LIBOR discontinuation: a guide for borrowers, lenders and derivatives users

There are now only six weeks to go before most LIBOR rates are no longer going to be quoted and therefore, borrowers and lenders need to have considered how they will transition the interest rate basis in those instruments.

Many interested parties and regulatory bodies have been working hard over the last few years to ensure that proper drafting is available to ensure the seamless transition from LIBOR to Sterling Overnight Index Average (SONIA) or other alternative risk-free rate as an interest rate benchmark in those relevant instruments that will endure past the end of 2021.

In this article, Martin Brown and Simon Sutcliffe explain what might happen if your organisation does not address LIBOR issues in your legacy transactions and therefore why, in nearly all cases, it is imperative that you do.

What to do if you have LIBOR-based financial instruments?

It is incorrect to assume that as a borrower or lender you do not need to prepare for the move away from LIBOR. You may be aware that there is currently legislation proposed that would impose a synthetic LIBOR rate in place of LIBOR after 31 December 2021 for those instruments that endure past that date and that have not otherwise addressed the discontinuation of LIBOR.

Prior to 29 September this year, there was an expectation that this legislative solution would likely only be available for “tough legacy” contracts, that is those contracts where it was considered effectively impossible to transition away from LIBOR. However, on 29 September, the FCA published a consultation paper that proposed to permit the use of synthetic sterling in all contracts except cleared derivatives and on 16 November they confirmed that would be the case.

Therefore, any references to “LIBOR” in a legacy contract (that has not already addressed the issue) will now be read as references to synthetic LIBOR. It is important to note that the FCA has compelled ICE Benchmark Administration to continue to publish synthetic LIBOR for at least twelve months. You might think that the above means that you can ignore those legacy LIBOR contracts – now that the FCA has confirmed its “not so tough legacy” contracts stance.

However, it is never as simple as that. The FCA has itself stressed: “While synthetic LIBOR reduces risk in the transition and provides a bridge to Risk-Free Rates like SONIA, it will not last indefinitely and contracts need to be moved away from LIBOR wherever possible.”

Also, it is not clear exactly how long the FCA may permit parties to these “not so tough legacy” contracts to carry on using synthetic LIBOR rather than sorting themselves out and transitioning to an alternative rate.

Additionally, the above may not apply to all legacy LIBOR contracts and will depend on, among other things, the parties to the instruments and the governing law of the financial instrument itself.

What about derivatives?

Many, if not most, buy-side derivatives users have by now been approached by their counterparty bank dealers to either adhere to ISDA’s ‘Fallbacks Protocol’, or to ‘actively transition’ their agreements to SONIA and other Risk-Free Rates (RFRs).

Those who have signed up to that protocol are in the relatively straightforward position that their contracts will, automatically, be amended upon LIBOR’s discontinuation. For GBP contracts, this will mean SONIA and a Credit Adjustment Spread (CAS) being applied to floating legs, as published by Bloomberg (ISDA’s selected calculation vendor), and the other terms of ISDA’s ‘Fallbacks Supplement’ coming into effect.

Those undertaking manual amendment processes, without relying on the Fallbacks Protocol, will have slightly more leeway over how their contracts are updated. Options will usually include the early termination of open transactions and their replacement with new transactions referencing only a new RFR and new pricing, or the continuation of transactions with a new RFR plus a CAS. Either way, close scrutiny of the new terms offered and a cross-read to ISDA’s supplements to its 2006 Definitions, or its new 2021 Definitions, is in order. For interest rate swaps and other hedging transactions, parties will also want to compare amended transaction agreements with the underlying loan or other financing agreement, to avoid hedging mismatches (basis risk).

Summary

The recent confirmation by the FCA that it will permit the use of synthetic sterling in all contracts except cleared derivatives may have put off what was expected to be a Christmas LIBOR rush. However, it would be foolhardy for any party to a legacy LIBOR contract to put their feet up and think there is now no need to worry.

It is still imperative for all parties to LIBOR-based contracts to ensure they effectively transition to a new reference rate unless it really is impossible to do so.

To do otherwise is to mean always looking over your shoulder waiting for the FCA to require you to do so and being very much behind the market curve. Or in a worst case scenario, even potentially having to rely on outdated fall-back provisions which rarely results in anything other than an increase in costs for a borrower.

If you have any questions on the article or if you would like to discuss any issues arising from the LIBOR discontinuation, please contact Martin Brown and Simon Sutcliffe.