LIBOR transition: practical issues for UK borrowers

While SONIA is the widely agreed upon replacement rate, the majority of floating-rate loans and derivatives are still indexed to LIBOR. The coming nine months are a crucial period for borrowers wishing to ensure that their financing arrangements are not adversely affected by the transition.

Fallback arrangements

Almost all loan contracts linked to LIBOR will contain some fallback provisions specifying how to calculate the floating rate if LIBOR is unavailable. For a small number of bank lenders, contracts drafted more recently may explicitly specify a switch to SONIA on a defined date before the end of 2021, alongside other provisions for the new calculation of interest such as compounding conventions and determination of the credit adjustment spread (CAS – see below). Unfortunately, such contracts are a small proportion of the total.

In most cases, the loan contract will need to be amended in order to document the move from LIBOR to SONIA. The majority of loans signed since 2017 (when the FCA announced its intention to withdraw support from LIBOR) specify that LIBOR’s discontinuation will trigger negotiations between the borrower and agent aimed at agreeing on a replacement benchmark and other associated amendments required for its use. The complexity of these negotiations will vary significantly. At one end of the spectrum, agreeing amendments to a bilateral loan where the agent is also the sole lender should be relatively straightforward. Doing the same for a large group of lenders will be more challenging and time-consuming.

With an eye to the potential for long negotiation periods, many contracts signed over the last year specify that amendment discussions should start in advance of LIBOR’s actual discontinuation. April 2021 is a common choice, in a nod to the Financial Conduct Authority’s direction that UK-supervised lenders should stop signing new loans linked to GBP LIBOR by the end of Q1 2021. This allows potentially lengthy discussions around the replacement benchmark and associated amendments to be conducted while LIBOR is still available to be used for the calculation of interest.

There is also a large body of problematic contracts that do not mandate such a renegotiation until LIBOR is actually discontinued — and a significant number that do not contemplate amendments at all. Worse, such contracts frequently contain interim fallback arrangements that are unattractive or impractical, having been designed for temporary unavailability of LIBOR rather than permanent discontinuation. A common example is the specification that, in the absence of LIBOR, the agent will obtain estimates from a group of reference banks on the rate at which they would expect to borrow in the interbank market for the interest period in question. Few agents would be operationally equipped to carry out such polls for all the loans on their books even if the reference banks were willing to provide quotes.

The overall message for borrowers is that, in their current state, a high proportion of fallback arrangements in loan contracts will make the calculation of interest difficult or impossible once LIBOR is discontinued. In some cases, borrowers may also be subject to a floating rate that depends on opaque and unchallengeable calculations of the lenders’ cost of funds.

To avoid these risks, such borrowers need to proactively engage with their lenders and switch their loan contracts from LIBOR to SONIA before LIBOR’s discontinuation, and agree associated amendments to allow for interest to be calculated using the new benchmark.

Calculation of the credit adjustment spread (CAS)

Historically, SONIA has typically fixed lower than LIBOR. As a result, counterparties moving a contract from LIBOR to SONIA will also agree on a spread to be added to SONIA to compensate for this difference — the CAS.

At present, there are two approaches to calculating the CAS:

• Backward-looking: CAS is calculated as the median of the historical spread between LIBOR and compounded SONIA for the relevant interest period, using daily data from the five years leading up to the transition date.
• Forward-looking: CAS is calculated as the average difference between the forward curves for LIBOR and compounded SONIA for the relevant interest period, over the period from the transition date to the contract’s termination date.

The backward-looking approach is common in the derivatives market as it is the methodology specified in the ISDA Fallbacks Supplement. It is also widely used in the fallback arrangements for LIBOR-linked loan contracts that explicitly specify a switch to SONIA.

While the outcomes from the two approaches are expected to converge as we approach LIBOR’s discontinuation date, they will not always give the same result. At the time of writing, for three-month interest periods the forward-looking approach gave a result up to five basis points lower than the backward-looking approach, with the exact difference dependent on the contract’s termination date.

Lender readiness

Different lenders are at very different stages in their LIBOR transition programmes. While an increasing number can provide SONIA-linked loans and derivatives (and some will now refuse to offer GBP loans linked to LIBOR), many are not yet operationally set up to do so. For those in the latter category, which includes most non-bank lenders, discussions about how to transition existing LIBOR loans over to SONIA may only be possible at a high level at present.

A third category of lender is able to offer SONIA loans and transition legacy LIBOR loans, but unable to offer some (or any) hedging products referencing SONIA. In these cases, borrowers should be particularly careful about agreeing to conventions on the loan that are difficult or impossible to mirror in the derivative market with a non-lender counterparty.

We anticipate that the FCA’s upcoming deadline for UK-supervised lenders to cease signing new loans on GBP LIBOR from 31 March 2021 will catalyse progress.

The ISDA Fallbacks Protocol — and whether to use it

Having taken effect on 25 January 2021, the ISDA Fallbacks Supplement amends the definition of GBP LIBOR in ISDAs signed after that date to include an explicit switch to compound SONIA plus a spread. It fully specifies the compounding calculation conventions involved and selects the backward-looking calculation approach for the CAS. Meanwhile, the ISDA Fallbacks Protocol allows counterparties to derivative contracts signed before 25 January 2021 to retroactively amend their contracts such that they also include the ISDA Fallbacks Supplement.

For borrowers that used derivatives to hedge their debt, it is important to highlight that adhering to the ISDA Fallbacks Protocol has no impact on the underlying loan contract — only the derivative. The compounding and other calculation conventions specified by the ISDA Fallbacks Supplement do not mirror the most common conventions emerging in loan market documentation. As a result, adhering to the ISDA Fallbacks Protocol may make it difficult for the borrower to fully mirror the terms of the loan in the derivative and maintain a fully effective hedging relationship.

Since LIBOR’s discontinuation was announced in 2017, many have understandably been waiting for market conventions to crystalise before beginning their transition programs. While there are still some uncertainties in this area, time is now running short. A proactive engagement with the issues described above is the only way for borrowers to ensure they are not exposed to unnecessary risks in nine months’ time.