“[T]he use of... forward-looking term rates is meant to be limited. These term rates cannot and will not be the primary avenue to transition [and] we think that any firms still delaying transition until term rates arrive are making a mistake.”
So said Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA) earlier this Summer. However, since “LIBOR transition” became a topic on everyone’s lips over two years ago, the loan markets had been proceeding on the assumption that forward-looking term risk-free reference rates (RFRs) would be developed as an alternative to LIBOR.
But with forward-looking term RFRs yet to be developed, taking heed of Mr Bailey and of demand from loan market participants and regulators, earlier this week the Loan Market Association (LMA) issued exposure drafts of its primary documents (Exposure Drafts) with accompanying commentary, showing interest calculated on the basis of backward-looking RFRs.
Interest calculated on a backward-looking basis
The approach proposed in the Exposure Drafts is to calculate the base reference rate (to which the margin is then added) by way of a compounded average of an overnight risk-free reference rate (SONIA, in the case of sterling and SOFR, in the case of US dollars) using the lookback method: i.e. interest is calculated on a compounding basis by reference to an interest rate setting period that starts and ends a certain number of days prior to the period in respect of which interest accrues: the “interest period”. Further explanation of the lookback method is given in the Financial Stability Board publication: “Overnight Risk Free Rates: A User’s Guide” (the FSB Guide).
As the LMA’s commentary notes, ideally an independent third party would calculate and publish the relevant base reference rate for any period necessary, but such a provider does not currently exist. Consequently, the Exposure Drafts provide for a fallback compounded rate to be calculated by the facility agent (or another finance party), based on a pre-determined methodology. Given the lack of an established market consensus, the calculation methodology is left blank - however the LMA’s expectation is that markets would use the proposed methodologies referenced in the FSB Guide.
The Exposure Drafts have been issued very much as such and do not, as the LMA stresses, contain recommended wording. Rather, their purpose is to trigger discussion and consideration of the structuring issues involved if the market requires:
- a lending product where the parties would like to base the calculation of interest on risk free reference rates such as SOFR and SONIA; and/ or
- a contingency for where forward-looking term rates are not in place when LIBOR is discontinued or no longer functional.
In the LMA’s own words; “the creation of such a new type of lending product, and the adaptation to it of existing market practices and documentation which have evolved and become ingrained over the course of more than 40 years, raises a number of structuring issues which are of a commercial nature and which are more fundamental than merely being "documentation issues".” Indeed, in the commentary to the Exposure Drafts, the LMA makes clear its continuing commitment to “the development of forward-looking term rates derived from RFRs and… to advocate their importance for cash markets”.
Consequently, we would join the LMA in encouraging all interested market participants to provide any feedback they may have on the Exposure Drafts and their accompanying commentary. We at CMS will be reviewing the Exposure Drafts and are interested in discussing any feedback with you. Please get in touch with your usual CMS contact or Patrick Donegan if you would like to discuss.