Transition From LIBOR Appears to Remain on Track (At Least for Now)
August 17, 2020
As both lenders and borrowers in the financial industry are well aware, the Financial Conduct Authority (FCA) of the United Kingdom publicly announced in 2017 that it would no longer compel financial institutions comprising the LIBOR panel banks to make submissions of London Interbank Offered Rate (LIBOR) quotes beyond the end of 2021. As a result, the industry has been diligently working to develop alternative and fallback benchmarks for LIBOR in financial contracts, including loan documents and swaps/derivatives contracts. U.S. dollar LIBOR is currently used as a reference rate for more than $200 trillion in notional amount of financial contracts in the cash and derivatives markets.
The Board of Governors of the Federal Reserve System organized a group of national and international stakeholders to study and make recommendations for the implementation of a new benchmark to replace LIBOR. Known as the Alternative Reference Rates Committee (ARRC), the group has undertaken a number of recommendations and best practices for adoption of an alternative benchmark. The ARRC’s recommended replacement rate is the Secured Overnight Financing Rate (SOFR) published by the Federal Reserve Bank of New York, which is based on the cost of overnight cash borrowings collateralized by U.S. Treasury Securities. Among the primary advantages that SOFR offers over LIBOR, according to ARRC, is that SOFR is based on actual transactions rather than estimated rate submissions by LIBOR panel banks and SOFR is an overnight nearly risk-free reference rate based on a high volume of transactions that correlates closely with other money market rates. It is expected that there ultimately will be established several flavors of SOFR, including SOFR in arrears, SOFR in advance and Term SOFR.
ARRC has, among a large number of other important publications and resources, produced suggested draft provisions for legacy and new financial contracts, both syndicated and bilateral, and developed a recommended time frame for adoption of these provisions. ARRC is strongly encouraging the widespread adoption of these provisions in order to establish uniform practices in the market and to ensure a smooth and orderly transition from LIBOR. ARRC’s suggested time frame for business loans and derivatives includes cessation of the use of LIBOR in new contracts not later than June 30, 2021, as-soon-as possible inclusion of ARRC recommended benchmark replacement language when amending or refinancing existing financial contracts and establishment of proposed replacement benchmarks at least six months prior to a benchmark replacement effective date following a triggering event under the financial contracts.
There has been widespread speculation as to what effect, if any, the emergence of COVID-19 and its disruptions of financial markets may have on the timing of cessation of LIBOR availability. ARRC, in the July 16, 2020 version of its FAQs published on the ARRC website, states that it will continue to focus on the established timeline for the transition from LIBOR in accordance with previously published guidance. However, the FAQs acknowledge that near-term, interim steps may be delayed given the current global pandemic.
Similar direction was provided by a March 25, 2020 published statement by the FCA to the effect that the assumption of cessation of LIBOR after 2021 has not changed. However, the FCA did allow some room to maneuver by acknowledging that some aspects of UK transition programs have been impacted and that particular segments of the UK market, including the loan market, are still more reliant on LIBOR, potentially affecting interim transition milestones. The FCA indicated that it will continue to monitor and assess developments and update the market as soon as possible.
Therefore, it seems clear that while there exists some potential for delay given the unknown duration and trajectory of the COVID-19 breakout, the most prudent course for both lenders and borrowers is presently to expect that LIBOR will no longer be available after December 31, 2021 and to continue their planning and preparations for that eventuality.
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