Eye on IBOR transition from a structured finance perspective
With December 31, 2021, in plain sight, preparation for the transition from the London Interbank Offered Rate ("LIBOR") and similar interbank offered rates ("IBORs") to replacement benchmark interest rates is accelerating rapidly. In this article, we explore a number of recent core developments affecting structured finance products.
ISDA IBOR Fallbacks Protocol and Supplement
The International Swaps and Derivatives Association ("ISDA") launched the long-awaited IBOR Fallbacks Protocol and related IBOR Fallbacks Supplement on October 23, 2020.1
The IBOR Fallbacks Protocol2 allows market participants that choose to adhere to it to incorporate fallback language into existing non-cleared derivatives with no further action. Derivatives contracts involving a counterparty that has not adhered to the Protocol will require a bilateral amendment to address IBOR cessation. The fallbacks in the Protocol apply upon a permanent cessation of an applicable IBOR. In addition, for LIBOR only, the fallback will become operative upon the occurrence of a pre-cessation trigger; that is, upon a determination by the UK Financial Conduct Authority ("FCA") that a particular LIBOR no longer is representative of its underlying market. ISDA reports that during the two-week period prior to official launch of the Protocol, 257 market participants elected to adhere to it.
Supplement No. 70 to the 2006 ISDA Definitions,3 which also takes effect on January 25, 2021, amends ISDA's standard definitions to incorporate appropriate fallbacks for GBP (United Kingdom), CHF (Switzerland), USD (United States), EUR (Europe) and JPY (Japan) LIBOR, as well as EURIBOR (Europe), TIBOR (Japan), BBSW (Australia), CDOR (Canada), HIBOR (Hong Kong), SOR (Singapore) and THBFIX (Thailand). These fallback rates are deemed robust and follow the recommendations of applicable governmental working groups. They will apply to new cleared and non-cleared interest rate derivatives that reference the 2006 Definitions from the effective date. The Supplement also addresses the treatment of discontinued rate maturities.
ARRC Recommendations and Resources
The US Alternative Reference Rates Committee (the "ARRC"), convened by the Federal Reserve Board and New York Federal Reserve Bank, has been very active in producing tools, across numerous product categories, to ease the transition from LIBOR to its recommended replacement: the Secured Overnight Financing Rate ("SOFR").
FALLBACK LANGUAGE AND SPREAD ADJUSTMENT
After conducting product-specific consultations, and refreshing its loan recommendations based on market evolution, the ARRC has produced final recommendations for key product categories that incorporate a "hardwired" approach to LIBOR fallback rate language. While the rate waterfall within the hardwired approach varies somewhat by product,4 the essence of falling back to Term SOFR is constant.
Separately, the ARRC published its recommendation for a spread adjustment to recognize the difference between LIBOR and SOFR resulting from the fact that SOFR is a secured rate while LIBOR is not. In response to global market preference to align product fallbacks with potentially linked derivative product fallbacks, the ARRC's recommendation mirrors that of ISDA: a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR.
It should be noted that many financial institutions still are considering whether SOFR is the appropriate fallback rate for them based on their funding models and loan activity structures, and specifically whether a more creditsensitive rate might be more suitable. For the structured finance market, there would be obvious implications for securitization and hedged transactions that are SOFRbased. In a statement5 released on November 6, 2020, US prudential banking regulators reiterated that banks should choose a robust replacement rate that is appropriate for their needs and include fallback language in their loan agreements providing for the use of such chosen rate if LIBOR were to be discontinued.
To assist market participants in preparing for LIBOR cessation, the ARRC released a set of recommended best practices in May 2020, which it updated in September.6 Included in these best practices are timelines and intermediate steps that market participants should consider to accelerate their transition to a replacement benchmark interest rate. Key recommendations include:
- New USD LIBOR cash products should include ARRC-recommended (or substantially similar) fallback language as soon as possible;
- Institutions should implement clear and rigorous internal programs to assess and address their LIBOR exposure across all relevant activities;
- Third-party technology and operations vendors relevant to the transition should complete all necessary enhancements to support SOFR by the end of 2020;
- For contracts specifying that a party will select a replacement rate at their discretion following a LIBOR transition event, the determining party should disclose their planned selection to relevant parties at least six months prior to the date that a replacement rate would become effective; and
- New use of USD LIBOR should stop, with timing depending on specific circumstances in each cash product market.
The following table shows the ARRC's recommended target end dates by product:
* The September 30, 2020, date for consumer loans refers to new applications for closedend residential mortgages using USD LIBOR and maturing after 2021.
As this article is published, on November 30, ICE Benchmark Administration ("IBA") has announced that it will consult in early December on its intention to cease the publication of the one-week and two-month USD LIBOR settings after December 31, 2021, and to cease publishing the remaining USD LIBOR settings after June 30, 2023. The effect of this announcement (which has been well received by global regulators), if any, on the ARRC's Best Practices timeline summarized above has not been determined.
Among the tools published by the ARRC are various recommended conventions for implementing LIBOR transition. The first of these was published in 2019 and related to floating rate notes ("FRNs"),7 which present a particularly thorny transition issue because, with their widely held market (and like many structured finance products), they are so difficult to amend. These were followed by recommended cross-currency swaps conventions in January 2020,8 syndicated loan "in arrears" conventions in July 2020,9 and bilateral loan "in arrears" conventions in November 2020.10
The FRN conventions identify considerations for market participants interested in using SOFR in new issuances, including explanations of different SOFR variants, the possible use of a SOFR Index,11 and the distinction among lockout, lookback and payment delay interest payment conventions. The November 2019 appendix supplemented the conventions with sample key provision term sheets by interest payment convention, and recommended FRN fallback language.
The swaps conventions analyze potential technical specifications for interdealer trading of cross-currency basis swaps based on IBORs and replacement risk-free rates ("RFRs"), including IBOR-IBOR, RFR-RFR and RFR-IBOR swaps. The ARRC notes that these conventions may not be suitable for dealer-to-customer or customer-to-customer transactions.
The most recent ARRC conventions support bilateral loans, are substantially similar to the syndicated loan conventions, and focus on the ARRC's recommended "in arrears" structures: daily simple SOFR and daily compounded SOFR. The conventions address both new and legacy loans, and analyze structural issues, including simple versus compounded SOFR, interest payment conventions, day counts, rounding, interest rate floors, break funding and use of the SOFR Index. The bilateral loan conventions also note that market participants choosing to adopt the Hedged Loan Approach to the ARRC's recommended bilateral loan fallback language (which falls back to ISDA's successor rate and spread adjustment) should follow ISDA's related conventions. Both the bilateral loan conventions and the syndicated loan conventions rely on the ARRC's August 2020 technical reference appendix, which provides additional detailed discussion and spreadsheet calculations of the different lookback methodologies, calculations for daily simple SOFR and daily compounded SOFR for loans and the implementation of daily interest rate floors.
Sterling Working Group Recommendations and Resources
Another active working group on the global stage is the UK Working Group on Sterling Risk-Free Reference Rates ("Sterling Working Group"), which recently finalized its spread adjustment recommendations and has produced a wealth of transition tools for market participants.
SPREAD ADJUSTMENT RECOMMENDATION
Consistent with its global counterparts, in September the Sterling Working Group recommended12 the use of the historical five-year median spread adjustment methodology when calculating the credit adjustment spread that should be applied to any relevant Sterling Overnight Index Average ("SONIA") rate chosen or recommended to replace GBP LIBOR pursuant to contractual fallback and replacement of screen rate provisions following a permanent cessation or precessation trigger in relation to GBP LIBOR.
CONVENTIONS AND OTHER GUIDANCE
During September and October 2020 alone, the Sterling Working Group has produced over a halfdozen resources, including an updated list of "top level priorities," a paper describing how issuers might transition difficult-to-amend contracts, such as bonds and securitizations, from LIBOR to risk-free rates, and several resources relating to loan market conventions and transition.
In updating its top level priorities,13 the Sterling Working Group emphasized the need to cease issuing LIBORreferencing products not later than the end of the first calendar quarter of 2021, and to accelerate efforts to transition derivative volumes from LIBOR to SONIA. Also updated were the roadmaps included in the priorities, as well as the product-specific target milestones, with active portfolio conversion still targeted to complete by the end of the third calendar quarter of 2021.
The guidance on transitioning difficult-to-amend bond and securitization transaction documents includes a discussion of the consent solicitation process, which already has been used successfully to transition these tough legacy contracts.14
Half of the recent resources relate to the loan market and the instruments that underlie many structured finance products. In publishing these resources, the Sterling Working Group has stated that it hoped to facilitate "the maximum possible degree of consistency across currencies, products and market,"15 and that although some interim transition targets were adjusted to address the COVID-19 pandemic, the importance of transitioning product portfolios before the end of 2021 is unchanged.16 The suite of resources includes detailed loans conventions17 (intended to support the use of SONIA in loan markets for sterling bilateral and syndicated facilities, including multicurrency syndicated facilities where there is a sterling currency option) and a paper outlining practical steps that market participants can take to amend GBP LIBOR-referencing loans to SONIA.18 The latter resource in particular emphasizes (i) the need to ensure that operating systems are updated to accommodate alternative reference rates, (ii) the importance of treating customers fairly and mitigating any transfer of value between the parties and (iii) the substantial time that will be required to amend all existing LIBOR-referencing loans.
The two most recent Sterling Working Group tools, released on October 16, 2020, are an overview of the key features of SONIA term rates19 and a summary of the freely available independent RFR calculators (particularly addressing compounded rates) in the market.20 The aim of these tools is to inform market participants about, and support, the use of SONIA variants, and to allow market participants to consider whether any amendments might be required to their operating systems or product offerings ahead of transition to such rates.
The UK Prudential Regulation Authority and FCA stated earlier this year21 that firms should expect stepped up regulatory engagement with respect to LIBOR transition, which will be a "key input to [the Financial Policy Committee's] consideration ... whether sufficient progress is being made to avoid seeking recourse to supervisory tools."
Progress in Europe
The transition to a new risk-free rate--the Euro ShortTerm Rate, or STR--has been slower in Europe than in the United States and United Kingdom. This may be because its interbank offered rate--EURIBOR--was reformed in 2019 to employ a "hybrid methodology" of rate quotation that relies on a three-level waterfall that prioritizes the use of real transaction data whenever available from a group of quoting banks that is larger than the LIBOR panel. The robustness of EURIBOR is reassessed annually, and currently is deemed to comply with the EU Benchmark Regulation ("BMR"). As a result of the 2019 reformation, the quotation and use of EURIBOR is not expected to cease as of January 1, 2022 (subject, of course, to ongoing robustness and BMR compliance).
Nonetheless, the European Central Bank ("ECB") is moving forward to establish STR as a robust and appropriate replacement rate and in October 2020 released a summary of the responses22 to its July 2020 consultation on compounded STR term rates.23 The respondents supported the proposed calculation methodologies for compounded rates and index values, as well as proposed day-count conventions, selection of maturities and rate precision of four decimal places.
Most recently, on November 23, 2020, the ECB released two new consultations: one on EURIBOR Fallback Trigger Events24 and one on STR-based EURIBOR Fallback Rates.25 The consultations seek market feedback with respect to a proposed set of potential permanent EURIBOR fallback trigger events, and to the most appropriate EURIBOR fallback provisions for cash products, including rate structure, spread adjustment, and market calculation conventions. Comments are due by January 15, 2021.
The National Working Group on Swiss Franc Reference Rates (the "Swiss Working Group") also has been making steady progress,26 emphasizing that conventions for its replacement rate, the Swiss Average Rate Overnight, or SARON, be consistent with the international market. The Swiss Working Group has published recommended fallback language that tracks ISDA's implementation.
Singapore Working Group Recommendations and Resources
The most ample set of transition guidance in Asia has been published in Singapore. On October 27, 2020, the Steering Committee for SOR Transition to SORA ("SC-STS") published27 a suite of IBOR transition guidance documents to lay the foundation for "a coordinated shift" from SOR to SORA.
Included in these resources were: recommended timelines28 for discontinuing the issuance of SOR-linked products (following an approach consistent with the United States, United Kingdom and Europe, but not beginning until late in the first quarter of 2021); a report on customer segments and preferences,29 which was compiled based on surveys of a range of market participants and provides guidance on adopting SORA for various types of loan products; a SORA market compendium30 (intended to serve as a companion to the customer segments report, and which analyzes key issues by product type and provides fallback language and conventions); and an end-user checklist31 providing practical steps that should be taken to effectively transition away from SOR.
These resources follow the publication by the Monetary Authority of Singapore, the administrator of SORA, of a SORA methodology document32 and related User Guide33 in September. SC-STS has stated that it will be publishing additional resources to assist corporate users and retail customers.
Legislative Solutions for Legacy Contracts
Perhaps the thorniest issue delaying transition from IBORs to applicable replacement benchmark rates is how to address so-called legacy contracts; that is, active contracts due to mature after 2021, that were entered into before fallback rates for a permanent discontinuance of LIBOR were contemplated, that are widely held by holders that are difficult or impossible to identify, and that require unanimous holder consent to amend essential provisions, such as the interest rate. The nature of these contracts has thwarted efforts to effectively transition them to a new benchmark interest rate. In response, governmental authorities in the United States, UK, and Europe have introduced legislative solutions to effect a mandatory and automatic transition, under specified circumstances, for these contracts.
New York Senate Bill S9070,34 introduced October 28, 2020, proposes to add a new Article 12 to New York's Uniform Commercial Code that substantially adopts the language from the proposed legislative solution35 produced by the ARRC in March 2020. The ARRC's proposal establishes both mandatory (for contracts that either are silent as to LIBOR cessation or that default to the last quoted LIBOR in such event) and permissive (for contracts granting the parties discretion to choose a fallback rate) applications of the statutory language, sets forth an "opt-out" provision, applies to all product types and provides a safe harbor for "conforming changes" consisting of operational or administrative adjustments to implement the transition. We understand that a similar bill, applicable to all states, including New York, is under consideration at the federal level.
On October 21, 2020, the UK government released its promised draft legislation36 to assist the "tough legacy" issue for certain LIBOR-referencing contracts by providing the FCA with new and enhanced powers to oversee the orderly wind-down of critical benchmarks, such as LIBOR. The legislation includes the authority, subject to specified requirements, for the FCA to direct a change in the methodology of a critical benchmark and extend its publication for a limited time period.
Contemporaneously, HM Treasury issued a policy statement37 supporting the proposed amendments to the UK Benchmark Regulation, encouraging firms to continue to prioritize active transition away from LIBOR to alternative benchmarks, and providing further detail on the framework for the FCA's enhanced powers.
Additional momentum was gained on November 18, 2020, when IBA announced its intention to cease the publication after December 31, 2021, of all tenors of GBP, EUR, CHF, and JPY LIBOR settings,38 and again on November 30, when IBA announced its intention to continue to publish the most frequently used tenors of USD LIBOR through June 30, 2023.39 Each of these proposals is subject to IBA consultations expected in December 2020. In connection with IBA's November 18 announcement, FCA stated40 that it will consult on policies for implementing its proposed new powers under the Financial Services Bill and released two new consultations: one with respect to the designation of benchmarks41 and one with respect to the exercise of its proposed new powers.42 43
Earlier this summer, in July, the European Commission proposed an amendment to the EU Benchmark Regulation44 to enable the amendment of specified financial instruments or contracts by way of a directly applicable regulation, to avoid a significant disruption in the functioning of the EU financial markets. A new Article 23(a) would empower the European Commission to designate a mandatory replacement benchmark and, by operation of law, replace all references to a benchmark that has ceased to be published with the replacement benchmark. This legislative solution would apply to financial instruments, financial contracts and measurements of the performance of an investment fund that are within the scope of the BMR; that is, in EU contracts involving EU supervised entities.45 The key components are consistent with the New York legislative approach, with the EU Benchmark Regulation amendment making the use of the statutory replacement mandatory in contracts with no fallback provision, fallbacks that only contemplate temporary benchmark suspension, and fallbacks that reference the last quoted benchmark (and operate to convert floating rate instruments into fixed rate instruments). For contracts that provide parties with a choice of fallback rates, as well as contracts involving non-supervised entities, the EU legislative solution is available as an option if the parties so choose.
Although December 31, 2021, is still more than a year away, multiple global regulators have targeted dates by which new originations of LIBOR-referencing products should cease, and the earliest of those dates are imminent.46 Transition efforts are accelerating quickly, and wise market participants should be well advanced in assessing their product portfolios and related operating systems, choosing an appropriate replacement rate (by product, if necessary), and commencing a move to hardwired fallbacks and related contract amendments. The complexities of structured finance products and their underlying instruments and possible hedges make this effort all the more critical. n
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