The discontinuation of LIBOR (the London Inter-bank Offered Rate) will have a transformative effect on the world’s financial services sector. LIBOR has, for decades, underpinned contracts affecting banks, asset managers, insurers and corporates estimated at US $350 trillion globally on a gross notional basis.
On 5 March 2021, the UK’s Financial Conduct Authority (FCA) announced that all LIBOR settings will either cease to be provided by any administrator or no longer be representative:
- immediately after 31 December 2021, for all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
- immediately after 30 June 2023, for remaining US dollar settings (Overnight and 1, 3, 6 and 12 Months),
The Alternative Rates Reference Committee (ARRC) commended the announcement and reminded the financial sector of previous US supervisory guidance ‘to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December, 2021, in order to facilitate an orderly – and safe and sound – LIBOR transition’.
LIBOR has long been used as an interest rate benchmark across a variety of financial contracts as well as for banks’ and other financial institutions’ own funding needs. The EBRD has been using LIBOR as its key benchmark for all floating rate US dollar denominated bonds, swaps and loans.
With the phasing out of LIBOR, the EBRD, like the rest of the market, will be required to turn to alternative reference rates. We have already started issuing bonds and entering derivatives indexed to alternative reference rate and have updated reference rate conventions in the loan products we offer our clients.
What alternative reference rate will replace USD LIBOR?
In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the rate to represent best practices in US dollar derivatives and financial markets. SOFR is based on observable repo rates, or the cost of borrowing cash overnight collateralized by US Treasury securities.
Because LIBOR represents the cost of funding of banks in the unsecured wholesale market for various tenors, including a term premium and credit-risk component which are not included in overnight RFRs, a Spread Adjustment reflecting this difference will need to be added to the LIBOR replacement rate in existing contracts.
What are the key features of the EBRD-proposed LIBOR Replacement Rate in loan agreements?
The key features of the reference rate methodology are that SOFR will be compounded in arrears, with an observation shift and a 10 business-day look-back period, using the SOFR Index to facilitate calculation.
The Spread Adjustment will depend on the timing of the conversion and will either be set as per the International Swaps and Derivatives Association’s (ISDA) five-year historical median approach or using the forward looking swap market.
Other loan agreement terms will also need to be adjusted to reflect the operational impact of replacing a term benchmark by an overnight benchmark.
How will the LIBOR transition be reflected in loan agreements?
As regards new loan agreements, the New York Federal Reserve has indicated that lenders should not enter into USD LIBOR linked loans as soon as practicable or at the latest by 31 December 2021. Until the EBRD starts offering SOFR linked loans, new loan agreements will include a mechanism providing for an automatic switch from LIBOR to SOFR on the pre-agreed transition date.
As regards existing loan agreements, over the coming months, the EBRD will be contacting all existing clients to amend the interest rate provisions in legacy LIBOR linked transactions maturing beyond June 2023. The amendment will introduce the new SOFR-linked conventions via an automatic ‘switch mechanism’ to be activated on a pre-agreed transition date.
For more information on the LIBOR transition and the EBRD-proposed LIBOR Replacement Rate clients should contact their EBRD relationship manager.