Recommendations

USD LIBOR transition involves working through new loan pricing structures, updating operating and IT systems, considering tax and accounting implications, staff training, and customer education and outreach.

Any new loan documentation due to mature after the end of June 2023 should provide for the use of an alternative rate to LIBOR, and legacy documentation due to mature after June 2023 should be amended.

Background

In July 2017, the UK Financial Conduct Authority (FCA) announced that, as of the end of 2021, it would withdraw its support for LIBOR and would no longer compel or encourage panel banks to provide quotations for the purposes of calculating LIBOR.

However, in November 2020 the UK FCA announced that most USD LIBOR tenors (1 week, 1, 3, 6 and 12 month USD LIBOR) would continue through to 30 June 2023.

This deadline still applies, and the remaining time to transition to an alternative basis for calculating interest is limited.

What will replace USD LIBOR?

LIBOR will be replaced by overnight "risk free rates" (RFRs) which have been identified for each LIBOR currency.

The RFR for US dollars is "Secured Overnight Financing Rate" (SOFR). It is a broad measure of the cost of borrowing cash overnight collateralised with US Treasury securities in the repurchase (repo) market. SOFR is administered by the Federal Reserve Bank of New York.

Differences between LIBOR and RFRs

Significant differences between LIBOR and RFRs that need to be addressed in order to integrate RFRs into documentation as a replacement for LIBOR include the following:

• LIBOR is a forward-looking rate with varying tenors attached; most RFRs (such as SOFR) are backward-looking daily rates and are only available the day after the period to which they relate.
• LIBOR factors in a premium for bank credit risk for the relevant tenor/period; RFRs are near to being risk-free and, as one day rates, do not factor in any term risk.
• LIBOR is available in multiple currencies and the rate for each is calculated on the basis of the same methodology; each RFR is administered by a different body and calculated using varying methodologies.
• LIBOR is administered in London and published around 11 am London time for a number of different currencies; RFRs are each administered locally in the relevant jurisdiction for each currency and are therefore published at different times.

It is also worth noting that there are key differences between the RFRs themselves which means, on a multicurrency facility, a single fix will not be possible. It may therefore be the case that different adjustments need to be applied for different currencies.

Using SOFR

A number of different methodologies have emerged in respect of the use of SOFR as a replacement for USD LIBOR. These include:

Compounded in arrear SOFR (cumulative or non-cumulative)

• Daily SOFRs are compounded over a period to produce a backward-looking rate using a mathematical formula (i.e., it is not true compounded interest).
• The amount of interest due for the interest period is only known once the last Daily SOFR needed for the calculation is available (i.e., at the end of the interest period). 
• In order to deal with intra-period events (e.g., prepayments) a non-cumulative compounding methodology is required, in order to be able calculate the interest that has accrued since the start of an interest period on any day during the interest period.

Daily simple SOFR

• This is a simple uncompounded and non-cumulative rate derived from the daily screen rate for SOFR. This is applied to the principal to determine the amount of interest due on each day during the interest period.
• As for compounded in arrear SOFR, the amount of interest due for the interest period is only known once the last Daily SOFR needed for the calculation is available (i.e., at the end of the interest period). Since it is non-cumulative, this creates issues for intra-period prepayments.

Term SOFR 

• Term SOFR is published by CME Group and ICE Benchmark Administration for 1, 3, 6 and 12 month tenors. It provides for forward-looking term rates known at start of period and is therefore a closer match for USD LIBOR than the other methodologies.
• It is calculated using SOFR forward transaction data (i.e., it is effectively the market's estimate of where SOFR will be over the following period and compounding those SOFRs over that period).
• In spite of being closer to USD LIBOR in application, Term SOFR does not represent a like-for-like match with USD LIBOR. It does not include bank credit or term premium, the shortest tenor available is 1 month and a user licence from CME Group is required.

If you require any advice as to the implications of the switch from LIBOR to RFRs or other support in transitioning away from LIBOR to an alternative benchmark, please do not hesitate to contact a member of the Banking & Finance practice.

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