The starting point is for corporates to examine their existing contracts to understand what exposures they have to LIBOR today and which of those contracts will need to transition, noting that LIBOR exposures can appear as the primary rate in a contract or as a secondary exposure (for example, a break cost or penalty interest clause linked to LIBOR).
The main affected products are loans, derivatives and bonds, but LIBOR might also be used in intercompany loans and internal transfer pricing arrangements. It is important to understand whether any contracts are linked (for example, loans with associated swaps) and determine whether these contracts must transition at the same time and on the same basis to maintain the effectiveness of the hedge.
Existing contracts referencing LIBOR will generally have fallback clauses setting out the arrangements for what happens if LIBOR is not available. However, in many cases these fallbacks only anticipate a temporary interruption to LIBOR, not its complete cessation. These fallbacks may not work in practice or may lead to a very different economic outcome from that envisaged by the contract. Fallbacks should be checked to see it they remain viable.
Banks have been preparing for IBOR transition for some time now and will all have developed successor products, pricing approaches and transition journeys for the main contracts that need to transition. Contacting your bank relationship manager is the next step. They should be able to agree your exposures and provide you with your transition options. While there are a range of options available, it is likely that the nature of your exposures will narrow the choices very quickly. Your bank will also be able to provide standard documentation to enable the transition of your contracts.
The most widely used alternative rate to GBP LIBOR will be sterling overnight index average (SONIA), compounded in arrears. This has different characteristics to LIBOR and is likely to require changes to systems and processes that will take time to implement. For those having to transition in a short time frame, likely to be less sophisticated companies, simpler options such as Bank Rate may be more appropriate and faster to implement.
The target in the UK is for most existing contracts to have contractually agreed transition by end Q3 this year. You should therefore expect to sign the transition documentation, agreeing the new benchmark rate, no later than end Q3 but, in many cases (particularly for loans), it is possible to defer the actual rate change until later – up to the first interest reset after cessation if necessary. GBP LIBOR will cease to be published after 31 December 2021, but the latest that an existing LIBOR contract can change the benchmark rate is the first interest reset date after the last reset in 2021 – so for a contract referencing six-month LIBOR that resets on 31 December, the effective date of the benchmark rate change could be as late as 30 June 2022.
For the majority of derivatives there are clear paths to transition – through a managed process set out by LCH for cleared swaps and through use of the International Swaps and Derivatives Association (ISDA) protocol for bilateral transactions written under ISDA documentation. Bilateral swaps written under non-ISDA documentation will need to be separately negotiated with the counterparty.
While the formal cessation date for GBP LIBOR has only recently been confirmed, we have been working on the assumption that it would cease on 31 December 2021 for some time. The Working Group on Sterling Risk-Free Reference Rates (RFR Working Group) has set a number of interim milestones firms are expected to meet on the way to the cessation date. From end Q3 2020 firms were expected to cease writing new GBP LIBOR loans unless they contained mandatory transition language. We have been working to build new SONIA products and update systems and processes to accommodate these and make sure they are deployed in advance of the Working Group milestones.
So, since end Q3 last year we have only written new GBP loans referencing SONIA, fixed rate, Bank Rate or LIBOR with mandatory transition language. From end Q1 this year the mandatory transition option was withdrawn, so new GBP loans are now only available referencing alternative rates – usually compounded SONIA, fixed rate or Bank Rate.
For existing contracts we have developed transition journeys for the main affected products and have been reaching out to customers on a phased basis, initially to make sure they are aware of the need to transition, then to discuss specific transition options and pricing for their exposures. Where the customer is aware of the transition, understands and accepts the proposition and is in a position to agree standard documentation, this can be a fairly quick process. We understand that some customers need more time to understand all the choices and implications, take external advice and to go through internal governance, so have factored this into our plans. Subject to positive customer engagement, we expect to meet the Q3 deadline for transitioning the majority of contracts.
Preparation is key. LIBOR transition has been described as the biggest change in financial markets in 200 years and the use of LIBOR is pervasive, so there is often far more to be done to get ready than might appear at first glance. Also, changes to products, systems, models and processes take time to design and implement so starting early is essential. Some of the interest conventions involved in daily compounding lead to complex calculations, so need to be thoroughly understood. The RFR Working Group page on the Bank of England website is an invaluable source of reference material giving guidance on SONIA conventions and recommendations.
This will vary from firm to firm. For some it might be getting an understanding of all exposures. For others it might be necessary internal system changes. In other cases it might be explaining the detail involved in risk-free rates compared to LIBOR to governing bodies to achieve the necessary approvals. In all cases, time is of the essence.
What is clear is that transition from LIBOR is a complex process that involves a wide range of activities that must be reviewed for impact and potential change. Key considerations for transition include:
The cessation date is fixed and will not move, so it is important that firms get themselves mobilised on this now.
The authorities and the RFR Working Group have been extremely helpful in relation to IBOR transition, publishing a range of documents on target milestones, recommendations for best practice and detailed technical papers on conventions to help achieve a smooth transition from LIBOR by the end of the year. The Financial Conduct Authority’s (FCA’s) Q&A on conduct risk during LIBOR transition has been invaluable in setting out expectations for firms to follow, alongside a number of supportive policy announcements.
The tough legacy legislation contained in the Financial Services Bill de-risks the transition significantly, and we look forward to forthcoming consultations from the FCA, which will determine how it uses its new powers and which contracts it applies to.
For SONIA contracts, all necessary conventions have been agreed and published and the expected timelines are clear, so there are now no excuses for any delays to transition.
Ian Fox is group IBOR transition director at Lloyds Bank