01/14/2021 | News release | Distributed by Public on 01/14/2021 03:57
For several decades, IBORs have been used as a reference rate to determine interest and other amounts payable under a significant proportion of financing transactions. Following announcements in 2017 by the regulator of LIBOR that it would no longer support LIBOR after 2021, the transition away from IBORs has become a top priority for many financial institutions in the GCC and beyond. US$ LIBOR is a particular focus in the GCC context, given that many financing transactions are denominated in US dollars. In this note, we look at the current timeframe for IBOR discontinuation, as well as market trends and documentary options. We also touch on the status of IBORs in local GCC jurisdictions.
This note focuses on IBOR transition in the loan markets. Whilst also facing the impact of IBOR transition, other financing markets (such as the derivatives and debt capital markets) are at different stages and, in some cases, are taking slightly different approaches.
And, whilst IBOR is predominately used in financing agreements, we also come across commercial contracts referencing IBORs (for example, default interest clauses). Whilst references to IBORs in these contracts often do not go to the heart of such commercial contracts, they may on occasion. As a result, the tentacles of IBOR transition are likely to spread well beyond the financial markets, so in-house commercial lawyers are advised to start reviewing their exposure to IBORs if they have not yet done so.
No, at least in the case of US$ LIBOR. Until very recently, 31 December 2021 has been the key LIBOR discontinuation date for all LIBOR currencies. In anticipation of this date, there have been recommendations (by the Alternative Reference Rate Committee in the US and the Financial Stability Board in the UK) that firms should stop using LIBOR on new transactions from mid-2021. Regulators have repeatedly emphasised that the market should not assume that LIBOR will still exist after 2021.
However, at the end of November 2020, the administrator of LIBOR (ICE Benchmark Administration Limited) announced that it was consulting on continuing to publish the key US$ LIBOR tenors (overnight and one, three, six and 12 months) until 30 June 2023. We expect that any such extension will be accompanied by restrictions on using US$ LIBOR on new transactions after the end of 2021, so that the extension period can be used to embed alternative pricing mechanisms in the US$ market and reduce legacy US$ LIBOR books. The intention here is to allow affected parties to refinance their short-term LIBOR exposures at their maturity in order to ensure an orderly transition is maintained. The consultation is due to close at the end of January 2021.
In the last few years, market participants entering into new IBOR-based loans with a tenor beyond 2021 have done so in the knowledge that IBOR may well disappear during the term of the loan. Different banks still have significantly different documentary preferences, and the LMA is in a market consultation phase with its recommended forms still being IBOR- rather than RFR-based. Broadly, four approaches to addressing the transition risk have emerged so far in the market:
The relevant amendments to the loan terms would provide for interest to be calculated by reference to an RFR-based rate (or other benchmark acceptable to the relevant regulator). Although few legacy IBOR loans have been amended to date, most banks with significant legacy IBOR books are actively planning to adopt this approach, by undertaking major 'bulk' repapering projects.
The transition away from IBOR (and towards rates based on overnight, virtually risk-free rates or 'RFRs') has been much slower in the loan markets than in other markets that have traditionally used IBOR, such as derivatives and bonds. Progress during 2020 was undoubtedly hindered by disruption related to COVID-19.
Whereas in the UK market, RFR, hard-wired switch and hard-wired fallback facilities are now becoming much more common, our experience is that, for loans in currencies other than sterling, IBOR remains very much the default option, in most cases without an alternative mechanism for rate calculation.
We anticipate that lenders will generally instigate this process, on both bilateral and syndicated transactions. On syndicated transactions, a lender wishing to start an amendment process would first need to put forward a proposal to the agent, and ask it to circulate this among the syndicate for discussion and agreement, before any proposal is put to the borrower.
Lenders would rely on the existing fallbacks in the facility agreement. Under typical fallbacks, following a permanent discontinuation of IBOR, the rate of interest is likely to be each lender's own cost of funds plus the margin (instead of IBOR plus the margin). This is clearly unattractive for a borrower. On a syndicated facility agreement, it is also unattractive for an agent, who will have to calculate different interest rates for different lenders. As such, this is unlikely to be a viable long-term solution.
Islamic finance is an important and substantial part of the GCC finance market. It too will be impacted by IBOR discontinuation, but in a significantly more profound manner. Islamic finance, at its core, relies on certainty of payment obligations at the time the payment obligations are agreed. The backward-looking RFRs pose a much greater challenge to the Islamic finance than to the conventional loan markets. Whilst there has been some discussions around forward-looking RFRs, which the Islamic finance market could look to, regulators have been reluctant to prioritise or promote this for fear of allowing the conventional loan markets to benefit, as well as the general view that this would effectively inherit a number of features that were the very essence as to why regulators wanted to transition away from IBOR in the first place.
There do not currently seem to be any plans to discontinue the main local IBORs used in the GCC markets for financing transactions denominated in local currencies - EIBOR, SAIBOR, OMIBOR and QIBOR, and these will continue to be published for the foreseeable future. However, as the underlying currencies to which these local GCC benchmarks apply are pegged to US dollars, the discontinuation of US$ LIBOR may still have an impact on their ongoing use.
Lenders in the GCC have been working to update their operating systems, financial modelling and documentation so as to be in a position to transition their loans as necessary when the time comes. For some, the possible extension of key US$ LIBOR tenors until mid-2023 may provide a welcome reprieve. In the meantime, the use of RFRs in the loan markets is not yet sufficiently settled for the LMA to issue standard provisions, and different banks continue to maintain different documentary preferences.