Developments around the termination of LIBOR and its replacement benchmarks
In the contribution below, our colleague Niek Groenendijk looks back and ahead at the developments surrounding the termination of LIBOR and its replacement benchmarks, and their continued relevance in the financial markets.
Where are we with LIBOR transition?
Status update as per January 2023
As of January 2023, the publication of 27 of 35 LIBOR settings had ended. For the remaining eight LIBOR settings, (i) three synthetic GBP settings are proposed to be available until the end of March 2023 (1- and 6 months synthetic GBP LIBOR) and end of March 2024 (3-months synthetic GBP LIBOR) respectively and (ii) five USD LIBOR settings are available until the end of June 2023, although it is currently proposed that 1-, 3-, 6-months USD LIBOR will be continued thereafter in synthetic form until the end of September 2024.
Synthetic LIBOR is calculated by reference to a term risk free rate (term SONIA in the case of synthetic GBP LIBOR and term SOFR in the case of synthetic USD LIBOR) and functions as a temporary solution for legacy contracts (with the exception of cleared derivatives).
Statutory solutions in 2021 and 2022
The year 2022 saw several statutory solutions for a number of LIBOR rates in tough legacy contracts. Examples include the European regulations nominating alternative benchmarks for contracts still referencing CHF LIBOR and EONIA and federal US legislation enacted in March 2022 addressing USD LIBOR exposures in contracts governed by US law (including the laws of any state of the US).
It is important for market participants to understand that in most cases these statutory solutions are not universal solutions for their entire LIBOR portfolio and may not always result in the desired outcome. The statutory solutions should therefore not be seen as an alternative for an active transitioning process as prescribed by various regulators.
The year 2023 and beyond
In 2023 financial market participants will continue to be required to dedicate significant resources to the LIBOR transition process. This year will remain challenging and will for many market participants be dedicated to cleaning up remaining synthetic LIBOR exposures and transitioning their USD LIBOR portfolio to appropriate risk free rates.
The results of a recent survey by the US ARRC reflected both “encouraging awareness of the need to be ready for the LIBOR transition” in respect of the USD LIBOR transition process, but also highlighted the need to ensure that transition plans are put into swift action for timely transitions before the end of June 2023 (being the date on which (non-synthetic) USD LIBOR ceases to be available).
Legacy transactions without proper fallbacks
Experience thus far has shown that old legacy transactions without appropriate fallbacks require a lot of attention and engagement of counterparties. This is particularly true for legacy bond issuances, where obtaining bondholder consent can be a time consuming and cumbersome process.
Particular challenges arise in getting counterparties engaged and getting them comfortable with the new interest rate mechanics. It continues to be key for market participants to tackle these tough legacy contracts as soon as possible.
Transactions with fallbacks
For transactions with fallbacks, it is important to understand not all fallback provisions operate in the same way. There are fallback provisions which (i) allow one of the parties to nominate a replacement benchmark unilaterally upon the occurrence of certain trigger events, (ii) automatically nominate a hardwired fallback benchmark upon the occurrence of certain trigger events or (iii) provide for a framework for the parties to the contract to renegotiate for an a replacement benchmark. In particular for fallback provisions falling in the third category, it should be noted that the renegotiation process and the documentation of the agreed position can be time consuming.
In general, market participants should not wait for any fallback provisions to be triggered but should instead implement an active transition of their remaining LIBOR exposures and actively engage with their counterparties.
Three key areas of focus include the following.
1. Alignment of benchmarks across various products
Where a financial transaction features various contracts or instruments referencing different benchmarks, it is important that all connected transactions transition in a consistent manner. Differences in conventions and standard fallbacks means that it is possible that differences in applicable rates arise if one simply relies on standard solutions and this is one of the key reasons why an active transition is important. With the added complexity of new risk free rates (e.g. term risk free rate or daily compounded risk free rate, daily floors or not, number of lookback days and observation shift or lag) it is now more important than ever to closely look at the details of the transactions and ensure that they work together.
2. Third party consents
It is not unusual for a finance transaction to involve third parties, such as third party guarantors and security providers or contracting parties for a construction project that that is being financed. Where third parties are involved, it is always necessary to check whether their consent needs to be obtained to make changes to the financing documentation, as this can be a significant factor contributing to delays.
3. Consequences for the collateral package
Where changes are made to financing contracts, it is always important to check whether such change does not adversely affect the collateral package. While in various jurisdictions it would be possible to change the terms of the financing transaction without adversely affecting the collateral package (depending on whether appropriate flexibility is included in the underlying security documents), this may not always be the case. An assessment will need to be made on a case-by-case basis.
If you have any questions in relation to benchmarks in your financial market transaction documentation, please feel free to contact the Stibbe Banking & Finance team.