August 24, 2017 - As LIBOR continues to create headlines in a sleepy August market, we wanted to update LSTA members on a number of issues. First, we recap the current state of preparation for a possible LIBOR transition or disruption. Second, we discuss principles for IBOR fallbacks in the derivatives space. Third, in the loan space, we discuss potential stakeholders (and their needs), and, fourth, provide very early thoughts on how credit documentation could reduce any risk of a market disruption if LIBOR were permanently discontinued. Finally, for comparison purposes, we describe the ISDA fallback approach for IBORs.
As readers likely know, with LIBOR facing reputational and liquidity stress, the U.S. Alternative Reference Rates Committee (“ARRC”) has been working for more than two years to develop an alternative rate. To be clear, this isn’t a loan market issue. The focus thus far has been on the $140 trillion of derivatives that reference LIBOR, as that market dwarfs all other LIBOR markets. In June, the Broad Treasuries Repo Financing Rate (“BTFR”) was announced as the alternative reference rate chosen by ARRC for USD LIBOR derivatives. As discussed in a recent LSTA webcast, BTFR has the benefit of being liquid and deep, it’s likely to remain robust over time, and it’s consistent with IOSCO’s Principles of Financial Benchmarks.
However, BTFR is not USD LIBOR; it’s a secured overnight rate. Therefore, it is lower than USD LIBOR. But – and this is key – the process of developing a potential LIBOR replacement is not over. As a very helpful ISDA webcast explained, it is expected that there will be a methodology for calculating a spread to account for bank credit risk (which is captured by LIBOR, but not BTFR) and a solution for 1-, 3-, 6- and 12-month term fixings so that BTFR could be used as a fallback in contracts that reference LIBOR.
A Principled Approach to Establishing Fallbacks for USD LIBOR and other IBORs
As discussed on slide 6 and minute 28 of the ISDA webcast, market participants are focused on four key considerations when drafting fallbacks that would apply for derivatives contracts (and could theoretically be implemented for other financial instruments such as loans):
1) To minimize any value transfer during implementation
2) To minimize the potential for market manipulation
3) To ensure the market continues in an undistorted way
4) To ensure that calculations are transparent and easy to replicate
Point 1 – no value transfer – should mean that both parties to the contracts should be in the same position after a transition to the new rate. To get to that point, work needs to be done to finalize a methodology for calculating a spread to apply to the risk-free rate (BTFR) that would account for bank credit risk that is captured by USD LIBOR and other IBORs, but is not in the risk-free rates such as BTFR. Second, there will need to be 1-, 3-, 6- and 12-month term fixings for the relevant risk-free rate. We are at the very early stages, and discussions around other asset classes – like loans – have not yet begun. That said, market participants have made very clear that the solutions for derivatives should work for (or at least be consistent with solutions for) underlying instruments hedged by derivatives.
The Loan Market & Stakeholders
While there are no definitive answers yet, thinking about the loan market as a whole may provide perspective (and help us plan for a plan!). Though overshadowed by the $140 trillion of swaps referencing LIBOR, the U.S. syndicated loan market is non-trivial, totaling $4.3 trillion of loan and loan commitments outstanding, according to the Shared National Credit Review. Of that, approximately $1 trillion is held by non-bank lenders and $3.3 trillion is held by U.S. and foreign banks. So there are at least four major loan market stakeholders, all of whom may have different needs.
First are borrowers, who are parties to all $4.3 trillion of loans. Obviously, they do not want their interest rates to rise simply due to a transition to a new risk free rate. They also presumably want/need the ability to hedge interest rate risk, so a rate that is directly relatable to BTFR is preferable.
Banks are a second major stakeholder group; they are party to roughly $3.3 trillion of syndicated investment grade and leveraged loans. While not a homogenous group, they presumably don’t want interest rates to decline simply due to a transition to a new risk free rate and they also presumably would prefer the rate to approximately reflect their cost of funds.
Institutional lenders – CLOs, loan mutual funds, etc. – are a third major stakeholder group; they are party to roughly $1 trillion of leveraged institutional loans. While presumably indifferent to the cost of funds concept, they also don’t want interest rates to decline simply due to a transition to a new risk free rate.
A fourth major stakeholder may be investors in loan investment vehicles. In this case, we are thinking of investors in the $450 billion CLO market. These investors do not want interest rates on their CLO notes to decline simply due to a transition to a new risk free rate. But in addition, they need to avoid a potential mismatch between the CLO note reference rate and the reference rate for the underlying loan collateral.
The LSTA, a trade association for the entire loan market, is aware of these different interests. We are committed to balancing the interests of our member constituents and working to facilitate any transition or fallback language that is necessary.
On to Loan Documentation
Even though it’s very early days, as market participants begin to educate themselves on the development of LIBOR fallbacks, naturally questions move quickly to loan documentation. However, in the absence of knowing what new benchmark the loan market will move to, it is premature to draft for a new benchmark now. Importantly, any transition to an alternative rate likely will take years and, once and if the rate is identified, new credit documentation can adopt a new alternative rate in a measured and orderly fashion.
What might lenders consider in the interim? First, most credit agreements already include customary fallback language if there is a temporary disruption to LIBOR, but it would be prudent for parties to review their existing credit agreements to understand 1) what fallback provisions exist in their agreements and 2) what amendment flexibility exists to address a discontinuation of LIBOR.
Second, as new agreements are drafted, parties may want to consider the ability to amend the agreement with less than 100% lender vote to avoid market disruption in the event LIBOR is permanently discontinued. (It should be noted that if BTFR is identified as the ultimate replacement rate, there also should be a bank credit risk spread and a term structure developed, so the replacement rate need not be an interest rate reduction.)
Such an approach is not without precedent. In 2014, in response to the discontinuance of BBA LIBOR, the Loan Market Association adopted an optional clause in its forms that would allow, in the event the screen rate is unavailable, the option for the borrower group and the majority lenders to amend the agreement to provide for another benchmark rate to apply. The LSTA does not have a “LIBOR” definition in its Model Credit Agreement Provisions, so we did not have to address a LIBOR discontinuation at that time. But, as we are developing our first full credit agreement – a form of investment grade revolver, we will consider whether to include a similar amendment ability in the event of a permanent LIBOR discontinuation. Of course, any step will first be vetted through our Primary Market Committee comprised of buyside, sellside and law firm members.
The ISDA Approach
As explained in the recent ISDA webinar, preliminary working group conclusions have identified certain potential IBOR discontinuation triggers to be used in determining whether the fallbacks described above should apply. In the case of USD LIBOR (or any other IBOR), these may include: 1) a public statement by the supervisor of the relevant IBOR administrator of the insolvency of the relevant IBOR administrator (i.e., ICE Benchmark Administration for LIBOR) (and there is no successor administrator), 2) a public statement by the relevant IBOR administrator that it will cease publishing the relevant IBOR permanently or indefinitely (and there is no successor administrator that will continue the publication of the relevant IBOR), 3) a public statement by the supervisor for the relevant IBOR administrator that the relevant IBOR has been permanently or indefinitely discontinued or 4) a public statement by that supervisor that the relevant IBOR may no longer be used.
The key is that the fallback would apply as of the first date that the relevant IBOR is not published after one of these triggers, not the date of any prior announcement. ISDA indicated that amendments to the 2006 ISDA Definitions to add the selected fallback rates upon a permanent discontinuation of LIBOR is anticipated. These would apply to transactions entered into from the date of the amendment to the relevant 2006 ISDA Definitions going forward. Furthermore, one of the possible last steps may be an ISDA protocol to amend legacy contracts referencing the applicable IBORs to include the amended definitions.
As mentioned before, the transition process is in the very early days. As the LSTA learns more, engages in the process, and coordinates with other trade associations, we will continue to keep our members updated.