An update on IBOR reform 5 November 2019

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Stephen McKenna

Co-Head, Private Debt & Capital Markets – EMEA

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The wave is getting closer | IBOR reform 

Last July, SANNE’s Private Debt & Capital Markets business prepared a briefing note on reference interest rates, highlighting the proposed discontinuation of LIBOR and EURIBOR by the end of 2021. This briefing note provides a summary of progress that has been made since then, in the context of bonds and loans.

The main differences between the new RFR (Risk-Free Reference) rates and current IBORs are as follows:
  • The current benchmarks are calculated on a forward-looking basis. In contrast, the RFRs are calculated on a daily basis referencing the real unsecured interbank funding values of the previous day. The rate would then be published on the following morning. For example, it is the equivalent of the previous day’s EONIA (Euro OverNight Index Average), based on actual data. The RFR methodology avoids the potential manipulation of the interest rates, as it would be based on real information as opposed to forecasts, however, the mechanics of setting interest rates at the beginning of the current period (T-2 Euribor / Libor USD and T for Libor GBP) will not be feasible in these circumstances, as the settlement at the end of the period would be unknown.
  • The current reference rates are published for different durations (1d, 1w, 1m, 3m, 6m, 12m), however, the RFRs are based on overnight values from the previous day and applied daily over the period. As a consequence, interest applicable to any period longer than one day must be constructed by combining daily references.
  • As a risk free concept, the RFR is a credit premium free rate. As a result, the rate does not reflect the real cost of funds to financial institutions, nor does it include an additional credit premium for the duration of the funding, since they are daily references.

It is increasingly evident that the market, systems, contracts and in general terms the culture of which bonds and loans are oriented towards is completely inverse to the current mechanics. Despite multiple problems and huge transition costs that the change of references will impact, there is no turning back. The sanctions that have been imposed to several banks during the last few years for the manipulation of the IBOR prices and the reluctance of banks to continue contributing to the IBORs has dictated the need for a change.

The Loan Market Association (LMA) Operations Working Group, has been actively reviewing the impact of the change and has recently published the first drafts of loan agreements adapted to the RFRs structure, and are proposing different alternatives when there may be different interpretations.

The main modifications proposed by the LMA are:

1. Interest calculation methodology

Interest shall be calculated as a result of compounding the RFR for the elected duration of the period. There are several ways in which rates can be compounded (for example, including weekends and/or rounding conventions) and will be clarified within the Loan Agreement. There is no doubt that a standard will be created soon, however, we do risk having different market practices as we do today for calculation basis (i.e. ACT/365 GPB and ACT/360 EUR).

The ideal scenario would be for Reuters or Bloomberg to publish the compounded rates at different tenors and with different compounding criteria on a daily basis, straight after the publication of the daily RFRs early in the morning. In any case, the Agents and Banks should have the capacity to generate automatic calculations of the compounded interest rates and it is therefore imperative that they adapt their systems accordingly.

In fact, the linear interpolation for the calculation of interest rates for non-published durations will no longer be applicable, as it is mathematically incorrect (unless the market practice accepts this simplification).

2. Interest fixing dates

Interest will no longer be calculated at the start of an interest period, as is the market practice today. This does not necessarily mean that it will be calculated precisely at the end of the period (in arrears), as it is not practice for syndicated loan calculations to be made on the date of payment.

The LMA are working on a solution to fix the interest rates well in advance of the interest payment date in order to allow both borrowers and lenders to record and manage cash reconciliations. The proposal would be around 5 to 10 natural days, although it would depend on the type of facility in question. For example, a RCF may require shorter periods. A business day convention will not work in this case, as the calculation day should always be the same to ensure that the calculation period has the same length as the period of interest and there should be no overlapping with the previous period.

How will this impact the funding process of the entities?

In theory, the banks accommodate their funding to the advanced fixing of rates on rollovers with similar tenors, ensuring a perfect match between their cost of funds and the revenues. The substantial change with RFR will require the banks to modify their funding mechanisms accordingly, with funding remuneration to be based on arrears calculations. The debt funds are a different animal, and will potentially not need to change their funding mechanics through capital calls, although they may need to adapt their hedging instruments.

3. Credit prime

Whilst being conscious that the RFRs are prime free rates, the LMA can only suggest that a credit premium should be considered in the loan agreements, to be added to the calculation of the applicable interest. This credit prime will vary depending on the currency and duration of the interest period. Hopefully, the calculation will be objective and purely mathematical, and will not require the Agents to consult the credit premium applicable for each lender on each fixing date.

In summary, market participants (and more importantly – Agents, Banks and Funds) need to start making big changes before the big wave arrives. The LMA have alerted the market that all changes should be fully implements by Q3 2020, even though the IBORs are anticipated to be discontinued sometime after this. We believe that it may become even more urgent, as it is likely that some US transactions will be structured on this basis and the rest of the market will follow.

The measures that need to be undertaken to adapt to the new RFRs are:

  • Technology: Loan Administration and Accounting systems should be adapted to deal with “in arrears” calculations, with compounding capabilities.
  • Legacy review: This is a major challenge, as the Banks, Funds and Agents will need to review their existing portfolio of loans and ascertain the best and most efficient way to novate agreements to the new calculation rationale. We have yet to see any loans being novated for this very reason, as most entities are simply waiting for a market standard. It is highly advisable that the entities start classifying the loans of their portfolio, before the market is flooded with novation and waiver requests.

The LMA has also prepared a draft novation agreement aiming to simplify the novation process, where the parties will just need to tick in the boxes of the agreed terms, making reference to the frame revised loan agreements published for each type of loan. This is of course helpful as it reduces the legal costs of the transition of the LMA based loans.

  • Training: This is probably not a complex change conceptually, but a game changer mechanically. The appropriate teams should be properly trained on the methodology and various consequences of the rate change, and we anticipate that there will be many seminars in the coming months on this topic.

When a big wave comes, you either surf it or it will swallow you. The RFR wave is certainly starting to get bigger as it approaches the coastline. Ever conscious of the importance to providing an excellent and seamless customer service, SANNE have created a working group for the RFRs transition and is already working on the three fronts listed above. SANNE is also an active participant in the LMA Agency working groups and is actively monitoring the market evolution on this topic.

For further information on our services please contact Fernando García Molina, Managing Director, AgenSynd – A SANNE Company and Stephen McKenna, Director, Product Development – Private Debt & Capital Markets.