April 28, 2020 - While the world has been focused on the COVID-19 crisis, LIBOR laborers have quietly been moving the ball forward. Specifically, there is increasing alignment on LIBOR fallbacks for cash and derivatives. Moreover, ISDA and Bloomberg will be publishing indicative spread adjustment language soon, so we’ll know the economics of hardwired fallbacks. We discuss all below.

As a refresher, hardwired LIBOR fallbacks answer the question “When LIBOR is no longer useable, to what rate does my contract fall back?” There are three parts to this question: 1) When is LIBOR no longer useable (in other words, what is the trigger to start the fallback)? 2) To what rate do I fall back? 3) What spread adjustment do I use to make the replacement rate more comparable to LIBOR?

Derivatives and cash products are becoming increasingly aligned. First, on triggers, ISDA originally only had “cessation” triggers, which were based around a statement that LIBOR had ceased or would soon cease. In contrast, cash products had cessation triggers, as well as a “pre-cessation” trigger that occurred when the relevant supervisor stated that LIBOR was no longer representative.  Because LIBOR could still exist while being non-representative, it was possible that cash products would switch from LIBOR to a replacement rate before derivatives switched.

That may change. On April 15th, ISDA released the preliminary results of its “pre-cessation trigger” consultation and announced that it “expects to move forward on the basis that pre-cessation fallbacks based on a non-representativeness determination … would apply.” While there is still a lot of wood to chop, ideally LIBOR-based cash and derivatives products will come into alignment on when they flip from LIBOR to a replacement rate.

There’s also good news on cash products flipping to nearly the same coupon. When USD LIBOR contracts flip to SOFR, there needs to be a “spread adjustment” to make the rates more comparable. Earlier this year, the ARRC issued a consultation on cash spread adjustments to inform its methodology. Several weeks ago, the ARRC recommended that cash products use ISDA’s methodology for determining the spread adjustment (i.e., the five-year historical median difference between LIBOR and SOFR). So now we know that i) USD cash and derivatives should flip to SOFR at the same time and ii) they should use the same spread adjustment methodology. This should reduce basis risk between derivatives and cash products at LIBOR cessation. (To be clear, though, derivatives will fall back to “SOFR Compounded in Arrears”. The hardwired fallback language for USD syndicated loans recommends a fallback waterfall, which uses “Forward Looking Term SOFR” as the first step in the waterfall. Thus, there is potential for a difference in the rates at LIBOR cessation.)

Knowing that derivatives and cash will fall back at the same time to approximately the same rate is very helpful. And, finally, we should have the “indicative” spread adjustments soon. Last week Bloomberg published the rulebook setting out final methodologies for the IBOR fallbacks that ISDA expects to implement. ISDA added that Bloomberg expects to publish indicative spread adjustments in the coming weeks. In effect, i) we now know that derivatives and cash fallbacks should trigger at the same time, ii) we know that their spread adjustments will be very similar and iii) we should know the indicative spread adjustment levels imminently. All these changes help smooth the path to using hardwired fallbacks for loans. (As a final editorial comment, the COVID-19 crisis should demonstrate why hardwired fallbacks – not the mass use of amendments after LIBOR cessation – is a better strategic plan.)

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