With the expected discontinuation of LIBOR at the end of 2021 fast approaching, the COVID-19 pandemic has forced financial institutions to reallocate resources and attention to portfolio crisis management. But based on recent statements by regulators and other industry organizations, there are no plans to delay the inevitable end of LIBOR. Financial institutions hoping for extra time to make the transition will instead have to buckle down and get to work.
In the United States, the Alternative Reference Rates Committee (ARRC) has taken the lead in shepherding the financial markets through the transition from US dollar LIBOR to the Secured Overnight Financing Rate (SOFR). The ARRC has worked closely with the International Swaps and Derivatives Association (ISDA), whose involvement in the transition effort is particularly vital given that derivatives transactions represent an estimated 95% of the outstanding gross notional value of financial products tied to US dollar LIBOR. In anticipation of the switch, these and other organizations developed roadmaps with recommended milestones to help ensure a smooth transition. COVID-19, however, has made it challenging for many financial institutions to keep up with these milestones, as focus has shifted to providing covenant relief and taking other measures to protect portfolios, along with the challenges of ensuring employee safety and facilitating remote working.
While the UK’s Financial Conduct Authority (FCA) recognized in March that the challenges presented by the COVID-19 pandemic are “likely to affect some of the interim transition milestones,” their ultimate view was that the “central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed.” In remarks made in July, John Williams, the head of the Federal Reserve Bank of New York, noted that the problems with LIBOR “became even more acute this spring during the period of severe market stress when term lending transactions based on LIBOR became even more scarce than usual.” Mr. Williams went on to echo the FCA’s position, stating that the “importance of transitioning from LIBOR is so great that, despite the effects of COVID-19, the overall timeline remains the same.”
Although some high profile SOFR-linked loans have cleared the market––such as the US$10 billion revolving credit facility Royal Dutch Shell negotiated with a 25-bank syndicate at the end of 2019––the reality is that such loans remain scarce, as many institutions are still not in a position to support SOFR-linked debt products and many aspects of the terms of such loans lack clear market consensus.
These hurdles were evidenced by the market’s response to the Main Street Lending Program (MSLP) established under the US government’s Coronavirus Aid, Relief, and Economic Security (CARES) Act. The initial plan was for MSLP loans to be issued with a SOFR-linked interest rate, but market participants expressed concerns about this requirement. The American Bankers Association argued that lenders were still working on new systems to administer SOFR-linked loans and that “such an abrupt transition to SOFR would deter participation in the MSLP.” And the Loan Syndications and Trading Association (LSTA) noted that requiring the use of a SOFR-linked rate would be problematic for parties who wanted to use the MSLP to upsize existing LIBOR-linked loans. The Federal Reserve responded by walking back its progressive position and switching to LIBOR-based pricing.
Despite concerns about delays to the SOFR transition due to pandemic-related disruptions, the ARRC, LSTA, ISDA and other organizations have continued to drive progress, forging ahead with market consultations and publishing new guidance. These efforts may be paying off, as the results of recent industry consultations suggest that views may be settling around key aspects of transition terms such as spread adjustments for cash products and pre-cessation fallback triggers for derivatives.
Spread adjustments are intended to minimize the differences between LIBOR and SOFR for existing LIBOR-based instruments. Because LIBOR is an unsecured forward-looking rate, it accounts for a degree of economic uncertainty (i.e., that the borrowing bank will not be able to repay the interbank loan) by incorporating a premium to cover this credit and liquidity risk. SOFR is based on secured overnight funding transactions, and so does not need to account for this risk. As a result, SOFR tends to be lower than LIBOR. Part of the transition will therefore require a spread adjustment that will be applied to SOFR for existing LIBOR-based instruments to minimize any changes in overall economics resulting from the shift to a new benchmark. Following the transition of legacy contracts from LIBOR to SOFR, new SOFR-based instruments will likely feature higher margins, rather than a spread adjustment, to achieve the desired economics. The spread adjustment will simply be included as a component element of a calculated margin specific to a borrower or credit facility.
Based on industry consultations led by the ARRC, market participants have expressed near-unanimous endorsement for using a spread adjustment for cash products (e.g., floating rate notes, syndicated loans, securitizations and bilateral business loans) that is based on a 5-year median of the historical spread between LIBOR and SOFR. ISDA is taking the same approach for derivatives, and many respondents to the ARRC consultation cited the importance of maintaining consistency with ISDA’s spread adjustment for hedging purposes. Additionally, both the ARRC and ISDA will use a static spread adjustment (i.e., it will be determined on a one-time basis and locked in). Respondents were unanimous in their view that the ARRC should align the timing of its spread adjustment determination for cash products with the timing of ISDA’s determination for derivatives.
ISDA has also made important progress by continuing market consultations during the COVID-19 pandemic. One lingering question from earlier consultations was whether and how a pre-cessation fallback trigger based on “non-representativeness” should be incorporated in the standard documentation for derivatives. Such a trigger would mean that derivatives tied to LIBOR would switch to a risk-free rate, such as SOFR, upon LIBOR becoming “unrepresentative” of the underlying market, even if it is still being published.
Though responses from market participants were mixed when this question was first raised in 2019, more recent consultations showed that a significant majority of respondents now support the inclusion of a pre-cessation fallback trigger, without optionality (i.e., all ISDA protocol adherents would be bound by the same terms), in both new and legacy documentation. Accordingly, ISDA is expected to include a pre-cessation fallback trigger when it publishes fallback language for derivatives contracts in the near future.
Wherever the market views on SOFR settle in the US, there will be global implications. US dollar LIBOR is used in instruments across international financial markets, and those markets are generally waiting to follow the ARRC’s lead on the transition to SOFR. For example, though the UK’s Loan Market Association (LMA) published an “exposure draft” of a SOFR-based loan agreement last year (which was used for the Royal Dutch Shell credit facility referenced above), the organization has held off on publishing a final form of the agreement pending additional market consensus. Once a clear path to SOFR has emerged in the US, the LMA and industry organizations in other jurisdictions are expected to adopt a similar approach to replacing US dollar LIBOR in their own markets.
Putting pen to paper
The competing demands introduced by the COVID-19 pandemic have also made the monumental task of documenting the transition away from LIBOR even more daunting for market participants. One of the biggest challenges is how to deal with existing documentation that includes problematic benchmark fallback provisions or, in some cases, no fallback provisions at all. While the derivatives market benefits from largely standardized documentation and the ability to broadly implement amendments via ISDA protocol, loan and bond documents need to be amended on an individual basis.
This amendment process will be costly and resource-intensive, particularly for broadly syndicated loans and bonds, each of which require consent from a great number of lenders or noteholders. Even streamlined amendment processes, such as those based on the ARRC’s “amendment approach” for benchmark fallbacks, could create significant challenges for market participants if a transition trigger event leads to a surge of amendment processes in the market. In addition, for documentation that relies on the “amendment approach,” there is a risk that, in the case of distressed credits, certain lenders or noteholders may seek to block an amendment in an attempt to extract other concessions from the company.
In an attempt to help alleviate some of these concerns in the loan market, the ARRC recently published a best practices guide that suggests parties should no longer adopt its “amendment approach” to fallback language (which effectively left fallback terms to future negotiation between the parties). The ARRC now recommends that all new issuances of floating rate notes and securitizations should incorporate fallback language based exclusively on its “hardwired approach,” with new issuances of business loans to follow suit by September 30, 2020. The hardwired approach includes specific fallback trigger events alongside a waterfall of potential SOFR-based successor rates and spread adjustments that would apply in lieu of LIBOR (depending on what actually becomes available and/or is recommended by the ARRC or certain other bodies). For floating rate note documentation, the ARRC has consistently proposed a single fallback approach that is similar to the hardwired approach for loans, with some differences to account for the particular characteristics of bonds.
The ARRC has also proposed legislation that could make the amendment process more efficient for loan and bond documentation governed by New York law (and would also apply to derivatives governed by New York law that are not amended by ISDA protocol). If enacted, the proposed legislation would (i) override any existing LIBOR-based fallback and instead require the use of the ARRC’s recommended benchmark replacement (i.e., presumably SOFR plus a spread adjustment); (ii) nullify any existing fallback language that requires polling lenders, noteholders or other market participants for rates; (iii) provide a safe harbor from litigation for the use of the recommended benchmark replacement; and (iv) provide that the recommended benchmark replacement will serve as the LIBOR fallback in contracts that do not have any existing fallback language.
However, the proposed legislation would not override any existing fallback that uses a non-LIBOR based rate (e.g., the “alternate base rate”), and parties could opt out of the application of the legislation by mutual agreement. Moreover, the legislation would not apply to documentation governed by English law or the laws of any other jurisdiction. As a result of these limitations, even if the proposed legislation is enacted, market participants would still need to contend with inconsistent fallback mechanisms across documentation in their portfolios.
While there are encouraging signs that markets are making progress in developing a defined framework for the transition to SOFR, it is clear that much work remains to be done, both in settling fallback terms and amending legacy documentation. For market participants, priorities may have shifted and resources may be scarcer due to the ongoing pandemic, but the timeline for LIBOR cessation has not budged. The clock is still ticking.