In early 2021, the requirement to transition all GBP LIBOR loans to risk-free rates ("RFRs") by 31 December 2021 seemed an almost impossible prospect.
The amount of material generated by the working groups, exposure groups, regulators and other market participants created a sense of analysis paralysis – with a daunting number of choices in documentation. Our alert in March gave a sense of the task ahead.
And now? With the pressure of a hard deadline, we have observed the market reach a form of consensus fairly quickly on most of the fundamental points in documentation:
|Issue||State of the Australian loan market||Recap of the issue||KWM observations on Australian loan market responses|
|RFR structure||Established position for Australian based transactions||
LIBOR is a forward-looking rate. The applicable rate is fixed at the start of each interest period, meaning parties know the amount of interest to be paid at the end of the period.
RFRs are backward-looking rates. The applicable rate is calculated at the end of the period based on the observable RFR during that period.
The shift from forward-looking to backward-looking rates has been the core technical challenge for market participants – and different methodologies were proposed by industry working groups for market consideration.
|Australian loan markets have widely adopted the "Daily Non-Cumulative Compounded RFR" methodology, with no observation shift and a 5 banking day lookback period. The drafting proposed by LMA, and adapted for Australia by APLMA, is generally used without substantive modification.|
|Rate Switch mechanism||Established architecture, but application varies between deals||
IBOR transition is at different stages across currencies, with some having imminent deadlines (eg GBP LIBOR and 2 month USD LIBOR) and others having none at all (eg BBSW/BBSY).
To accommodate this, the LMA/APLMA form documents include flexibility for parties to:
The approach varies by currency:
For rate switch agreements, there are some nuances in the “trigger event” definition and switch mechanics to be settled in documentation.
|Credit Adjustment Spread||Established position||As a “risk-free” rate, by definition an RFR will always be lower than an interbank rate (which includes implicit credit risk and liquidity premiums). To make the switch to RFRs economically neutral, a “credit adjustment spread” (“CAS”) is included as an additional component of interest to bridge the gap between LIBOR and the RFR.||
Initially we expected the CAS would be heavily negotiated. We saw some early movers run auction style price discovery exercises to set the rates. Others considered formulae for a non-static CAS (although this had its own set of challenges).
This changed when ISDA and Bloomberg published the 5-year historical median spreads to 5 March 2021 (available here). Those fixed rates were quickly and enthusiastically adopted on most transactions. In part, parties took comfort from the observable methodology, meaningful sample period (which includes period of disruption in markets) and institutional credibility of those rates. Aligning with ISDA’s approach also created efficiency for hedging. We also suspect most parties are also happy to have an easy fix with a clear “market” position to fall behind rather than needing to re-negotiate the CAS for every transaction.
Over the longer term, it remains to be seen whether CAS will be absorbed into the margin and cease to be a separate component of interest.
|Zero floor method||Fairly well settled||
In LIBOR loans, if a zero floor is applied margin will not be affected if LIBOR falls below zero.
The CAS is a new component of interest between the RFR and the margin, so there was potential for parties to debate whether the zero floor should apply to:
We have not seen the zero floor method as a significant issue on transactions – with most applying the floor (if there is one) to RFR + CAS.
That approach is consistent with an economically neutral transition for a LIBOR loan with a zero floor where LIBOR should (in theory) be equivalent to the RFR + CAS. It should also reduce misalignments between the base rate and associated hedging.
LMA/APLMA’s proposed drafting for this outcome has been widely adopted – which reduces the RFR so that RFR + CAS = zero. However, some lenders may prefer alternative approaches where the CAS is adjusted or a hybrid approach where both RFR and the CAS are adjusted.
|Non-standard interest periods||Different solutions in the market||The CAS is generally a fixed number for standard interest periods. A solution is required to set the CAS for non-standard interest periods.||There are different solutions in the market. In our view, the most balanced outcome is for an interpolation of the CAS applicable for the 2 nearest standard interest periods. However, some participants have elected for the CAS to be fixed using the next longer or shorter standard interest period.|
|Some debate on cost of funds fallback||LIBOR loan documents include fallbacks for setting the base rate where LIBOR ceases to be available. Those fallbacks are less appropriate for RFR loans and/or do not align with the policy objectives of the shift to RFRs.||
LMA/APLMA guidance documents include a number of fall-back options if the chosen RFR ceases to be available.
The first fall-back is a central bank rate. To minimise the economic impact of a shift from an RFR to a central bank rate, some (but not all) documents include an adjustment to account for the spread between those two rates. There are slightly different formulae in the market to calculate this, but these are generally based on a trimmed mean of the spread over a historical period (e.g. over the preceding 5 banking days where an RFR was available).
The second potential fall-back is “cost of funds”. There has been some controversy on whether this is necessary or appropriate as a central bank rate should always be available. However, the option for cost of funds can be (and is often) selected as the ultimate fallback for a black swan event.
An area of significant debate (both theoretical and in practice) is whether and how break costs should be charged for prepayments made mid-interest period. Break cost concepts in LIBOR loan document are based on the assumptions that there are redeployment costs for mid-interest period prepayments (eg if lenders fund themselves by entering into matching term loan arrangements in the interbank market).
In a world where RFRs apply, borrowers have argued that break costs are irrelevant as there is no matching term funding for Banks.
We have seen a range of outcomes:
Market disruption provisions in LIBOR loans are intended to protect lenders against disruption in the interbank funding market, by allowing them to replace a published screen rate with a rate that reflects their cost of funding where they cannot fund themselves at the relevant benchmark rate.
Borrowers argue that market disruption provisions are not appropriate in the context of an RFR loan because the RFR is not necessarily reflective of how commercial lenders fund themselves.
This is the most debated point in the market, but ultimately the outcome is binary and the LMA/APLMA documents facilitate either outcome.
If a specified percentage of lenders notify that their funding costs exceed the “Market Disruption Rate”, this can be replaced with the lenders’ cost of funds. The Market Disruption Rate is defined as the compounded RFR for the relevant interest period plus the CAS.
Speak to us today
King & Wood Mallesons has been closely involved at all levels with the transition to RFRs. We have also devised an innovative solution to streamline the process of amending loan documents efficiently to implement RFR amendments. Please reach out to find out how we can help your business today.
KWM resources on LIBOR transition