New developments in plans for replacement of LIBOR

Background and relevance

Mr Bailey's speech comes one year after the FCA first flagged its intention to cease exercising its powers to compel LIBOR panel banks to provide quotes after 2021. Following that announcement, there has been much discussion among stakeholders in the debt and derivatives markets about what might replace LIBOR as an alternative benchmark rate. With his new speech, Mr Bailey has provided valuable insight into the FCA's views on what the post-LIBOR world could look like.

Mr Bailey's views are relevant to clients that use LIBOR as a benchmark for pricing loans or other financial instruments. 

Key takeaways

A key take-away from the recent speech was the FCA's assurance that the discontinuation of LIBOR is something that should be viewed as a certainty and not a remote possibility. In the FCA's view, financial stability depends on stakeholders in the relevant markets being fully prepared for the transition to LIBOR's replacement.

On the issue of what exactly should replace LIBOR, Mr Bailey's speech focused on the advantages of risk-free rates ("RFRs"). A number of jurisdictions have identified certain RFRs as potential successors to LIBOR, notably the UK (Sterling Overnight Index Average or SONIA), the US (Secured Overnight Financing Rate or SOFR) and Japan (Tokyo Overnight Average Rate or TONA). The EU is still working to identify its preferred RFR but has announced that a Euro Short Term Rate (ESTER) will commence publication in 2019.

At this stage, with little guidance as to what the replacement benchmark will actually be, we suggest that it would be wise to ensure that fallback rate clauses are included in loan documents and that, for syndicated loans, the level of lender consent required is considered. 

Comparison of LIBOR and RFRs

There are, however, certain key differences between LIBOR and RFRs, as highlighted by the note published by the Loan Mark Association (LMA) and the Association of Corporate Treasurers (ACT) on 20 July 2018 (a little more than a week after Mr Bailey's speech). In particular, the following key concerns were highlighted from a syndicated loans perspective:

• a transition from an overnight RFR without the availability of a forward-looking term rate would present practical and operational difficulties for borrowers, lenders and agents. In particular, LIBOR is generally set at the beginning of each interest period (typically 1, 3 or 6 months) and therefore allows borrowers and lenders to predict what the interest amount will be for the relevant period, whereas currently available RFRs tend to be backward-looking rates that fluctuate daily; and
• as RFRs do not price in either term risk (see bullet above) or bank credit risk (LIBOR being an interbank borrower rate), if applied to existing loans without there being a corresponding increase in the fixed margin, the amount of interest payable would decrease (this point is obviously more of a concern to lenders).

Mr Bailey's speech does, however, allude to these concerns and concedes that there is a need, in relation to syndicated loans, to explore the potential for creating forward-looking term rates based on the RFRs. 

In terms of how the above may affect your loan documentation, the Loan Market Association recently published a "Replacement of Screen Rate" clause for inclusion in facility agreements. This clause does not actually replace LIBOR, rather it allows for amendments to be made upon the occurrence of a "Screen Rate Replacement Event", ranging from the discontinuation of LIBOR to the parties' determination that the Screen Rate is no longer appropriate. Following the LMA standard clause, the choice of the "Replacement Benchmark" (the proposed replacement benchmark definition is broad enough to include a rate that is generally accepted as the relevant successor) falls to Majority Lenders and the borrower (i.e. not all Lenders).