Preparations being made in the UK | replacement Sterling Risk Free Rate
Amy Crick: Good morning, and welcome to our latest client briefing on the topic of LIBOR transition. I am Amy Crick and I head up the Northern Eastern and Scotland Real Estate teams within Barclays Corporate Bank. I am joined today by three of our specialists on the topic of LIBOR transition. Rob Bourke, our head of ITV debt structuring, Richard Cavell, a director in our Risk Solutions Group and Doug Laurie, our programme lead for the LIBOR Transition Project.
Before I hand over to Rob for today's presentation, I wanted to set the scene by quoting from a speech from Andrew Bailey, the Governor of the Bank of England. He says, 'well, the summit or the summits that are the cessation dates for LIBOR are now clearly on the horizon, with the FCA announcing earlier in the year that Friday, the 31st December 2021 will be the final publication date. The panel bank sterling, Japanese yen, Swiss franc and euro LIBOR rates, along with a number of lesser used US dollar tenors, the remaining US dollar tenors will cease in mid-2023. These summits have been on the horizon for over a decade and have been well signposted that they are now clearly visible. But at any time, I will tell you the hardest part of mountaineering is often the descent. It can often be more treacherous than the climb'.
In today's session, we'll be answering a number of frequently-asked-questions on the topic of LIBOR transition and outlining the steps that you must now take in the form of pre-emptive action to ensure that you are able to navigate the descent from the LIBOR summit on a sure footing. As with all of our legal briefings, we will aim to keep this as brief as possible. You will hear back from me at the end of the session when I will be presenting your questions to our team of experts. And on that, a reminder to use the Q&A box on the platform to submit your questions. Rob, over to you.
Rob Bourke: Thank you, Amy. And good morning and welcome from me. We last hosted a call like this on the 5th of March serendipitously, as that was also the date that the IBA made its pre-cessation announcement, and fallback five-year historic median spreads became locked. Now, hopefully, that statement made sense to you, and concepts such as pre-cessation credit adjustments, spreads and five-year historic median are relatively familiar. And if they are, this call should serve as an update on the project. Key developments over the last month. A summary of the more pressing themes and to look ahead for the second half of the year. But if those concepts aren't familiar, you might find it helpful to listen to the playback of that March call.
Now, as then, we are conscious that this is a relatively esoteric topic and that attention span cannot be expected to hold for the full hour. So you might be relieved to hear that the presentation itself is timed at roughly 25 minutes, leaving for Q&A. This morning - the areas we're going to be covering this morning are those that we have encountered most often in the last few months. We're going to start by reminding ourselves of the timing milestones, the most pressing being in sterling. Sterling LIBOR will for practical purposes, cease to exist beyond 31st December this year. This has been well signposted and is hopefully not news. But do be aware, however, the UK regulatory authorities have a nearer-term focus on the 30th of September. The concern is that leaving transition conversations until later in the year risks a bottleneck of demand on management, lenders, advisers and lawyers time and bandwidth. And we can already see that many law firms are increasingly busy covering LIBOR transition alongside new origination and refinancing.
So the FCA and PRA have made it clear to lenders that they expect them to be working with borrowers to an end of September milestone. And the recent announcement from the Risk-Free Rate Working Group written with inputs from the ARRC and UK finance have underlined the point. So regulatory scrutiny is intensifying. And if you have not already, you should expect to notice a higher level of communication from your lending group over the coming weeks.
Turning then first of today's topics, extension options. Any new study facility today or any increase, even by way of accordion needs to be on a SONIA or Bank of England bank rate basis, and this has been the case since the regulatory deadline of 31st first of March. From that date, banks have only been permitted to document switch provisions as a means of active transition when no new LIBOR exposure is being created. There has, however, been some ambiguity around embedded extension options, i.e. extension options that have already been documented in the facility agreement. Does their exercise create new LIBOR exposure?
UK regulators are becoming more focused on these situations, and even where the extension option is pre-existing or embedded, i.e. known to the banks at the time of the original credit approval and therefore no surprise to anybody, they would expect parties to deal with transition as part of exercising the option, immediately transitioning the facility to SONIA or Bank of England base rate, sorry, Bank of England bank rate or as a minimum, including switch language such that the facility transitioned to solely on cessation. So if you have an extension option in place that you intend to exercise shortly and would prefer to do this as quickly and mechanically as possible, leaving LIBOR or transition as a dedicated exercise later this year, please be aware that banks will ask you to ensure that switch language is included.
If you have a multi-currency facility, you will find that there are separate considerations for the major currencies. The situation with Euros is straightforward, with the ECB not having set a cessation date, there is no need to change existing EURIBOR-based drafting. There is nevertheless a EURIBOR alternative, ESTER, and banks can offer the same compounding methodology as per SONIA and SOFR with LMA documentation following the same conventions as for SONIA.
The situation with US dollars is, however, more complicated. You may recall the Fed announced in December last year that the cessation date for dollars was to be extended to June 2023. This means that dollar does not face the same near-term transition pressure as sterling. You may choose, therefore, to leave your dollar provision unchanged for the time being and address the necessary amendments closer to that June 2023 deadline, and some borrowers have chosen to go down that route. Others have preferred to avoid the need for another LIBOR-related amendment process. The management time it involves and the legal costs incurred and address dollars as part of the sterling transition process. As a reminder, LMA documentation uses the same conventions for SOFR, as for SONIA and ESTER, and a document that either moved to SOFR immediately upon amendment or on a switch date pre-June 2023 won't need any more dollar LIBOR-related amendments.
There is, though, a risk that dollar conventions evolve over the intervening period and that the market eventually settles on a construct that is not reflected in your document. You may decide that is not a risk you want to take and would prefer to run a dedicated dollar amendment process at some point over the next 18 months. On the other hand, you may take the view that the published SOFR conventions are fit for purpose, having been endorsed as such by the US authorities, and that any difference that might arise versus emerging conventions between now and June 2023 are likely to be minimal and/or not worth the additional expense in time and legal fees that would come with a second Amendment process.
Why has there been this delay in dollar LIBOR transition? In short, it's because the US authorities recognise that different conventions could emerge. And if we're to try to simplify the drivers for this, we could point to two things. First, the dollar OIS market is far larger and more liquid than, say, its sterling equivalent. A term rate that was built off the executable levels in the OIS market could well, therefore, meet the core regulatory criteria of observable real-world liquidity.
The second reason is that SOFR, unlike SONIA, is a secure rate. It is secured on US Treasury bills, and so the SOFR rate can reflect not only the level of stress in the banking system, as does SONIA, but also sentiment around future Fed policy. To address this point, US banks have been exploring the idea of a credit-sensitive spread. For example, the Bloomberg Short-term Bank Yield Index, or BSBY, seeks to measure the average yields at which large global banks access senior unsecured funding in US dollars. The idea being that this better reflects the risk in the overall banking system that a LIBOR replacement should be expressing. US regulators, however, are wary of the underlying data and overarching governance of credit-sensitive rates and the potential that use of such rates may lead to similar issues to LIBOR in the future.
But if there is to be an acceptance that SOFR is not as clean a representation of the near risk-free rate in US dollars, it may be that appropriately governed term rates are the better solution. And we expect the ARRC to recommend a SOFR term rate in quarter three this year, driven by the expected increase in underlying SOFR-base to derivatives through the SOFR First Initiative, which plans to switch global swap screens, 'SOFR rather than US dollars'. Now, although overnight compound in arrears rates will remain the most liquid and closest to the derivative market, allowing clients to standardise the interest methodology across currencies, the SOFR term rate is expected to have a much broader set of use cases than the equivalent SONIA term rate.
What has been encouraging and reassuring is the pace with which the LIBOR transition topic has moved since the deadline for new sterling issuance last September. At that time and even by the March call, there were question marks around the underlying conventions for compounded SONIA. You may recall some of the moving parts, such as lag versus observation shift and cumulative versus non-cumulative compounding. Happily, this is no longer a topic of debate. Those moving parts are settled. Lenders, advisers, the NNI and lawyers are clear that the convention for compounded SONIA is a five-day lag without observationship and non-cumulative compounding.
But with the compounding formulae and methodology now having achieved the status of standard boilerplate language, the key commercial decisions for you to consider are when to transition at cessation or earlier. The multicurrency facilities, whether to solve for all currencies now or accept that they will be further amendments as conventions crystallise, particularly in the case of US dollars. And if you are moving from LIBOR to SONIA, i.e., not base rate, which method of agreeing the credit adjustments spread, do you prefer? The five-year historic medium or forward rates? In the weeks since the last call, it has become clear that more borrowers seeking an active transition rather than transition cessation want to understand the relationship between the five-year historic median and a forward rate, the associated pros and cons.
As a quick recap, the five-year hostoric median spreads announced on 5th of March will be the fallback spreads that apply to derivative contracts, adhering to the ISDA fallback protocol from cessation on the 31st December. They have been endorsed by regulators as an appropriate method for addressing economic equivalence when transitioning loan contracts. There needs to be a credit adjustment spread because compounded SONIA has historically produced a lower rate than its equivalent LIBOR. Without a credit adjustment spread or cost and with margins remaining unchanged, there would be a value transfer upon transition.
The core Barclays offering remains transition at cessation using the five-year historic median. That way, as we outlined in the previous call, contracts are kept on LIBOR for as long as possible under the current shape of the sterling LIBOR curve. That means a lower interest bill versus actively moving to SONIA plus the five-year historic median credit adjustments [inaudible]. That relationship could change between now and year-end, in which case borrowers can expect an active transition at an earlier date than 31st December. Or you may choose to transition ahead of cessation for operational reasons or in order to align with an associated hedge.
Now, an earlier transition is known as an active transition, and for active transition, regulators have stated that while a five-year historic median plus remains appropriate, borrowers and lenders can also consider a forward rate. Credit adjustment spread using forward rates type[?] spread being seen in the market today, as opposed to the fallback spreads of the market, would apply from 30 December, forward rates are also tailored to the facility's maturity date. As we approach cessation, the gap between the forward rates and the five-year historic median should close. But for the time being, there is a difference, and Forward rates are lower.
For Illustration, five-year historic median spread for Sterling are set out in this table are frequency basis points for one month interest period, 11.9 for three months and 27.7 basis points for six months. For a facility with three years until a bullet maturity, the forward rates as of 24th of June, when the first draft of this presentation was written, were 2.5 basis points at one month, 9.9 at three and 20.8 at six months. So a difference of roughly 0.5 to 7 basis points, respectively.
An active transition today using forward rates would therefore produce lower interest costs than transitioning today using the five-year historic median. However, it is important to recognise that remaining on LIBOR until cessation continues to offer a lower interest cost in that period to cessation. There can be no guarantee that this dynamic will continue for the rest of this year, but if we take one month interest period as an example, compounded SONIA sacrifice basis points, plus a forward rate cost of 3 basis points, 3.3 basis points, so it's a 3 basis points, will yield more interest than one-month LIBOR of sacrifice 5.5 basis points. So a decision to opt for active transition needs to consider the remaining life of the facility and the interest savings that could be realised through remaining on LIBOR until cessation.
Now, for the avoidance of doubt and conscious of the jargon that any technical subject will spawn, actively taking steps to ensure your facility is ready for a transition at cessation is not the same as active transition. Active transition is moving now from LIBOR to SONIA plus cost, which could be the forward rate. Transition at cessation means staying on LIBOR until cessation, then automatically switching to LIBOR, plus the five-year historic median cost. But you will need to take steps actively ahead of cessation to ensure your facility is ready for that transition.
Forward rates also bring some practical operational considerations. Each rate is bespoke to the remaining life of your facility and requires a specific calculation. Banks may involve their swap desk to produce and/or verify those rates, and banks typically have their own swap pricing tools. You may wish to ask a number of banks to produce rates in order to identify consensus levels. There is also the question of when to calculate the forward rate. Banks may want to know the rates before they can obtain final credit approvals. Leaving the calculation until late in the process might mean banks don't have time to confirm approvals before the proposed amendment date. And we cannot yet point to settled market conventions on forward rates.
But we can say in summary that forward rates currently yield a lower cash than the five-year historic median. That agreeing forward rate and deciding when to fix those rates brings operational considerations. And that a lower forward rate cost needs to be weighed against the cost of LIBOR until cessation then certainly plus five-year historic median until maturity.
The last topic we're going to address today in the presentation is loan-linked hedging. When hedging is involved, the key questions of when to transition with what credit adjustment spread and on what conventions necessarily take on another dimension. ESTER has established a defined set of conventions for the derivative market. However, these definitions don't all align to those of the loan market. Each situation will have its own commercial drivers and considerations that we can perhaps set out some key questions to address.
First, is the swap linked, i.e., a condition of the loan approval or a standalone hedge? Is your swap counterparty the same as your lending bank or banks? In a club or syndicated facility, do all lenders participate in the swap, or is it held with a subset? If the latter will all lenders accept the protocols agreed with the swap counterparties? Will these sign up to the ESTER fallback protocol, if you haven't already or actively transition the derivative? Do you and your counterparty or counterparties agree on the approach to reconciling the differences in the ISDA and loan conventions around large shift and floors? There is no one-size-fits-all or right and wrong answer to these questions, but we cannot overstress the importance of early engagement and dialogue.
By way of illustration, let's take a relatively simple scenario. A bilateral loan fully hedged by way of a linked swap of matching tenor transitioning at cessation using the ESTER fallback protocol will have a five-year historic median cash payable by the borrower on the loan that matched the five-year historic median cash payable to the borrower on the swap. However, even in the simplest example, the conventions behind the loan and the derivative will differ. The lag period for calculating the interest costs is two business days in the ESTER fallback conventions, but five business days in the loan conventions that we described earlier if the conventions use observation shift, loan conventions do not. On these points where the amendments are being made bilaterally, by outside of it, the fallback protocol, Barclays would avoid a mismatch by amending the hedging agreement to align to the five business day loan convention without observation shift.
There is also a difference in the conventions for treating SONIA floors, for which the Bank of England recommends the following for loan transition. First, parties are free to decide whether the floor applies following the transition to SONIA and at what level. Second, for legacy contracts containing a floor, it is recommended that SONIA is adjusted so that SONIA plus the credit adjustments spread is not less than the floor. And third, that the floor is applied daily and not at the end of the interest period. The derivatives convention, on the other hand, is for an average rather than a daily floor.
The Barclays core offerings to align the transaction to the convention's average floor on the hedge and daily floor on the loan. We do, however, need to highlight that this could result in a mismatch in the event that rates were to go negative in the middle of an interest period. If this is a concern, the benefit of daily floor protection in the derivative can be purchased. In fact, to be transitioning by reference to a forward rate cost, the five-year historic medium does not apply and the costs will be calculated by market-driven price in much the same way as we discussed earlier for the line[?]. This may result in a lower cost to the five-year historic median being payable or take effect through a corresponding adjustment to the swap or strike rate.
To reiterate, there is not a perfect answer to many of the questions that loan-linked hedging poses. But we do sense that banks fully appreciate the desire to minimise basis risk, and we'll work with you to effect[?] a seamless transition across the loan and hedge as possible. Of course, early engagement is recommended not just for loan-linked heading, but across the LIBOR transition topic. As we move through the second half of this year with customers - with summer holidays not too far away, and many borrowers having reporting season as a priority in September, quarter four will be with us before we know it. And we expect to see a marked increase in LIBOR transmission and activity over the coming months. And we do not underestimate the scope of bandwidth compression, not just among lenders, but also the lawyer and adviser communities as we head into Q4.
Barclays is ready now to help you navigate this change, please don't hesitate to ask your relationship director how we can assist. Now as we started a couple of minutes late, I think that is pretty much bang on 25 minutes. So, Amy, I'm going to hand the mic back to you.
Amy Crick: Thank you, Rob, and for that really, really useful update. And so in summary, I think what I'm hearing is before you crack your summer holiday suitcase this year, there are a few important things that you need to put in motion now to arrange for the transition of your facilities from LIBOR to the alternative rates if you've not already done so. And as a quick recap, the questions that you will need to answer are, firstly, the sterling facilities, you have to decide if you will move to SONIA and/or if you are in state for our Bank of England base rate offering. Secondly, for - and - secondly, when are you going to transition? And is it going to be at cessation or earlier? And as outlined by Rob, our core offering remains transition activation, but an alternative active transition may be more suitable for you.
Thirdly, is there any loan-linked hedging in place? And if so, will you transition that at the same time at cessation or earlier? And will you sign up to the ISDA fallback protocol? So multicurrency facilities, you will need to decide whether to sell for all currencies now or accept that there will be further amendments as conventions crystallise. And finally, if you are moving from LIBOR to SONIA, which method of agreeing the credit adjustment spreads do you prefer? The five-year historic median or a forward rate?
We will now take a look at some of the questions that have come through the platform and thank you very much for those that have presented those questions to us. A reminder, if you do have a question, then please submit those in the Q&A box on the platform and we will try and get through as many as we can in the next ten minutes. First question and I'm just looking at the platform is I want to increase my facilities by just a small amount. Is a transition activation still available to me? Rob, are you able to take that one?
Rob Bourke: Sure. And the simple answer is no, it is not. Increasing the facility amount, even by way of a documented accordion option, counts as a new LIBOR exposure, and therefore such request or exercising an accordion option can be done, but it would have to move the facility to SONIA at the same time. So it would have to be an active transition, you wouldn't be able to wait to switch until cessation.
Amy Crick: Lovely. Thank you, Rob. We've got now a few questions that are coming through on loan-linked hedging. The first question I'll direct to you, Richard. How do we sign up to the ISDA fallback protocol?
Richard Cavell: Thanks, Amy. So the ISDA fallback protocol, is that, as you'd imagine, government by ISDA, so very simply, it's via their website. So a couple of different ways of getting at it. But probably one of the simplest ways is either just to do a search engine, search for ISDA LIBOR fallback protocols and follow the link. Or you can type in isda.org/protocols, plural, and that'll take you specifically to the ISDA the protocols website. Now, to reduce a number of these things and so if you scroll down, I think it's probably about four or five down, there's a specific one called ISDA 2020 LIBOR Fallbacks Protocol, and to help, it was produced on the 23rd of October. And so they list these by dates of production. So 23rd of October last year, and it's called the ISDA 2020 LIBOR Fallback Protocol.
And it will take you to a very good website there, which has an overview of what it is. It has frequently asked questions and then down the right-hand side, it has all the links for information that you'd want, including, you know, the exact detail of what it is, the document itself, plus a very good step by step guide as to literally how you work your way through the system and actually sign up to it. And in addition to that, you can also view who has adhered to it as well.
Amy Crick: Lovely. Thank you, Richard. The next question that's come through is my hedging tenor does not match my loan tenor. Does this influence how I approach agreeing the credit adjustments spread? I'll take that one. If you have a longer-dated hedge in tenor and you are proposing to actively transition at a forward credit adjustment spread, then this may result in a different credit adjustment spread that would have been quoted for an active transition on the shorter-dated loan. This may very well not be a concern to you if your loan is fully hedged, but if it is only partially hedged, then you may want to preserve the ability to match the forward credit adjustment spread to the tenor of the loan. And certainly Barclays, we can facilitate that for you.
The next question relates to syndicated facilities with linked hedging and therefore a number of hedging counterparts. The question is will a transition activation at a five-year historic median be easier to coordinate with the multiple hedging counterparties? And are there any downsides? Richard, are you able to take that one for us?
Richard Cavell: But yeah, sure, no problem. So simple answer it well, actually, there's multiple kind of layers to this, but the easiest way to get consistent adjustment spread at transition is to do it via the protocol. That would ensure that you get exactly the same credit adjustments spread across all counterparties on your derivative. Point to note on that, though, is the - and the loan terms are not exactly the same. So using the obvious example, look back periods, it's five days in loans, typically in two days in the derivatives. Therefore, there will need to be some amendment to the derivative to match back to the loan terms after you've transitioned under the protocol.
The other thing as well to mention is you can't kind of get - you can't guarantee that there won't be an execution charge to make those amendments. It should be very small if there is one, and there might not be one. But of course, when you're dealing with multiple banks, you know, we can't speak for other people. But you are starting. You are at the same starting point. That I suppose is probably the best way to describe it. A couple of other things to note. Clearly, any early debt amendment, as Rob has just alluded to in this Q&A and at the beginning of his talk, any early debt amendment would impact on your - or could impact on your ability to use the protocol if you were trying to match up terms. If you have to move your debt to SONIA early and you're trying to match the timing, then obviously you can't rely on the fallbacks for that.
But alternatively, as well, you can still transition without the protocol. You know that's done bilaterally with each of your hedge counterparties. It's likely to have slightly different credit adjustment spreads across or counterparties, but you're locked in at that point, so you at least know what those numbers are, even if they might be different. And we have seen some clients do it already, so I did one earlier on in the week for a client with - where we executed outright and they did the same - likewise with the other counterparties.
Worth noting, just regardless of your strategy signing up to the protocol, if nothing else, it does provide a backstop. It doesn't prevent active transmission if you've signed up and it doesn't cost anything to do, so it's worth worthwhile considering doing it even if you are considering an active transition. So I guess going back to the original question, Amy, you know, yes, it is easier, but it's not perfect, and it needs to be weighed up with the alternatives to determine what's best for your individual situation.
Amy Crick: Thank you, Richard. Just looking at the questions coming through now, we've got a couple of ones around legal advice and legal costs. Doug, I'm going to direct these to you if that's okay. The first question is, do I need to get my own legal advice and appoint a lawyer?
Doug Laurie: Ultimately, yes, you should consider taking your own legal advice. In terms of legal costs for any transition, Barclays for bilateral facilities will pick up the cost of transition, so we will pick up our own legal costs. But I think the expectation would be that clients would pick up any costs that they have in engaging with their own advisers.
Amy Crick: Absolutely. Thank you, Doug. Next question - and we just got a couple more is what happens if I do not consent to the amendments? How will the loan operate if it is not amended? Doug or Rob, do you have - either of you have a preference to take that one?
Doug Laurie: I'm happy, Amy, it's Doug. So Ultimately, I would suggest that each client looks at their loan agreement carefully to understand what would happen. I think there is a danger in some contracts that the contract or there is essentially uncertainty around how interest would be calculated post liable cessation and thus the reason or the benefit and the focus on updating documentation. There has been some focus from the authorities around potentially some form of tough legacy protection for contracts which don't transition or are unable to transition on time. That, I think is very much a full battle lost, last chance saloon mechanism and we are yet to see how that would work, but potentially it may leave clients in a worse off position. So I think the focus at the moment is around trying to transition and to negotiate terms which are applicable to everyone in the syndicate or work for everyone in the syndicate. But I guess there is potentially a fallback option, but it may not be suitable for a client and there is likely to be significant restrictions from the authorities around issues.
Amy Crick: Thank you, Doug. And I think the final question that we'll present today is if the US regulators are looking at a term rate solution, is it likely that the UK and other authorities will have to follow suit?
Doug Laurie: Let me tackle one, Amy.
Amy Crick: Thank you, Doug.
Doug Laurie: Yeah, I'm happy to take that one, Amy. So I think it is unlikely. So the - as I think Rob mentioned earlier in the presentation, there is a way to generate a term rate based on underlying swaps and futures activity on the underlying risk-free rates, but volumes in sort of one-month, three-month tenors are not as liquid as overnight tenors, so it potentially has stronger benefits than some of the challenges we have in LIBOR today. But the underlying market in some cases is still relatively low. So from a UK perspective, the authorities have therefore generated a term rate for very, very specific use cases, but are concerned or are restricting usage because I think in their view, the compounded rates are much more liquid and also that if the rates are overused, there is a risk that the underlying derivative data, which is used to derive that that banks may become worried about[?] and continue to provide that rate, and we end up with a similar challenge to LIBOR today.
So for US dollars, the US dollar market is much more liquid, and therefore there is a belief that there may be - that particular rate may be able to support more use cases than the one[?]-year term rates. But I think, as Rob mentioned earlier in the presentation, the most liquid and the solution that will be the closest to the derivative market and easier to hedge would be a compounded in a rear[?] solution.
Amy Crick: Thank you, Doug. And I expect we can wrap it up there. And I would just like to finally take the opportunity to thank our team of experts and for joining us today and thank you all for listening. I wish you all a safe and happy summer. And Operator, we can close the call there. Thank you.