It is starting to feel as if we are nearing the end of a long climb, in fact the end of a long period of uncertainty, for financial institutions and businesses alike, on how to deal with LIBOR transition. Having to keep an eye on regulators' statements, legislation, market developments and a large number of publications and webinars from trade bodies, takes quite an effort and indeed a considerable amount of time, not least when parties are also dealing with the economic fallout of the pandemic and trying to keep trade going. So, are we nearly there?
We now know that we have the following Risk-Free Reference Rates (RFRs)[1] available, namely:
- Sterling Overnight Index Average (SONIA) comprising SONIA overnight, SONIA compounded in arrears and Term SONIA (from Refinitiv and ICE Benchmark Administration) for Sterling;
- Secured Overnight Financing Rate (SOFR) comprising daily SOFR, SOFR compounded in arrears, SOFR in advance, and recently, Term SOFR from CME Group for US Dollars (USD); and
- Euro Short Term Rate (ESTR) for euros. There will be a Term Rate for ESTR at some point in the future. In addition, we still have EURIBOR available.
Use of Term Rates
The introduction of Term SOFR for USD will provide a real boost to the trade finance industry. Regulators in the UK, the US and the EU have recognised and implemented the need for forward-looking term rate which can be used in transactions in the trade finance sector. Where regulated entities wish to use a term rate, they should refer to the Bank of England's Use Case paper and the market standards for the use of Term SONIA Reference Rates issued by the FICC Markets Standards Board. The Alternative Reference Rates Committee's (ARRC) 'Best Practice Recommendations Related to Scope of Use of the Term Rate' supports the use of Term SOFR for trade finance. In a nutshell, there must be a good reason, namely a "robust rationale", to use a term rate rather than a risk-free reference rate compounded in arrears, no matter in which market sector the transaction sits.
Smooth transition
Legislation to help facilitate a smooth transition of the market away from LIBOR is under way in both the US[2] and the UK[3] to preserve the continuity of contracts, and which will protect legacy and tough legacy contracts which have not yet been amended or cannot be amended to use an RFR.
In anticipation of the cessation of Sterling LIBOR on 31 December 2021, the Financial Conduct Authority (FCA) confirmed that synthetic 1-, 3- and 6-month LIBOR settings will be available for the duration of 2022. However, the rates, calculated using a different methodology, will be reviewed annually and the FCA cannot guarantee they will be published after the end of 2022. Perhaps this is a lifeline for regulated entities where a borrower has not engaged with the idea of having to amend a legacy contract based on LIBOR. The FCA's statement in the recent FAQs published on the FCA's website appears to give the parties some additional time to use synthetic LIBOR, while still aiming to amend the legacy contracts.
When it comes to the use of RFRs for USD transactions, the end of 2021 signifies the end of publication of 1 week and 2-month USD LIBOR. 1-, 3-, 6- and 12-month LIBOR will continue for legacy contracts until 30 June 2023. However, there is no guarantee that, by the end of June 2023, there will be a synthetic USD LIBOR. Market participants are being asked to move to SOFR rates as soon as possible. Indeed, in its sixth (and final) symposium on 26 October 2021, the ARRC brought together banks and borrowers to hear their views on the transition from LIBOR and emphasised the need for corporate borrowers to engage and move over to SOFR rates as soon as possible.
While there has been a lot of commentary regarding fallbacks to replace LIBOR, we now have to take a different approach and think about what the appropriate fallbacks would be when we start with an RFR, either SONIA or SOFR. The ARRC, in its fifth symposium, discussed whether to use credit sensitive rates as fallbacks. Gary Gensler at the SEC suggested that the Bloomberg Short-Term Bank Yield Index (BSBY), (a rate that a number of commercial banks had been advocating as a replacement for LIBOR, and which was listed in the LMA guidance as a possible fallback) should not be used as a fallback as the foundation of the rate as liquidity was much too narrow. To use it, he said, would almost be like replacing LIBOR with something very similar.
Credit Adjustment Spread
The use of a Credit Adjustment Spread (CAS) should be to retain the same economic effect when transactions are moved over from LIBOR to an RFR. However, the LSTA in a recent interesting paper[4] pointed out that in fact LIBOR and RFRs have been much closer in real terms than expected, so in some cases using a CAS could produce a little windfall which was never the intention, as it was thought e.g. SOFR would be lower than USD LIBOR. In short, and as reiterated by the ARRC's sixth symposium, the use of a CAS and the applicable rate for the CAS are negotiable. So, we expect lenders and borrowers may be looking closely at pricing for legacy contracts and new RFR contracts.
Drafting
These concepts and jargon relating to RFRs are now appearing in real transaction documentation and there are some helpful guidance notes and template drafting which can help when we come to look at finance documentation. Here are some examples:
- LMA RFR documentation[5];
- LMA guidance on the use of Term RFRs;
- LMA Illustrative Definitions of Term SONIA;
- LSTA concept document for Term SOFR[6];
- LMA new exposure draft term SOFR documentation for developing markets - (published 27 October 2021); and
- 'Joint Guidance on the use of Risk-Free Reference Term Rates in Trade and Export Finance,' issued jointly by ITFA (International Trade and Finance Association) and us, Sullivan & Worcester UK LLP, which can be found here.
There is also a variety of different articles and commentaries available on drafting. We are delighted to share with you a recent article from the Journal of International Banking and Financial Law (JIBFL), "The drafting jigsaw: LIBOR reform and forward looking term rates" written by Jacqueline Cook, our Senior Knowledge Development Lawyer,[7] which takes a step back to look at which elements of published and bespoke drafting can assist.
Are we there yet?
Well, nearly is probably the right answer! We have the rate for US dollar and Sterling LIBOR replacements, and other currencies and rates are following fast. We have the concepts which are slowly becoming recognised. New RFR jargon is becoming embedded into finance term sheets and documentation.
Yes, we have guidance and yes, we have some exposure drafts and recommended documents from trade and industry bodies, but it will take some time before there are settled market norms for the drafting of RFRs. This is because many transactions in the trade and export finance arena are tailored to the client and the assets, and include structures not set out in LMA or LSTA documentation.
Please click here to view our webinar "Some Things To Look Out For In Trade Finance In 2021 and Beyond," which covers the status of LIBOR Reform as at September 2021 as well as commentary on ESG, URDTT and the Dear CEO letter on trade finance activity.
[1]This blog does not provide a comprehensive list of all RFRs in all currencies. It focuses on Sterling and USD.
[2] Senate Bill S297B/Assembly Bill 164B, signed 6 April 2021.
[3] Critical Benchmarks (References and Administrators Liability) Bill [HL].
[4] The title of the paper: 'In search of… 'fair' spread adjustments for new SOFR loans.' Download and read the article here.
[5] See www.lma.org.eu – available to members.
[6] See https://www.lsta.org/content/term-sofr-concept-document/ - available to members.
[7] Journal of International Banking and Financial Law (2021) 9 JIBFL, page 642.
