GBP LIBOR transition for derivatives and use of the ISDA fallbacks

On 5 March 2021, the UK Financial Conduct Authority (FCA) confirmed that GBP LIBOR will no longer be permissible as a benchmark rate after 31 December 2021. All loans and derivatives referencing LIBOR will transition to a new benchmark rate, which most likely will be SONIA. SONIA is a transaction-based rate that represents the cost of borrowing cash overnight on an unsecured basis. The Bank of England publishes SONIA at 9 a.m. each morning using data from transactions made on the previous day. The syndicated commercial debt market has largely settled on a SONIA calculation which is compounded in arrears, with a five-day lag and embedding a credit spread adjustment (CAS) to account for any economic difference between the SONIA compounded in arrears and LIBOR. Commercially, the two major negotiation points for borrowers are:

1. How to calculate the CAS (using either a forward-looking methodology or a historical rate)
2. How to treat the interest rate floor (usually at 0%)

This uniformity in the calculation which has emerged in the loan market is not always applied to the derivative which is hedging the loan. This is presenting challenges in the coordination of the transition between the two. When a lender is also the hedge provider, this coordination is more straightforward. However, transitioning a derivative indexed to LIBOR over to SONIA could result in frictional costs, which borrowers should negotiate. We’ve described the two approaches for transitioning derivatives to SONIA below.

Practicalities of transitioning derivatives — different approaches for swaps versus caps

1.) Restructure

The first option is to restructure the LIBOR-referencing derivatives to a compounded SONIA on the same date as the loan transition and applying the same compounding formula.

For swaps, there is still a liquid basis swap market that reflects the difference between a LIBOR/SONIA swap for a contract beginning on the transition date and ending on the swap maturity date (the “forward basis”). For loans transitioning ahead of year-end 2021, most lenders are accepting this methodology as a way of calculating the CAS to move from LIBOR to SONIA (alongside some other methodologies). If the forward basis can be commercially agreed to apply to the loan, this would exactly match the spread that would be received under the floating-rate leg of the swap. In short, there will be no change in total interest payable when combining the swap and loan (apart from the frictional trading cost of the restructure which is estimated to be around one basis point).

For caps, the borrower can simply adjust the strike rate so that the SONIA cap has equal value to the LIBOR cap. The rate will be close to the existing cap strike given the SONIA cap theoretically has marginally lower value, but the difference may be offset by the restructure costs.

2.) ISDA fallback

An alternative route which can avoid the restructure of the derivative (and any frictional costs) is to rely on ISDA amended fallback definitions.

ISDA Protocol

From the end of 2020, banks and their counterparties were able to sign up to the 2020 ISDA IBOR Fallbacks Protocol which retrospectively amends legacy derivative contracts governed by ISDA to automatically convert from a derivative indexed to LIBOR to a derivative indexed to SONIA, compounded in arrears plus a spread adjustment. The problem with this approach is that the ISDA Protocol uses fallback definitions contained in Supplement 70 as the means to convert LIBOR trades to SONIA compounded in arrears. The baseline compounding methodology found in ISDA Supplement 70 does not align with the conventions that have been developed in the loan markets (SONIA compounded in arrears with a five-day lookback). Rather, ISDA’s default compounding methodology uses an observational shift methodology with two-banking day lag, which leads to a slightly different compounded calculation relative to the loan calculations. Relying on this methodology will mean a mismatch on the calculation for the underlying interest rate for the loan versus derivative.

ISDA Bilateral Agreement

In response to market feedback on this discrepancy, ISDA published an updated Supplement 75 in May 2021; allowing market participants greater flexibility to align the compounding methodology in their derivative with the compounding methodology adopted in their loan. Market participants now can incorporate Supplement 75 into the terms of their transaction and match the five-day lag for both the loan and the accompanying hedge. However, market participants cannot simply adhere to ISDA’s Protocol to take advantage of this. Market participants will need to enter a bilateral amendment, which incorporates both ISDA’s Supplement 70, containing the general transition terms, as amended by the recently updated Supplement 75 to ensure the calculation will match the loan. It is not automatic that a bank counterparty will agree to the bi-lateral agreement, so a borrower should raise this as early in their discussions as possible.

Assuming the bank counterparty agrees to the bilateral, the current hedges would remain referencing LIBOR until 31 December 2021 and then beyond 2021, remaining at the same swap rate/cap strike but receive/reference compounding SONIA plus a CAS of 11.93 bps (3-month). This method is attractive because the hedge does not need to be amended, or re-traded, and remains as it is today, just looking to the new index beyond the end of this year and avoiding any frictional cost. The hedge will continue to reference LIBOR for the remainder of this year whilst the loan potentially transitions before (depending on the date agreed). The risk of material divergence of LIBOR and SONIA before year-end is low, so this option should be considered. It is particularly attractive for caps where restructure costs may have a more material impact compared to the value of the cap.