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15 November 2019
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.
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:
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.
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.