While most firms are well advanced in their plans to transition away from LIBOR, the need to be ready to use alternatives to US dollar LIBOR for most new trades by end-2021 is still posing challenges for some smaller market participants.
While liquidity in alternative risk-free rates (RFRs) is growing, there remains some way to go. In late July, the U.S. Federal Reserve-backed Alternative Reference Rates Committee adopted a series of CME’s Group Inc’s forward-looking term benchmarks tied to the Secured Overnight Financing Rate (term rates for one-, three- and six-month tenors based on SOFR futures traded). This adds a repertoire of potentially robust forward-looking rates for participants in markets for syndicated corporate loans and collateralized loan obligations.
However, the difficulty for smaller banks remains that there are currently no industry standard templates which have suitable methods for dealing with interest payments. Smaller banks are wary of compounding as this requires expensive new systems to compute the calculations. Some smaller banks have yet to invest in the IT required to operate the systems needed to undertake the calculations required for some of the available compounded risk-free rates.
Horses for courses
This calculation issue is made worse by the fact that different products often require different approaches for the optimal replacement benchmark, so that banks may need to operate more than one model. For example, in trade finance, it is important to have a term rate. Payments under trade finance loans are often funded by, or otherwise linked to, other transactions, for example, sales and purchases of commodities, hedging transactions or the issue of letters of credit. In consequence, there is an advantage in using a forward-looking rate which is readily available and which does not fluctuate over a 24 hour period – it is easier for parties to ensure that payments will match and to plan cash flows. It is also preferable for many trade finance borrowers who do not have access to pricing information from the derivatives market and are therefore unable to calculate or anticipate swaps-based forward-looking rates. Meanwhile, for other products, a term rate would be inappropriate
Examples of replacement options for USD LIBOR, are set out in the table, each have their advantages and disadvantages for smaller banks:
|Regulatory issues||Availability of standard documents||Operational issues|
|Sofra compounded in arrears||Fewer legal / regulatory issues. Works well with hedging arrangements||More than for other options but still in development||Operationally difficult for smaller banks|
|SOFR compounded in advance||Fewer legal / regulatory issues||Some but still in development||Some operational challenges|
|Term SOFR||More legal / regulatory issues to consider||Still in development||Good – avoids the need to compound. Appropriate for trade finance|
|Daily simple SOFR||Fewer legal / regulatory issues||Some but still in development||Some operational challenges|
Banks will need to develop templates which fit with their systems and operational capabilities For example, if they decide they want to develop a term rate, their new documents will need to address a wide range of novel issues. Term rate documents operate differently to standard LIBOR loan agreements in a number of areas. By way of example, we highlight two differences in approach:
New fallback provisions
The term rate documents need fallbacks to be considered in the context of both: (i) temporary unavailability (i.e. the term rate is not published on a given day); and (ii) permanent cessation.
In the case of temporary unavailability, parties may wish to consider the use of the central banks rates at the end of the temporary unavailability waterfall as per the standard documentation.
Approach to market disruption and break costs
The market disruption provisions in LIBOR standard documents provide that if a specified proportion of lenders report that the interest rate benchmark understates the cost to them of funding their participation in a loan, the pricing of the loan for the relevant interest period changes from being the interest rate benchmark plus the margin to being the lenders’ reported cost of funds plus the margin.
Break costs are intended to compensate a lender for the broken funding costs it may incur on any ‘matched funding’ arrangements it may have in place. Underpinning these provisions is the fundamental premise that the facilities are structured so as to be priced on the basis of a benchmark that is intended to represent an identifiable approximation of the lenders’ likely cost of funds plus a margin.
Given the nature of SOFR, parties to transactions will need to determine whether these underlying funding considerations remain relevant to loans which are based on a term rate and, therefore, how the concepts of market disruption and break costs are appropriate in relation to those loans.
Going it alone
For a number of products there is now a pressing need for documents and a lack of market standards. For some, it is not an option to wait for new market standard documents to be developed as they need to begin drafting documents for new business. As such they will need to carefully select an appropriate alternative rate and consider how they address the various new legal and operational issues that arise with that rate.