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29 October 2019
The London Interbank Offer Rate (LIBOR) is the benchmark reference rate commonly used in commercial loans to calculate interest payments in variable (floating) rate loans.
Following the large scale LIBOR fixing scandal exposed in 2011, and a general decline in the importance of interbank lending within the financial markets, the Financial Conduct Authority (FCA) has indicated that it wants to move the financial markets away from using LIBOR as a benchmark in favour of using instead risk free rates (RFRs) which are based on actual transaction data and so less susceptible to manipulation by the end of 2021.
The FCA announced in July 2017 that it will no longer compel or encourage banks to provide quotations for LIBOR after the end of 2021 and told market participants that they should therefore plan a transition to an alternative rate based firmly on actual transactions data before then.
Each currency of LIBOR has its own existing alternative RFR identified by the relevant working groups.
|Currency||Risk-Free Rate||Administrator||Working Group|
(Sterling Overnight Index Average)
|Bank of England||Bank of England Working Group on Sterling Risk-Free Reference Rates|
(Secured Overnight Funding Rate)
|Federal Reserve Bank of New York||Alternative Reference Rates Committee|
(Euro Short-Term Rate)
|European Central Bank||Working Group on Euro Risk-Free Rates|
(Swiss Averaged Rate Overnight)
|SIX Swiss Exchange||Swiss National Working Group|
(Tokyo Overnight Average Rate)
|Bank of Japan||Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks|
However, for the loan market these rates cause some operational and commercial difficulties with the working groups now discussing how to develop Risk Free Rates better suited to purpose. Considerable uncertainty therefore remains, even now with the 2021 deadline looming, as to exactly what alternatives will be available.
What does this mean for borrowers with new loans?
There are differences between RFR and LIBOR which are significant for the loan market. The fundamental difference is that existing RFR’s are based on historical transaction data and so (unlike LIBOR) there is no element of “forward looking” to the expected movements in interest rate market over the interest period built into the rate.
The practical and commercial effect of this is that where interest rate payments are referenced to RFRs, such as SONIA, borrowers can expect loans to be offered on terms where the borrower has less notice as to the interest payments they will make as they will likely be calculated at or shortly before the date when payment is due, rather than at the beginning of the interest period as is usual for LIBOR loans. Therefore, it will no longer be clear well in advance what will be payable.
Industry working groups are continuing work to try to develop “forward looking” rates based on RFRs. For SONIA it is hoped this will be available in 2020, but it requires development of a market for overnight index swaps or a futures market referencing RFRs.
In the meantime, “averaging” or “compounding” mechanisms are being developed into contracts using the daily RFR rates published over the interest period (or a period starting and ending a few days before the interest period to allow at least some notice of the payment required).
Borrowers in the real estate market should make sure they understand the financial and the practical implications of the interest payment mechanisms and benchmarks proposed, in particular:
What does this mean for borrowers with existing loans
Real estate borrowers with existing loans referencing LIBOR should consider the following:
What borrowers should do now
Borrowers in the real estate market need to understand and plan for the impact on their business. Despite the current lack of a new reference rate there are steps you can be taking now to prepare.
Identify loan agreements based on LIBOR which are due to mature after 2021 and any associated interest rate hedging.
Understand what fallback mechanisms are contained in these agreements, and
which parties must consent to replace LIBOR with an alternative rate.
Consider whether the position under your current loan documentation will be commercially acceptable to you when LIBOR is discontinued (or becomes a rate which does not reflect the market rate for lenders’ cost of funds, i.e. “Zombie LIBOR”).
If you consider the position commercially acceptable, consider waiting for the lender to approach you with any proposals and consider carefully with legal and specialist financial advisors the economic effect of those proposals. Review carefully any proposed amendments allowing the lender to change the rate without consent in advance of proposals as to a new reference rate.
If the contractual position as drafted is not commercially acceptable, seek to negotiate an amendment with the lender to specify a rate acceptable to both parties, with pricing adjusted as necessary on a negotiated basis to avoid “value transfer”. Alternatively, agree a mechanism to deal fairly with selecting a new rate when the position is clearer overall in 2021.
The strength of the borrower’s negotiating position will depend on the individual circumstances, and it may be that engagement as to the new reference rate is not possible until close to the discontinuation. However, waiting for the lender to raise this issue without assessing the available options and their commercial impact risks being underprepared for negotiations with the lender. It may mean there is insufficient time to investigate refinance options before LIBOR is discontinued in the event a commercially acceptable solution cannot be agreed.
This article was originally published in Estates Gazette on 29 October.
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