The Loan Syndications and Trading Association (LSTA) offered pieces of advice on the transition away from the London Interbank Offered Rate (Libor).
Responding to recent reports that Libor could “linger” longer than expected due to regulators potentially changing their stance on the transition, the LSTA pointed to a speech last month by Edwin Schooling Latter, Director of Markets and Wholesale Policy for the Financial Conduct Authority (FCA) that said quite the opposite. Schooling Latter proclaimed that there is “wide recognition” that Libor will end by 2020.
Taking Schooling Latter’s speech into consideration, the LSTA examined the challenges to certain loans that rely on Libor and may not able to be fixed by the time 2021 rolls around. One of his key points was that the smoothest transition away from Libor will be achieved by replacing or amending contracts that reference Libor before fallback provisions are triggered.
ADDRESSING LIBOR CESSATION
The LSTA believes that there are three ways in which the markets can and should address Libor cessation.
- Appropriate fallback language must be included in contracts that clearly dictates what will happen when Libor ends and is no longer usable.
- New contracts should be written on non-LIBOR rates, such as the Secured Overnight Financing Rate (SOFR) in the United States.
- There will be some contracts where changing contractual references to Libor will not be possible. In these instances, additional steps will need to be taken.
According to the LSTA, the loan market has been moving forward on Libor fallbacks, which allow contracts to transition from Libor to a new reference rate upon a trigger event. The Alternative Reference Rates Committee (ARRC) Business Loans Working group, which is co-chaired by the LSTA and the American Bankers Association, is finalizing the ARRC Recommended Fallback Language, which is expected for publication in the spring.
Though the LSTA recognizes the need for fallbacks, the organization agrees with the FCA that the best way to address Libor cessation is moving on to a new rate before the deadline. “It will likely be in market participants’ best interests to have moved away from Libor contracts to ones based on the RFRs before liquidity in Libor-referencing contracts has significantly declined,” Schooling Latter said. “In the early days of transition there was the question of who would have the boldness and agility to be among the first to move away from Libor to initially less liquid alternatives. When we approach the end of that transition, we may instead find reluctance to be the last to remain on Libor.”
The ARRC Fallback Language recognizes this and offers a framework for an “opt-in” trigger that would allow for Libor-based loans to switch to a replacement rate once it becomes the market standard rather than wait for Libor’s end.
But is SOFR truly going to become that market standard? Kim MacLeod, partner with Hunton Andrews Kurth and a speaker at AFP 2018, said she is still seeing “a whole lot of wait-and-see” when it comes to Libor and SOFR. “All the deals I’m closing have stuck to Libor and just included fallback language,” she said. “My sense is no one is comfortable enough with SOFR or what comes next to stake themselves out on it in the syndicated market. The LSTA will undoubtedly be in the lead here.”
Although there are no reports of new loans being written that are based on SOFR, the LSTA noted that there have been about $50 billion in SOFR-based securities issued since June 2017. This is an indication that SOFR securities “are not a pipe dream” and the first SOFR loans may emerge this year, LSTA said.
Schooling Latter warned of “uncertainty” around continuing to write contracts that reference Libor and urged a move to alternative rates: “This continued uncertainty is one reason why we continue to urge those still creating new contracts that reference Libor, and have a contract life beyond end-2021, to move rapidly instead to the new [risk-free rates (RFRs)] whose continued publication beyond that date can be relied upon.”
Finally, there will be some contracts that cannot realistically transition to Libor. “While contracts of this kind should be a diminishing share of the total over time, there may, because of historical issuance, still be a material volume of such contracts in cash markets into the 2030s,” Schooling Latter said.
The FCA believes that Libor’s cessation could lead to a “force majeure event” and contract frustration for this hopefully small group of loans that reference Libor. In this instance, the Benchmark Regulation would allow continued publication and use of Libor, which would be restricted to contracts that use it “in certain circumstances.” Nevertheless, since most loans do have fallback mechanisms and can be amended, “do not rely upon the regulators potentially propping up Libor after the end of 2021 for existing loans,” the LSTA said.