LIBOR stands for The London Inter-Bank Offered Rate, which is the benchmark interest rate for banks to borrow from and lend to one another. Essentially, it’s the rate for unsecured short-term borrowing in the inter-bank market. It is administered by the Intercontinental Exchange (ICE), which calculates the rates on the basis of submissions by the panel banks and publishes it daily. It is computed for five currencies including the US Dollar, the Euro, the British Pound, the Japanese Yen, and the Swiss Franc, with seven different maturities namely overnight, 1 week, 1 month, 2 months, 3 months, 6 months and 12 months. It is used as a key interest rate benchmark across a number of Derivatives, Bonds, Loans, Securitizations, Deposits and other products.

Prior to the ICE, LIBOR was administered by the British Bankers Association (BBA) until 2014. Due to the controversy related to the rigging and manipulation of LIBOR during the financial crisis of 2008, whilst the LIBOR was published by British Bankers Association (BBA) Libor, financial market regulators across the world have decided to phase out the LIBOR altogether by Jun 30, 2023. LIBOR is now expected to be replaced by new Risk-Free Rates (RFRs) across the global financial markets. Currently, the working groups associated with the different jurisdictions and with different product categories are devising market conventions and finalising the aspects involved in the transition of LIBOR linked loan, derivatives and other products to the new alternate benchmarks.

The Alternate Reference Rates Committee (ARRC) in the US is responsible for the transition away from USD LIBOR to SOFR. The ARRC comprises of the private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from USD LIBOR to a more robust reference rate. These include banks and non-banking financial institutions, along with banking and financial sector regulators as ex-officio members. The ARRC has published a detailed note with suggested fall back provisions for use in bilateral facilities, syndicated facilities, floating rate notes and securitisations.

Fall back language comprises of contractual provisions that specify the trigger events for a transition to a replacement rate, the replacement rate, and the spread adjusted to align the replacement rate with the benchmark being replaced: in this case, USD LIBOR. The idea is to define the processes in the event LIBOR (or any other benchmark rate) is not available. The ARRC stated in their report that most of the contracts referencing LIBOR may not have a robust fall back language. Hence, they have published a recommended set of fall back provisions that can be used by the market participants with an aim to reduce serious market disruptions in the event that LIBOR is no longer usable. Firms are advised to incorporate robust fall back language in the new contracts referencing USD LIBOR to help facilitate a smooth transition to the alternative reference rates.

Since there is a lack of industry standard documentation across lending products, fall back provisions vary from deal to deal, and some contracts may not contain fall back provisions at all.

Generally, the existing fall back provisions in loan documents only apply when a rate becomes temporarily unavailable. The fall back options were not intended to cater to a scenario of permanent cessation. The fall backs themselves are based on LIBOR rates and, therefore, do not work once LIBOR is permanently discontinued and replaced by a different benchmark rate. Existing fall backs also, do not include the ability to adjust the credit spreads to ‘re-balance’ the economic equation.

Unlike the standard International Swaps and Derivatives Association (ISDA) agreement, facility agreements are negotiated on a deal-by-deal basis. However, lending documents generally follow similar conventions, interest is comprised of LIBOR plus a margin, interest periods are selected by the borrower and the rate is set at the beginning of the relevant interest period, with the interest payment falling due at the end of that period. Because of the structural differences between LIBOR and Risk-Free Rates (RFRs), it is not a simple case of ‘like for like’ substitution. While LIBOR was calculated on the basis of expected rates, RFRs are based on the data of actual transactions. As RFRs begin to gain market acceptance, RFR market conventions will emerge. In the meantime, the loan industry bodies have published consultation drafts for market participants to consider and use in rare transactions (where the lender and customer are both ready to use RFR).

ISDA will be updating the 2006 ISDA definitions for the LIBOR fall backs. Each affected currency will have a specific set of fall backs. Generally, the structure of the proposed fall back waterfall for LIBOR is:

1. Adjusted RFR (i.e. overnight daily simple/compounded RFR + spread adjustment)
2. Recommended replacement rate for RFR (as formally recommended by the Central Bank or other supervisor)
3. Central Bank rate + spread adjustment.

ISDA will keep on publishing the Libor fall backs and updates on the same. The effective date for LIBOR fall backs is expected to be <3> to <4> months after the publication date. Any new Derivative trades using the 2006 ISDA definitions, entered into after the effective date, will automatically include the new LIBOR fall backs.

Derivative trades entered into before the effective date will not automatically include the new LIBOR fall backs. ISDA will release a protocol at the same time as updating the 2006 ISDA definitions to cover this legacy trade population. Both parties must adhere to the protocol for the LIBOR fall backs to apply to the legacy trades. If one or both parties do not adhere to the protocol, then the existing fall backs remain unless, the parties separately agree to the applicable LIBOR fall backs for their trade. This approach will take a lot longer.

The protocol is the way in which ISDA enables the adhering parties to amend Derivative transactions and agreements with other adhering parties. The protocol applies to the Derivative transactions and agreements entered into, before the effective date of the LIBOR fall back changes to the 2006 ISDA Definitions. A party’s agreement to use the protocol is referred to as the ‘adherence’. The process of adherence can be done directly through the ISDA’s website and requires a party to execute an Adherence Letter, which can be uploaded on ISDA’s website. ISDA will publish the names of the adhering parties. For parties that are ‘ISDA Primary Members’, the cost will be USD 500. For all others, adherence will be free till Jan 25, 2021, which is the date on which the protocol comes into effect. Counterparties may exclude agreements (including confirmations) from the operation of the protocol by written agreement. The operational impact of some agreements being covered by the protocol and others not (and needing bilateral amendment to include robust fall backs) needs to be carefully considered by the parties.

There are some key differences between the LIBOR rate and the RFRs, which necessitate the ‘Spread adjustment’ to be incorporated. For instance, RFRs are backward looking overnight rates and do not include a term structure or credit spread. RFRs are also near risk-free rates and may be secured or unsecured. By contrast, LIBOR is an expected rate that is unsecure and quoted for multiple tenures. Since LIBOR is an inter-bank rate, it includes a bank credit risk element as well. For all existing transactions, the Spread adjustment will be a one-off exercise that will entail inclusion of a static factor that is calculated once the LIBOR cessation is formally announced. The spread adjustment for Derivatives will be based on the 5-year median of the LIBOR-RFR spread.

Bloomberg Index Services Limited (BISL) has been selected by ISDA as a calculating agent to calculate and publish the ‘Spread adjustment’ for Derivatives. Bloomberg will publish the RFR, the spread adjustment, and the all-in fall back rate for selected tenures.

Consultations are currently ongoing between various Loan and other Market associations, in order to develop a protocol on the transition from LIBOR to RFRs.

Once the most appropriate strategy for the transition is finalised between the borrower and the lender (and will most likely follow guidance from the relevant Loan Market Association and be dependent on the emergence of market conventions), the facility agreement will need to be amended to reflect the RFR-related amendments.

The specific transition process will depend on the terms of each facility agreement and will therefore, need to be managed on a case-by-case basis.

While industry bodies representing the Loan Market and ISDA are trying to establish consistency across product types, it might be difficult to match the fall back terms across the markets, as their members may have differing views with respect to the product specific requirements (e.g. first fall-back for loans is a forward-looking term RFR (if one exists)).

Products that require discounting like Trade Receivables and Payables may need forward-looking term rates. However, it is unclear whether forward-looking term rates will be available in time. Industry is still assessing the appropriate solution for these products.

LIBOR is a forward-looking rate (i.e. the interest rate and the interest amount due are known at the start of the loan period but the interest payment is made at the end of the period). So borrowers are aware of the cash outflows in advance and can keep funds available accordingly.

However, RFRs are backward looking rates. Hence, the applicable daily fixings for the entire interest period will be known only at the end of the interest period, resulting in the final interest amount being calculated only at the end of the tenure. While transparency is an advantage of the new regime, the disadvantage is that borrowers will not know the interest payable on the due date at the beginning of the interest period, leading to cash flow related uncertainty compared to the LIBOR regime.

The industry bodies are currently considering various options like backward shifting of the observation period for a certain number of business days for the calculation of interest.

ICICI Bank is not a legal, tax or accounting advice agent. The company should seek independent legal, accounting and tax advice on the transition from LIBOR to RFR.

While different Loan and Market associations are trying to align the protocols, there is unlikely to be a match due to the different product segments. Hence, potential differences in the fall back methodology between different product types may complicate the transition. Due to this aspect, entities will have to carefully consider the impact of a transition of any products that are linked (such as a loan and hedge).