Understanding the LIBOR Transition

The London Interbank Offered Rate (LIBOR) is the most widely used reference rate in the world, used to set the rates for a wide variety of financial transactions, including business loans, corporate bonds and derivatives. LIBOR serves as a reference rate for tens of millions of transactions worth more than $400 trillion globally. However, regulators worldwide have called on market participants to prepare for a transition away from LIBOR by the end of 2021 and a global effort is underway to replace LIBOR by that date. This article gives a brief overview of why the LIBOR transition is happening, the organization leading the U.S. transition, the rate expected to replace LIBOR and key steps for legal counsel advising equipment lenders that have loans or agreements with LIBOR as their adjustable interest rate.

Why LIBOR Is Being Replaced

LIBOR was intended to represent the cost of short-term, unsecured, wholesale borrowing by large banks and, in the case of U.S. Dollars, the rate at which such banks lend one another funds denominated in U.S. Dollars (USD LIBOR). Presently, LIBOR is determined by the ICE Benchmark Administration Limited based on estimates submitted by panel banks. Since the volume of interbank transactions on which panel banks base their LIBOR estimates has significantly decreased over the past decade, the calculation of LIBOR is increasingly based on hypothetical transactions and expert judgement. This has led to increased concerns regarding LIBOR’s credibility. In 2017, the United Kingdom’s Financial Conduct Authority (FCA), the entity responsible for regulating LIBOR, reached an agreement with the panel banks to continue to submit LIBOR estimates until the end of 2021, but there is no guaranty that sufficient banks will continue submitting estimates to maintain a representative LIBOR rate beyond 2021. As recently as May 2020, the FCA indicated that, despite the COVID-19 pandemic, market participants should prepare for cessation of LIBOR as of the end of 2021.

Leading the U.S. LIBOR Transition

In the U.S., the Alternative Reference Rates Committee (ARRC) is leading the transition from USD LIBOR to alternative reference rates. The ARRC is a group of private-market participants and federal agencies convened by, among others, the Federal Reserve Board and Federal Reserve Bank of New York. The ARRC was initially established in 2014 to identify risk-free alternative reference rates for USD LIBOR and create an implementation plan to support an orderly adoption of such rates. In October 2017, the ARRC published its Paced Transition Plan, with specific steps and timelines designed to encourage adoption of the ARRC-selected alternative reference rate. Since then, the ARRC has published, among other helpful resources, a practical implementation checklist that outlines potential steps to mitigate risks and ensure a smooth transition, recommended fallback language for a variety of products (including bilateral business loans), and best practices for LIBOR transition, including for third-party technology and operations vendors.

A Replacement for LIBOR

After three years evaluating potential alternative reference rates and extensive discussion and market feedback, the ARRC selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight secured by Treasury securities. The Federal Reserve Bank of New York began publishing SOFR on April 3, 2018 and publishes daily rates and volumes on its website.

The following are certain key differences between SOFR and LIBOR:

• SOFR is a secured rate. As a secured rate, SOFR does not reflect LIBOR’s unsecured credit component.
  
  
• SOFR is an overnight rate. LIBOR is a forward-looking rate with seven tenors (overnight, one week, one month, two months, three months, six months and 12 months). Currently there is not a forward-looking SOFR (term SOFR), but the ARRC’s Paced Transition Plan anticipates term SOFR being available in late 2021. However, the availability of a term SOFR requires sufficient transactions in the SOFR derivative market, and its production cannot be guaranteed. Therefore, market participants must formulate a plan if term SOFR is unavailable or not acceptable for use. Alternatives to term SOFR include daily SOFR or compounded average SOFR used in advance or in arrears. In March 2020, the Federal Reserve Bank of New York began publishing 30-, 90- and 180-day SOFR compounded averages.
  
  
• SOFR is backed by a robust market. The market underlying SOFR has a daily trading volume in excess of $1 trillion and has demonstrated consistent volume for several years. In contrast, it is estimated that daily volume of three-month transactions for LIBOR may be less than $500 million.
  
  
• SOFR is on average lower than LIBOR. Using SOFR simulations provided by the Federal Reserve Bank of New York, it is calculated that, since August 2014, SOFR has averaged 12 bps, 24 bps and 39 bps less than 1-month, 3-month and 6-month LIBOR, respectively. In April 2020, during the COVID-19 pandemic, the spread between one-month LIBOR and compounded SOFR reached historic highs. The difference between LIBOR and SOFR will necessitate use of a “spread adjustment,” as discussed below, when converting LIBOR loans to SOFR.


• Average SOFR has been less volatile than LIBOR. Despite greater overnight variability, the 3-month average of SOFR has been less volatile than 3-month LIBOR. Despite a sharp increase in SOFR over a few days in September 2019, the 3-month average of SOFR rose only two basis points. By comparison, the 3-month average of LIBOR rose four basis points over the same period. Financial products are generally expected to use an average of SOFR, not a single day’s reading of the rate.

Key Transition Steps

The following are key steps for LIBOR transition of business loans. The ARRC best practices provide that institutions should take active steps to meet the timelines in the best practices.

• Fallback Language in New Transactions: All new business loans, renewals and refinancings with maturities after Dec. 31, 2021 should include ARRC-recommended (or substantially similar) “hardwired” “fallback language” as soon as possible, but in no event later than Sept. 30, 2020. “Fallback language” is contractual provisions that specify when and how the transition from LIBOR to a replacement rate will occur, how the replacement rate will be selected (because the development of term SOFR is not certain, fallback language cannot simply specify a move to term SOFR), and how to calculate the interest rate under the contract (the transition will include a spread adjustment to make the replacement rate more comparable to the LIBOR rate). The ARRC has published recommended fallback language for a variety of transactions. The ARRC “hardwired approach” provides a waterfall that establishes what the replacement rate will be depending on which rates are available when the transition is made (with term SOFR generally being the first step in the waterfall). This is in contrast to the ARRC “amendment approach” which provides a process for identifying the rate but does not include specific rate options.
  
  
• Development of SOFR Products: The development of products will include decisions as to the appropriate use of SOFR. While the ARRC’s Paced Transition Plan envisions a term SOFR availability in late 2021, if term SOFR does not develop by that time, products are likely to use an average calculation of SOFR. The rate used may dictate the complexity of the changes to a lender’s documentation and systems. For example, reliance on published rates may only require simple documentation changes while use of another rate may require inclusion of technical formulas in rate definitions. Third-party technology and operations vendors relevant to business loans should complete all necessary enhancements to support SOFR by Sept. 30, 2020.
  
  
• Sunset of LIBOR Products: The ARRC recommends that after June 30, 2021 no new business loans, renewals or refinancings with maturities after Dec. 31, 2021 should use LIBOR.


• Remediation of Existing LIBOR Transactions: Lenders should develop plans for remediating existing LIBOR contracts to include robust fallback language or transition contracts directly to an alternative reference rate.
  
  
• Transition of Remaining LIBOR Transactions: Lenders should develop plans for transitioning contracts using the fallback language in such contracts. Where business loans specify that one party will select the replacement rate at its discretion, that party should disclose the replacement rate and spread adjustment methodology at least six months prior to the date that the replacement rate would become effective.

How a lender or finance company chooses to transition from LIBOR and the alternative rate used will depend on a variety of factors, and lenders and finance companies will need to work closely with counsel, pricing, technology, operations, documentation and other teams to determine the best strategy for each phase of the transition. Obligors will also need to determine whether they have products that mature after Dec. 31, 2021 that use LIBOR as the reference rate and familiarize themselves with the approach their lender or finance company will take to transition away from LIBOR.