LIBOR Transition – the way forward
The London Interbank Offered Rate ("LIBOR") is arguably the financial world's most important number; it is a proxy for banks' marginal funding costs and serves as benchmark rate in millions of loans, floating-rate debt, and financial contracts. The publication of the LIBOR will in all likelihood, cease by the end of 2021. The shift from LIBOR is an immense change to global finance and will have far-reaching impacts on the financial services industry.
The process to adopting to a market without LIBOR has already started. Some markets, including the derivatives market, have come a long way with the transition from LIBOR to so-called risk-free reference rates (“RFR“). Alternative reference rates (“ARR“s) are recommended to replace LIBOR currency rates in key markets, including the Secured Overnight Financing Rate (“SOFR“) in the US and the Sterling Overnight Index Average (“SONIA“) in the UK. The Loan Market Association (“LMA“) is working with the market, other trade associations and the regulators on the transition and have published, amongst other, a Reference Rate Selection Agreement and a Replacement Screen Rate Clause, together with an users guide. The Replacement Screen Rate Clause was also incorporated into the LMA facility agreements as of 28 February 2020 in order to facilitate further flexibility for the upcoming transition.
It is common for loan or credit agreements to include Unavailability of Screen Rate Clauses with fallback options such as reference bank rates, shortened interest periods, interpolated rates and cost of funds mechanisms. It is also common with Market Disruption Clauses for the situation where lenders’ costs of funding is in excess of LIBOR. There are, however, very few loan or credit agreements that provide for a pre-agreed alternative to LIBOR or other alternative reference rates if LIBOR is cancelled.
Since very few of the loan or credit agreements offers a long-term alternative to LIBOR for the calculation of interest, the interest rates related to the bank’s funding costs will need to be calculated manually for each interest period for each such loan or credit agreement. In view of the large number of loan or credit agreements referencing LIBOR, such manual calculation will prove difficult, or even impossible. The result will rather be that amendment agreements will have to be entered into for each loan or credit agreement referencing LIBOR, amending the agreements to reflect an alternative reference rate for the interest rate calculation. The users’ guide and Replacement Screen Rate Clause published by LMA could give useful guidance in this respect.
But even though the market has known about the cancellation of LIBOR for some time, the end of publication of LIBOR will potentially result in market disruptions. All companies with an exposure to LIBOR should therefore start preparing to transition their exposure away from LIBOR as soon as possible. The cancellation of LIBOR could have an impact on existing contracts, on a company’s liquidity, on its financial reporting and on tax (to mention a few). This again raises a number of questions and challenges, including which alternative reference rate to be used in existing and future contracts and agreements, which lender consent requirement should apply in loan agreements, whether the change in the reference rate would affect the pricing of the loan, who should cover the amendment costs and how a reference rate in a loan/credit agreement will relate to the reference rate under the relating interest rate hedging (to mention a few).
The list of uncertainties is long and we are just beginning to see the start of the transition away from LIBOR. There are reason to believe that loan agreements entered into in the near future will have to deal with this uncertainty and offer a clear alternative to LIBOR or even better reference other interest rate benchmarks for the calculation of interest.
End note: For the Norwegian market, the Central Bank of Norway (Norges Bank)’s working group has recommended a reformed version of the Norwegian Overnight Weighted Average (“NOWA“) as an alternative to NIBOR. Although there is an expectation that liquidity in NIBOR will gradually decline, there is no proposal yet to liquidate NIBOR. Therefore, there is reason to assume that the liquidation of LIBOR (and not NIBOR) will have more severe consequences for the Norwegian loan market than the reformation of NIBOR.