The Libor transition continues, with replacements starting to address cash products. These risk-free rates, or RFRs, offer benefits and challenges.

The initiative to replace Libor with so-called risk-free rates (RFRs) is moving into a critical stage for corporates, as the market seeks to develop methodologies to smooth the transition and the forward-looking term rates commercial borrowers prefer.

The Secured Overnight Reference Rate (SOFR) in the United States and the United Kingdom’s Sterling Overnight Index Average (SONIA) are the RFRs furthest ahead in terms of development, with similar benchmarks in Switzerland, Japan and the European Union in the works or planned. SONIA has been an active benchmark for several years, and the Federal Reserve Bank of New York began publishing SOFR in April 2018.

In May, major derivative exchanges introduced derivative contracts based on the two RFRs, and they’ve supported active if relatively small markets in the instruments. In addition, numerous banks and governmental institutions have issued bonds and other RFR-based loan products in support of the new benchmark.

TERM RFRS

Key to corporate borrowers is the development of term RFRs that, similar to Libor, allow borrowers to look forward and understand what their payments will be at the end of each term to better manage cash flows. The pricing of most large commercial loans, for example, floats over three-month Libor, and borrowers know what the payment will be at the end of each three-month term for the duration of their loans.

RFRs, instead, are overnight rates, so borrowers do not know their final payment until the end of the term, when daily rate is compounded in arrears. In light of SONIA’s head start, the ICE Benchmark Administration (IBA) has been able to derive a forward-looking term version of the RFR from the trading of SONIA-based futures at the Intercontinental Exchange, an affiliate. It displays that rate as well as the compounded-in-arrears rate for the one-, three- and six-month RFR, allowing comparison with the term version.

The ICE website also provides daily settings for active RFRs, currently SONIA, SOFR and Japan’s Tokyo Overnight Average (TONA).

The Alternative Reference Rates Committee (ARRC), the NY Fed-sponsored body that chose SOFR to replace Libor, announced last fall that it planned to begin an indicative term rate for SOFR early this year. When that happens, the ICE website will be able to display the forward-looking SOFR; it already provides SOFR compounded in arrears.

The clock is ticking to develop term RFRs, in part because the IBA may be unable to publish Libor after 2021, when large banks’ obligation to submit their interbank lending rates expires, requiring existing Libor-based products to use another benchmark rate. In addition, banks’ submissions are dwindling and often amount to less than $1 billion a day, compared to the $800 billion in transparent overnight repurchase agreements used to generate SOFR. That has raised concerns about Libor disappearing even sooner than the 2021 deadline.

The ARRC released consultations in late September that sought public feedback to help develop fallback language for syndicated loans and floating-rate notes. In early December it issued similar consultations for bilateral business loans and securitizations.

FALLBACK LANGUAGE

The consultations provide descriptions of fallbacks envisioned by ARRC, comprising representatives from mostly financial companies. A key issue is whether to take a “hardwired” approach, favored by banks because it would facilitate adjusting the thousands of lending contracts they hold with customers, or a more flexible “amendment” approach. One exception is the Bank of Nova Scotia, which supports a hardwired approach but expressed concern that for syndicated loans the ARRC has proposed a term SOFR to be the primary fallback rate, “although this benchmark has yet to be developed.”

However the term RFRs and fallback language for various financial products shape up—and the International Swaps and Derivatives Association is developing fallback language for derivatives—corporates should begin preparing for the transition away from Libor by familiarizing themselves with the fallback language the ARRC suggests in the consultations.

Eric Juzenas, a director on Chatham Financial’s global regulatory solutions team, said there will very likely be variations to ARRC’s fallback language, driven by differences in products and market segments, but it will be used as a starting point for most dealers and lenders updating their documentation. Given the uncertainty about when ARRC’s fallback language will be operational, “corporates must preserve the flexibility to protect themselves if the fallbacks do not operate as planned,” Juzenas said. “Particularly the ability to negotiate an appropriate spread adjustment in the event of Libor unavailability.”

Spread adjustments are essential because the methods to calculate Libor and the RFRs are very different and so result in different rate levels, and unwanted “transfers of value” could result. Juzenas said language from the ARRC proposals has already started to show up in some loan documentation. He added that the hardwired approach provides contractual and legal certainty should Libor become unavailable but given term rates and spread adjustments have yet to be developed, it is uncertain how they will work in practice.

The amendment-based approaches, instead, contemplate negotiation or reasonable consultation between parties to determine a successor rate and spread adjustment. However, Juzenas said, negotiations inherently risk one party exerting leverage over the other, resulting in an outcome that diverges from the originally negotiated intent.

Interested in more Libor transition guidance? Download AFP's guide, The Road to Liboration.