Updated 5/25/2023

Correction: Synthetic LIBOR will not be available as a fallback index to uncleared derivative contracts documented under US law. Those transactions would be covered under the LIBOR Act.

USD LIBOR, a floating rate benchmark, is being phased out. The original December 31, 2021 deadline was extended to June 30, 2023, as regulators were concerned with the lack of progress in amending LIBOR-based instruments.

Despite that extension, regulators determined that a hard cut-off of LIBOR’s publication after June 30 could still have negative consequences for the financial markets. The solution … Synthetic LIBOR!

The Facts and Bottom Line

On April 3, 2023, the UK Financial Conduct Authority (“FCA”) announced that it would compel LIBOR’s administrator, IBA, to continue publishing “LIBOR” after June 30, 2023, and until September 30, 2024. However, the math behind the “LIBOR” screen rate will be CME Term SOFR + the ARRC/ISDA credit spread adjustments (“CSAs”) of .11448%, .26141%, .42826% for one, three, and six-month interest periods, respectively.

However, Synthetic LIBOR cannot be used in contracts that have incorporated the ARRC (Alternative Reference Rate Committee) recommended Hardwired and Amendment Approach LIBOR replacement language or derivatives with updated 2021 ISDA definitions since the LIBOR Screen rate will “no longer be representative.” On March 5, 2021, the FCA first announced that after¹ June 30, 2023, LIBOR will “no longer be representative” of a deep and reliable Eurodollar interbank market. The phrase “no longer representative” is referenced 1) in the January 25, 2021 updated ISDA Definitions, which address LIBOR fallback language in derivative products, and 2) in the ARRC replacement language, which was widely adopted in commercial loans starting in 2018. When LIBOR is “no longer representative,” certain mechanics apply to replace LIBOR with an alternative benchmark, typically Term SOFR or Daily Simple SOFR.

While borrowers who do not have ARRC language in their agreements may be able to rely on Synthetic LIBOR until Sept. 2024, interest costs may be higher than amending an agreement to SOFR now. Many borrowers are able to negotiate much lower CSAs with their lenders, providing a benefit relative to the ARRC CSA built into Synthetic LIBOR. The banks are under pressure from the regulators to remediate loans, so most are motivated to accommodate lower CSAs. Market convention for newly syndicated loans also points to lower CSAs than ARRC/ISDA’s.

For uncleared derivative contracts, such as swaps or caps, documented under U.S. law, the LIBOR Act passed by Congress on March 22, 2022, is the safety net for those who have not yet incorporated the updated ISDA definitions for LIBOR’s replacement or ISDA’s Protocol. The automatic ISDA SOFR Fallback Rate is Daily Compounded SOFR plus the ISDA spread adjustments for each relevant calculation period. Synthetic LIBOR will not apply to these contracts if they are documented under U.S. law.

Consider a borrower whose loan benefits from Synthetic LIBOR, but whose hedges do not. If the hedging covenant is tied specifically to the index or interest expense on the loan, a borrower risks facing technical default. The loan would convert to Term SOFR, but the hedges would convert to Daily Compounded SOFR. The technical default would continue until waived or amended. For those with broadly defined hedge covenants or none, the borrower would carry the basis risk between the interest paid on the loan and the floating rate payment received on the hedge.

Therefore, if you have a hedge on the books that was executed prior to January 25, 2021, and have yet to update the agreements with your banks, consider amending as soon as possible to achieve your desired outcome. However, note that since regulators have curtailed the ability for swap dealers to hedge their Term SOFR swap exposure in the market, the average dealer charges an additional ~3.5 basis points (but can be as high as 8 to 10 basis points) to transition hedges to Term SOFR.

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Background

The uniformity of the ARRC’s LIBOR replacement language and its widespread adoption has had a large impact on remediating loans. The issue is that many (many!) loans do not contain the “no longer representative” language, either because the credit agreement pre-dated the ARRC language, lenders chose not to adopt it or lawyers added alternative language. These contracts are generally referred to as “tough” legacy agreements. They’re tough because any change to a “money” term (e.g., the interest rate and credit spread) almost universally requires 100% lender consent, whereas the ARRC or ARRC-like Amendment Approach language was intentionally designed to have Required Lenders, typically more than 50%, reject a LIBOR transition amendment if the commercial terms are not satisfactory. As of the beginning of May, an estimated 8%² of syndicated leveraged loans are considered “tough” legacy contracts, which have yet to be amended. Add to that, an undeterminable number of private bilateral and syndicated loans that would also be considered tough.

For these tough legacy loan agreements, if LIBOR is no longer ascertainable by the administrative agent or lender, the borrower typically reverts to the Prime Rate. Prime is 2% or 3% higher than LIBOR, depending on the terms of the agreement — OUCH! And a very big ouch when LIBOR rates are already hovering at 5%. For ISDA-based hedges without the benefit of the new ISDA definitions, the fallback is a dealer poll. If LIBOR is no longer available on the screens, what will dealers be asking of each other?

Despite years of communications and announcements on the demise of LIBOR from the ARRC, banks, the press and regulators, not enough loans or hedges have transitioned to SOFR, especially the tough legacy contracts. The regulators couldn’t extend the June 30, 2023 deadline since the FCA’s March 5, 2021 announcement already triggered a Benchmark Transition Event in the widely incorporated ARRC language and in the new ISDA definitions; nor would the regulators want to push out the date again given the main objective of eradicating all LIBOR-based referenced instruments.

The regulators needed to lengthen the runway since thousands of domestic and international borrowers would face punitive contractual provisions if their contracts are not amended by July 1, 2023: The intent of synthetic LIBOR is to extend the amount of time to amend tough legacy LIBOR contracts and let many of those loans refinance or mature naturally.

The Last Word

Synthetic LIBOR really is the fifth SOFR choice available to some in the market: Daily Compounded SOFR, Daily Simple SOFR, Term SOFR and 30-day SOFR Average. Yes, Synthetic LIBOR may be a bit complicated, but when you look behind the curtain, you see the newcomer isn’t so bad.

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1 There is a misconception to many in the market that the “deadline” is on June 30, but it is after June 30 so borrowers will be able to use the June 30 reset if they need additional time to amend their loans.

2 Source: Covenant Review