility criteria, sorted by days to maturity and plotted on to a daily yield curve. The IBA has been building this data for the whole of 2018. Interestingly when tracked against LIBOR for the same period, the rates track similar curves. It is currently seeking feedback on its proposed methodology.
While the benchmark providers seek to develop a methodology which can be accepted by the market for a forward–looking rate, anybody currently using LIBOR should be preparing for the change. Investors, banks and companies active in the shipping sector are starting to examine their books for transactions using LIBOR which run past December 31, 2021. Many of these deals will have been documented before the replacement of LIBOR was contemplated. Taking loan agreements as an example, if the parties cannot agree to an amendment to a loan agreement to allow for a revised mechanism for rate setting, the market disruption provisions will usually apply. This clause often provides that an interpolated LIBOR is used which, if not available, is replaced by reference bank rates or a bank’s cost of funds. Many banks are now reluctant to act as reference banks and have a strong preference not to reveal their cost of funds. This leaves room for negotiation for borrowers as the clock ticks down to December 31, 2021. Given some of the challenges facing the shipping industry over the last few years, a number of hedge funds have taken positions in loan agreements and also are examining their position and voting power in individual loan agreements to assess their ability to play their position to their advantage.
It is widely anticipated that the market will settle on a replacement rate which will then be adopted. In the case of derivative contracts, ISDA is developing a protocol which can be entered into between two companies and will amend each derivative contract to which they are party. Although a very elegant solution, this will need to be looked at carefully, to ensure that any other contracts are amended at the same time and in the same way as that derivative contract, for example where interest rate hedging relates to a specific loan transaction, any amendments to LIBOR should occur simultaneously and any calculations should be performed in an identical manner. The loan market will require some more paperwork. We anticipate that amendment agreements for each loan agreement will need to be entered into, with consents potentially required from borrowers, guarantors, export credit agencies, risk insurers and, in some cases, charterers. This will all take time.
As the marathon continues to find a rate to replace LIBOR which can be adopted by the market, it is worth assessing your position and getting ready for the upcoming negotiation, consent and amendment exercise. Given the enormity of the change which affects all elements of your business, knowing your voting power, consent rights and potential fallback position will be essential. It may pay to be prepared.
The EU is very likely to push ahead with creating a carbon border adjustment mechanism, as soon as compliance with WTO rules can be assured.
© Norton Rose Fulbright LLP 2020