The London Interbank Offered Rate (“LIBOR”) will soon begin its long good-bye. The currencies for which LIBOR will initially be phased out include GBP and JPY. In this regard the Financial Conduct Authority (“FCA”) in the UK has already issued a press release in which it confirmed that, to avoid disruption to legacy contracts that reference the one, three and six month GBP and JPY LIBOR settings, it will require the LIBOR benchmark administrator to publish these settings under a “synthetic” methodology, based on term risk-free rates, for the duration of 2022. These six LIBOR settings will be available only for use in some legacy contracts, and are not for use in new business.
The question on most lips in South Africa, however, is what options are available to market participants in place of USD LIBOR and do we really have to use that backward looking rate. Two things are true:
- USD transactions by number and volume make up the biggest hard currency exposure in South Africa (and likely most other jurisdictions in Africa), and
- the US domestic market appears, at this stage to favour a multi-rate environment (notwithstanding the recommendations of its risk free rate working group).
The wide spread but informal endorsement of different rates has, allowed parties to start thinking more broadly about the rates that they wish to apply in respect of their own products.
To recap; USD LIBOR will continue to be published until end June 2023, which means that legacy loans can continue to use USD LIBOR for the time being. New loans should not be referencing USD LIBOR or if loans do use USD LIBOR, in the case of most South African new hard currency loans, those new loans should contain rate switch language that will bake into a document the chosen alternative rate. This will also set, amongst to the switch and economic related items, the date on which the rate switch will occur or at the very least replacement of screen rate language (tweaked for bilateral loans).
compounded in arrears SOFR
As in the UK, the compounded in arrears structure, using the Secured Overnight Financing Rate (“SOFR”) is an option for USD loans and remains the rate recommended by the Alternative Reference Rate Committee (“ARRC”). The ARRC was established in the US to deal with the transition away from USD LIBOR. This rate remains recommended on the basis that it:
- complies with IOSCO principles,
- is based on transaction data, and
- is incapable of manipulation.
With this structure, the overnight SOFR rates are compounded over the relevant interest period and the interest payable at the end of the term is not known up front, though some visibility can be offered by calculating the rates over an observation period. The LMA recommended form risk free rate agreements use this rate methodology. Compounding in arrears is a methodology that compounds daily values of the overnight rate, throughout the relevant term period.
daily simple SOFR
The ARRC has recommended daily simple SOFR for its simplicity. For daily simple SOFR in arrears, SOFR is sourced daily and multiplied by the outstanding principal of the loan. In general, compounding in arrears is chosen above daily simple SOFR because it reflects the practical reality that a borrower would not pay interest daily but rather over a term.
SOFR averages (applied in advance)
Another option in the US loan market is to use SOFR averages (applied in advance), which reflect the SOFR rates from a prior 30, 90 or 180 day period. These SOFR in advance rates provide visibility as to interest payments at the start of the interest period akin to the LIBOR world we currently operate in. Yet, as they are based on the prior rates, SOFR averages don’t reflect movements during the actual interest period. So, while this has payment certainty for a borrower, for example, the borrower may need to hedge any basis risk associated with utilising a historical rate.
By contrast, term SOFR looks at what the rate would be over a given term based on what is implied by derivatives markets for the term and is conceptually the closest to LIBOR. On 3 August 2021, the ARRC formally recommended the CME Group’s forward-looking SOFR term rates. Alongside this recommendation, the ARRC issued Term SOFR—scope of use. The three key situations in which the ARRC has recommended Term SOFR for use (alongside other forms of SOFR) are:
- for business loans, particularly multi-lender facilities, and trade finance loans,
- certain securitisations that hold underlying business loans or other assets that reference Term SOFR and where those assets cannot easily reference other forms of SOFR, and
- end-user facing derivatives intended to hedge cash products that reference Term SOFR.
Term SOFR has considerable wider use cases than Term SONIA (the UK recommended risk free rate). The ARRC continues to recommend that market participants continue to use overnight SOFR or SOFR Averages rather than Term SOFR in other situations, including, inter alia, the derivatives market (except for the limited use case above), floating rate notes, and most securitisations. Such has been the demand for a term rate in the developing markets where the movement to a backward looking rate is practically difficult that the LMA is currently working on a term rate document for the developing markets. The draft document will initially be published in exposure draft form.
credit sensitive rates
In the domestic US market, some institutions are promoting the use of credit sensitive rates, such as Bloomberg’s Short Term Bank Yield index (BSBY), and the American Interbank Offered Rate (AMERIBOR) instead of SOFR. This is being strongly discouraged by UK and US regulators, principally because these rates do not comply with the IOSCO principles of robustness leading to (potential) financial instability and the possibility of rate manipulation (much like LIBOR). Parties that choose to use these rates should also consider the hedging risks associated with using an alternative rate such as this.
This article commenced with two truths; here is another – this is a dynamic space. Be ready, don’t wait to understand your best positions until your bank presents you with its best option.
This article was first published by ENSafrica (www.ENSafrica.com) on 13 October 2021.
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