UK: The Brave New World Of RFRs

LIBOR has almost been consigned to history for new transactions. However, there are still some areas relating to the use of near riskfree rates (RFRs) where the market has not yet settled.

Five tenors of USD LIBOR continue to be published and remain representative, but the new use of USD LIBOR is prohibited in most circumstances. Various forms of SOFR are in use in the lending and bond markets, and the conventions around the use of term SOFR, in particular, are still nascent.

Synthetic LIBOR continues to be published for one, three and six month sterling and yen LIBOR, however this is not available for use in new contracts in most circumstances. It is intended to assist legacy transactions which were not actively moved to RFRs before 31 December 2021 and is not a long-term solution. In this briefing we discuss these issues in more detail.

What are the options for new USD debt?

• The FCA has prohibited the new use by supervised entities of the five remaining USD LIBOR settings after 31 December 2021. The same approach has been taken in a number of other jurisdictions, including the US.
• In the US loans market, there are several available forms of SOFR including:
  • Daily simple SOFR in arrear;
  • SOFR compounded in arrear;
  • SOFR compounded in advance; and
  • term SOFR.
• The bond market has adopted a similar mixture of approaches for using SOFR to calculate interest.
• Compounding in arrear:
  • In the UK, since many lenders are now familiar with compounding in arrear, and term SONIA is only recommended for use in limited circumstances, a number of lending transactions have adopted the compounding in arrear methodology, following the LMA documents.
  • There are relatively few points to debate when using the compounded in arrear approach: for example, whether a credit adjustment spread (CAS) to compensate for the term liquidity premium that was an element of LIBOR but is not reflected in RFRs remains relevant for day one RFR loans or whether this should now be priced into the margin.
  • The market is largely settled on most other elements of the use of compounded RFRs for sterling, and these agreed market conventions often flow through to the use of SOFR, such as the exclusion of break costs (albeit some lenders may seek a limit on voluntary prepayments to reduce the administrative burden of mid-interest period calculations) and market disruption.
  • However, these conventions are not settled for all currencies, for example SGD loans have tended to use the swaps convention of a shift rather than a lag approach, and settle the CAS on a deal-bydeal basis rather than using a settled approach.
• Term SOFR: the Alternative Reference Rate Committee (ARRC) supports the use of term SOFR in the US in certain circumstances. The LMA has published an exposure draft term SOFR developing markets loan agreement. This is not yet in recommended form; it provides a useful starting point but there is likely to be some change in market practice over the coming months and it is not yet clear how widely term SOFR will be adopted in other markets.
  • Term SOFR is calculated using derivatives to measure the forward-looking market expectation of future overnight SOFR over a period.
  • The CME Term SOFR Reference Rates are endorsed by the ARRC in the US and used in the LMA drafts. They are calculated for each day that the New York Federal Reserve calculates and publishes SOFR, and published at 5:00 am CT (usually 11am London time). They are published for one, three, six and 12 month tenors. A licence from CME Group is required for their use in calculations.
  • Term SOFR is an economic concept and not representative of lenders' funding costs. Therefore, whether elements of LIBOR loans which are predicated on the lenders' costs of funding their participation in a loan matching the reference rate in that loan (such as market disruption provisions, where the lenders' cost of funds for the loan in question is compared to the reference rate in the loan, or break costs) remain relevant to term RFRs is still an open question.
  • The approach to calculating term SOFR for interest periods other than the four for which CME Term SOFR is published, and particularly for periods of less than one month, will therefore need to be carefully considered. Interpolation may be used, but for periods of less than one month, is interpolation between overnight SOFR and one month term SOFR the correct approach?
  • Longer-term fallbacks, should term SOFR be unavailable, also need to be considered. The use of simple average SOFR or a central bank rate as a fallback may be feasible, but falling back to some formulation of compounded SOFR, with all of the systems complexity that requires, may not be possible in all markets. There is likely to be a bifurcation in approaches in different markets on this.
  • Whether the CAS should be priced into the margin now, or whether it should comprise a separate element of the interest rate will need to be agreed. If it is to be a separate element, other questions arise in relation to its calculation, such as whether it should be a dynamic number (since the term liquidity premium element of LIBOR would fluctuate between now and 30 June 2023) or a fixed figure, for example the ISDA spread adjustment commonly used in the compounded in arrear methodology.
• ISDA used the compounding in arrear methodology in its Protocol and Supplement; it has produced draft term SOFR documentation though term SOFR swaps are not yet commonly used.
• In contrast, term SONIA has a much more limited use case and the compounded in arrear methodology is expected to be used in most debt transactions. Term SONIA is expected to be used only in certain markets which have a particular need for a forward-looking term rate, such as trade finance, export finance and emerging markets. Debt in these markets is often denominated in USD rather than sterling in any case, but there may be some multi-currency examples.

Synthetic LIBOR: what is it, and how is it used?

What is synthetic LIBOR?

• In order to reduce potential disruption to markets, the FCA used its powers under the Financial Services Act 2021 (which amended the UK Benchmark Regulation) to designate certain tenors of sterling and yen LIBOR as critical benchmarks. It was then able to compel ICE Benchmark Administration Limited (IBA) to continue to publish LIBOR for those tenors and currencies, using an altered methodology, and this is known as synthetic LIBOR.
• The critical benchmarks to date are one, three and six month sterling and yen LIBOR.
• Instead of being calculated using panel bank submissions, they are calculated as being the sum of:
  • the IBA term SONIA reference rate and the applicable fixed ISDA spread adjustment for each tenor, for sterling; and
  • the Quick Benchmarks Inc TORF (Tokyo Term Risk Free Rate, which is a forward-looking term TONA rate) and the applicable fixed ISDA spread adjustment for each tenor, for yen.
• Term RFRs are forward-looking term rates like LIBOR. They are a measure of the expectation of the relevant RFRs over a time period, based on data from the derivatives markets.
• The ISDA spread for each tenor is the credit adjustment spread published for the ISDA Fallbacks Protocol and Supplement that is published by Bloomberg and which is calculated as the five-year historical median spread between LIBOR and the corresponding RFR.
• The FCA has said that it does not expect that the changes in the calculation methodology for producing synthetic LIBOR should affect how LIBOR is displayed on the relevant screen pages.

Why should we not use it?

• Synthetic LIBOR for yen will cease to be published at the end of 2022; sterling synthetic LIBOR may be published, subject to annual review, for up to 10 years, though the FCA intends to canvass views on retiring one and six month synthetic sterling LIBOR at the end of 2022, so the concept is timelimited.
• The FCA has expressly said that synthetic LIBOR is not representative of the underlying market and economic reality that LIBOR was intended to measure.
• One reason for this is that the CAS, which is intended to measure the term credit premium element of LIBOR, is static, and not fluctuating.
• Another is that it is only published for the three tenors for each currency, so what rate applies for periods of less than one month, or greater than six months, would need to be carefully considered.
• There is a general prohibition (subject to exceptions) on the use by UK Benchmark Regulation supervised entities of the designated critical benchmarks (being one, three and six month sterling and yen LIBOR) since they no longer accurately represent the market or economic reality they seek to measure. The temporary use by supervised entities of the critical benchmarks is permitted in all legacy LIBOR contracts, other than cleared derivatives, that have not been changed at or ahead of end-31 December 2021.
• There is no restriction on the use of designated benchmarks by unsupervised entities, for example corporates, though it is unlikely to be a long-term solution or the choice of rate for new contracts between corporates, as discussed above.

Use of synthetic LIBOR in contracts

• Whether synthetic LIBOR is available for use in legacy contracts will often be a complex jurisdictional jigsaw, dependent on the legislative fixes in place in the relevant jurisdictions.
• In the UK, the Critical Benchmarks Act 2021 is intended to provide certainty that contractual references to LIBOR will be to synthetic LIBOR (where available). It applies to all legacy LIBOR contracts (save for cleared derivatives) and has retrospective effect in that it applies to contracts already in force.
• Where an English law contract includes a fallback waterfall that is triggered by the cessation or unavailability of LIBOR, the Critical Benchmarks Act 2021 provides that that fallback waterfall will NOT be triggered by the publication of synthetic LIBOR, ie references to LIBOR should be to synthetic LIBOR, for periods where this is published (one, three and six months, for sterling and yen). For other periods and currencies, it may be more complicated, and dependent on contractual interpretation.
• The Critical Benchmarks Act will not override fallbacks or replacement rates that have been agreed through active transition to RFRs.
• There are separate legislative fixes in the US and Europe, which can add to the complexity in crossborder deals. Our Banking Disputes team are very happy to discuss further if helpful.
• While synthetic LIBOR should be helpful for legacy loan agreements, the enormous active transition efforts in late 2021 and early 2022 should reduce the reliance on it.
• Synthetic LIBOR is generally not available for use in derivatives.
• Because of the difficulty in conducting consent solicitations in relation to bonds, many legacy deals will use synthetic LIBOR. The US legislative fix is likely to be of particular interest, given that consent thresholds are commonly 100 per cent. in New York law governed bonds, which makes consent solicitations of legacy US dollar LIBOR bonds under New York law impractical. Our debt capital markets team would be happy to discuss this further if helpful.
• Synthetic LIBOR may be useful for legacy commercial contracts where active transition has not been possible, though do note that it is time-limited. Non-UK law contracts will also require more complex contractual analysis, in addition to consideration of the legislative fixes available.

EURIBOR fallbacks

• The European Central Bank has made recommendations as to the fallbacks to EURIBOR, and the trigger events for those fallbacks to take effect. For corporate lending products these are either:
  • a backward-looking compounded ESTR plus a credit adjustment spread; or
  • a two-level waterfall, consisting of a forward-looking term ESTR on the first level, and a backward-looking compounded ESTR on the second.
• These recommendations are not commonly used currently in the loans market, and have not been given effect in the LMA recommended forms of facility agreements (though they could be adapted to do so); it is not clear what forward-looking ESTR should be used, and the ECB recommendations for the backward-looking compounded rate are not specific to the loans market so differ from the approach taken in relation to the compounded in arrear methodology used elsewhere in the LMA documents. However, some lenders are beginning to consider including these fallbacks in their euro loans.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.