The Move from IBORs to Risk-free Rates – Where are we Now?

As we pass the June 2023 deadline for US dollar LIBOR transition, it seems like a good time to reflect on where the market is on IBOR transition. Over the last few weeks there has been increased activity from global regulators and currency working groups with some important updates that corporates should be aware of.

Overall, despite the size of the task, transition seems under control with market participants generally seeming to be better prepared than they were at the end of 2021. However, there are still pockets (for example, in developing markets) where transition has been slower and more work is needed.

So what do corporates need to know? This article sets out where transition is across various currencies, what you need to watch out for, and what you need to be doing.

US dollar LIBOR

The US dollar domestic loan market has largely been moving to term SOFR (given the use cases for term SOFR are broader than for other term risk-free rates ("RFRs")). This contrasts with the position in EMEA where the focus has been on compounded SOFR in arrears, although we are seeing some increasing use of term SOFR. We expect that mix to remain in EMEA given differing needs between corporates – there is no one size fits all approach.

There have been a couple of recent developments in respect of US dollar transition which will be of interest to corporates:

Synthetic US dollar LIBOR

On 3 April 2023, the UK Financial Conduct Authority ("FCA") confirmed that synthetic US dollar LIBOR will be published until end-September 2024 for 1, 3 and 6 month tenors. This will operate in the same way as synthetic sterling and Yen LIBOR did, i.e. it will appear on the same screen as LIBOR currently does. The idea being that this should mean that references to US dollar LIBOR in contracts can be read as referring to the synthetic rate without the need to amend the contract. Of course, that will be depend on what the particular contract says, and also the tenors referenced, but that is the broad intention behind it. And that also explains why the European Commission has not looked to exercise its powers under the EU Benchmarks Regulation to designate a replacement rate (since synthetic LIBOR should also be helpful for contracts governed by the law of an EU member state).

Whilst synthetic LIBOR is a helpful tool, corporates need to bear in mind that: it is not available for use in new transactions; it can only be used in legacy contracts; it is intended for tough legacy contracts; it is only available for certain tenors; and it is only temporary. What it has allowed parties to do is to take a risk-based approach to prioritisation in terms of their transition activity (for example, a backstop revolving credit facility which is due to expire before September 2024 could be allowed to runoff rather than being remediated). Corporates may wish to consider a similar approach to their US dollar LIBOR legacy book.

One thing to be aware of with this approach is whether you are happy with the economics of moving to synthetic US dollar LIBOR (which equals term SOFR plus the relevant ISDA credit adjustment spread ("CAS")). The ISDA CAS was set in March 2021 and, whilst some parties are happy to adopt this given it will apply to many fallbacks taking effect at the end of June, it may be that some corporates would prefer negotiating the CAS by taking an active approach to transition. There are costs / benefits to be considered in either approach.

Corporates should also consider which tenors of US dollar LIBOR they are using in their contracts. If those tenors are not covered by synthetic LIBOR, or able to be interpolated from synthetic LIBOR, speak to your lenders as to how the rate will be determined going forward if the contract is not able to be remediated before end-June.

Hedging term SOFR

The hedging of term SOFR loans has been the subject of much discussion in the market. The ARRC term SOFR use cases restrict the use of term SOFR in the derivatives market to end-users looking to hedge term SOFR cash products and restricts interdealer trading of term SOFR in the derivatives market.

Corporates looking to hedge term SOFR have been met with higher costs (relative to hedging compounded SOFR) or, in some cases, lack of availability. The higher costs of hedging term SOFR are not surprising due to the fact that liquidity in the derivatives mar-ket is centred on compounded SOFR in arrears (the ISDA Protocol, for example, provides for fallbacks to compounded SOFR in arrears as the standard in the derivatives market). This coupled with the restrictions on inter-dealer trading of term SOFR has led to banks taking on one-way risk and factoring this basis risk into pricing.

In addition to pricing discussions, more recent concerns have been around the capacity of firms to offer term SOFR hedges going forward. In particular, with fallbacks due to be activated across the market at end-June, this could lead to increased demand for term SOFR hedges and therefore dealers reaching their internal limits on risk.

In April, the ARRC therefore decided to update its term SOFR use cases to offer another option for dealers to offset their risk by allowing them to enter term SOFR-SOFR basis swaps with any non-dealer participant even if the non-dealer firm does not have a term SOFR cash exposure. The idea is that this will draw in parties like hedge funds, asset managers, pension funds and bank treasurers to the market on the other side of the term SOFR-SOFR basis market. This is not intended to impact the cost of hedging term SOFR relative to hedging compounded SOFR and indeed the ARRC encourages borrowers to consider other forms of SOFR if they wish to hedge more efficiently (such as compounded SOFR in arrears). Corporates may wish to ask their lenders to set out the general cost of hedging each option so that they can make an informed decision as to the costs and relative basis risks.

Long-term fallbacks to term SOFR

Another topic of ongoing discussion is the long-term fallback to term SOFR. The Financial Stability Board ("FSB") has made clear that contracts referencing term RFRs need to have robust fallbacks in place, in many cases linked to the overnight RFR. Generally, in the corporate loan market, we see the use of either a central bank rate or compounded in arrears used as the primary fallback (after interpolation).

However, there are instances where parties are using cost of funds as the primary fallback mainly because 'it has always been there' and not wanting to incur costs on drafting for a new fallback. However, corporates may wish to discuss with their law firms LMA recommended form documentation which has drafting for more robust fallbacks as that can easily be adapted for use.

It is worth remembering that cost of funds as a fallback is likely to be more expensive for a borrower as it involves paying either an average of the cost of funds of each lender, or each individual lender’s cost of funds – this could vary quite widely, especially if the lender group consists of different types of financial institution located in different jurisdic-tions. There is also a question mark over whether a cost of funds fallback could be implemented practically given the reluctance of lenders to share their cost of funds. So do think carefully about whether to include cost of funds as a primary fallback. The LIBOR transition process has taught us that cost of funds is not a robust fallback – if it was we would not be having to amend legacy deals!

EURIBOR

EURIBOR remains an outlier amongst the key IBORs in that there are no plans to discontinue EURIBOR. However, the Euro RFR Working Group (which consists of private and public sector representatives) has been focused on introducing more robust fallbacks to contracts referencing EURIBOR. The LIBOR transition process has shown just how painful the process can be of having to amend legacy deals and so it is better to be prepared by having robust fallbacks in place when documenting new and refinanced transactions.

Whilst the bond and derivatives markets have adopted robust fallbacks for EURIBOR, the loan market has been slow to adopt the Euro RFR Working Group's May 2021 recommendations on EURIBOR fallback rates and trigger events. As a result, the Working Group recently published new guidance for corporate lending products on implementing the May 2021 recommendations.

The Working Group has reiterated the need for corporate lending products to implement robust fallbacks and that cost of funds and replacement of screen rate language are not workable permanent fallbacks or scalable options should EURIBOR ever be discontinued.

What is a robust fallback to EURIBOR?

Unsurprisingly the options set out by the Working Group will be very familiar – there is a choice of either compounded €STR or term €STR depending on the use cases set out by the Working Group in its May 2021 recommendations. There are now term €STR rates available for use and in prototype form (namely EMMI's Efterm and Refinitiv's term €STR). So there are options for corporates to consider and also wording available to insert into loans to reference either compounded rates or term rates as fallbacks. Further work is also currently being done by the LMA to reflect drafting for term €STR.

Do speak to your lenders and lawyers about the latest Working Group guidance and options for robust fallbacks as this will be making its way into new and refinanced contracts.

Sterling and Swiss franc LIBOR

Transition in these markets has progressed very successfully. The Swiss market had always been very clear about the move to compounded rates, with no term SARON rate available (and none on the horizon). There have been no reported issues following the end-2021 transition deadline.

It is a similar story in the sterling market given that term SONIA is only available for limited use cases. As a result, borrowers have adapted to compounded SONIA in arrears across most products. Whilst a synthetic sterling LIBOR rate was produced, the 1 and 6 month rates were discontinued at the end of March 2023, with the 3 month synthetic sterling LIBOR rate due to be published until end-March 2024 for the small remaining tail of tough legacy transactions (namely in the bond market and private finance initiative space).

Other currencies

The transition to RFRs is also relevant for other currencies which corporates may use in their business. For example, there have been recent consultations on fallbacks to CIBOR in Denmark and in Poland there are proposals to transition away from WIBOR (although no formal cessation announcements have been made). Canadian dollar transition is also underway with CDOR being discontinued in June 2024. Corporates will need to check what is happening in the currency jurisdictions most relevant to them. The annual FSB progress reports on benchmark transition are always a good source of information in this respect, but you can also contact trade associations, as well as your lenders and lawyers.

Are there other issues still exercising the market?

Although we have been on this transition journey since July 2017, it has taken some time given the complexity of the transition. There are still a number of issues which continue to impact the market, a number of which have already been discussed in this article (including timing of transition, hedging of term RFRs and the importance of robust fallbacks). In addition, corporates should also be aware of the following:

• Pricing: credit adjustment spreads ("CAS") have been applied for legacy transition to ensure the transition is as economically neutral as possible. The considerations around the use of the ISDA CAS for legacy transition are discussed earlier in this article. There are also ongoing negotiations around whether new deals which directly reference RFRs at the outset should have a separate CAS element on top of the margin given differences between LIBOR and RFRs, whether any such difference should be included within the margin itself, or whether there should be any reflection of such differences at all. It is im-portant for corporates to understand the economics and position being proposed by their lenders.
  
  
• Hedging and the ISDA protocol: as well as considerations around hedging term RFRs, corporates that use hedging should also be aware that the ISDA protocol and standard definitions for new transactions reference compounded RFRs in arrears. However, ISDA standard documentation uses slightly different conventions (namely a two day lookback with observation shift) to those used in the cash markets. As a result of these differences, do be aware that if you are signed up to the ISDA protocol, there may a slight mismatch between the rates on your hedges and related cash products once the protocol takes effect (or for new deals if using the standard definitions). ISDA has recognised these differences and, in order to assist parties with better matching their hedging to their cash products, the LMA worked with ISDA on their rate options and confirmation templates which reflect conventions in LMA documentation.
  
  
• Intercompany loans: think about the most appropriate rates for these loans. Some currency working groups have issued specific recommendations on the most appropriate rate, whereas others have not.
  
  
• Systems: whilst treasury system providers have been making updates to reflect RFRs, it is important to be aware of the potential scope for differences between different systems in respect of payment dates and calculation of interest. Whilst there have always been differences in holiday calendars between different jurisdictions, so making sure payment dates are aligned in multicurrency and cross-border transactions is nothing new, we have heard of instances where treasury and bank systems may not have been aligned on payment dates.
  
  In addition, the move from a forward-looking term rate like LIBOR to daily RFR rates being compounded over a period could lead to potential differences in calculating a rate if the parties and their systems are not aligned in terms of which holidays are relevant during the interest calculation period. Rates are now being set in each individual jurisdiction rather than a LIBOR rate being set in London for different currencies. Any discrepancies in the way that interest has been calculated may only be identified when the borrower receives the calculation from the bank close to the end of the interest period. So corporates should take care and check calculations to identify any discrepancies and ensure systems are aligned. It is for this reason that many contracts now contain a concept of "banking days" in addition to "business days", with business days being relevant for payment dates, but the concept of banking days being relevant for calculation of interest (i.e. the relevant banking days will be determined by the drawn currency only and not by any other currencies or jurisdictions which might be relevant under the contract).
  
  
• Accounting: The transition has had an impact on accounting treatment with accounting standards being updated to reflect the transition. For example, the transition could impact the application of hedge accounting. A discussion of accounting considerations is beyond the scope of this article, and this author's expertise(!), but accounting treatment should be carefully considered.

Despite these remaining considerations, the market largely seems to be adapting well to the new normal. There is still of course work to do, but continued education and communication will remain the key tools to ensure we all get through this transition together. Do reach out if you have any questions and good luck with the transition!

Kam Hessling, Loan Market Association (LMA) for the Equity & Debt Working Group (Association of German Treasurers - VDT)