LIBOR transition: The risks of interim milestone delay for the cash market due to COVID-19

The Working Group on Sterling Risk-Free Reference Rates (RFRWG) has published a further statement on the impact of COVID-19 for firms’ LIBOR transition plans.

The latest statement follows the earlier joint statement made by the FCA, Bank of England and RFRWG on 25 March 2020, in which the regulators set out their initial response to the impact of COVID-19 on transition plans.

In this blog post we consider the specific delays to interim LIBOR transition milestones that have been announced, the likely effect such delay is likely to have on loan market LIBOR transition and how this may impact the profile of the associated litigation risks.

Overarching theme of the regulators’ COVID-19 impact statements

Both of the statements published by the regulators/working group, emphasise that the deadline for LIBOR cessation remains fixed for end-2021 and firms cannot rely on LIBOR being published after that date, notwithstanding the impact of COVID-19 on firms’ steps to prepare for that event. The regulators are working with the RFRWG and its sub-groups and task forces to consider how all firms’ LIBOR transition plans may be impacted.

However, recognising the reality at least in the short term, it is clear that some interim transition milestones may be delayed. The most recent communication announces the first key date to be affected.

Delay to key interim milestone in the loan market

The first key interim LIBOR transition milestone to be affected by COVID-19 is the deadline by which the cash market is recommended to stop issuing LIBOR linked loans. That deadline was originally the end of Q3 2020 but has now been pushed back to the end of Q1 2021.

The RFRWG’s current timetable as to the use of LIBOR-linked loan products is now as follows:

• By the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
• After the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives; and
• All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.

The regulators have repeatedly acknowledged that the loan market has made less progress in transitioning away from LIBOR than other markets. This led to various initiatives earlier this year to accelerate change, with an emphasis on steps to alleviate some of the difficulties which were faced in the cash markets: The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks? In particular, the Bank of England announced the publication of a SONIA-linked index from July 2020 to support market participants to cease issuing LIBOR-based cash products (maturing beyond 2021). It is therefore perhaps not surprising that the first interim milestone to be relaxed is in that market.

Impact on loan market LIBOR transition 

Given that one of the most important drivers to move the cash market to new risk free rates (RFRs) is to stop writing new loans linked to LIBOR, the RFRWG’s decision to delay this particular milestone is significant, though not surprising given the pressures that both lenders and corporates find themselves under as a result of COVID-19.

While there was significant impetus from both lenders and corporates behind a movement to RFRs in the loan markets in Q1 of 2020 (for example British American Tobacco signed a USD 6bn revolving credit facility linked to both SONIA and SOFR in March – see this press release), which will be further boosted by the publication of central bank indices, there has been an understandable hiatus as the impact of COVID-19 has been felt. The issues around market conventions for compounding, and the development of new loan and treasury management systems to support RFR loans, have not yet been resolved, nor has the calculation been fully settled of the credit spread above the RFRs to ensure that the transfer is value neutral. Once the immediate impact of COVID-19 has abated, attention will need to be turned to these once again.

During the extension period (i.e. the six-month period from the original deadline of end-Q3 2020 to end-Q1 2021), the RFRWG’s guidelines state that all new and re-financed LIBOR-linked loans should include a robust fallback mechanisms to enable transition to SONIA (or other alternatives) when LIBOR ceases. For example, through pre-agreed conversion terms or an agreed process for renegotiation.

Profile of litigation risks: impact of delay

Most loans currently being issued include more robust fallbacks of the kind envisaged by the RFRWG’s guidelines (i.e. including an agreed process for renegotiation when LIBOR ceases). However – importantly – the deadline relaxation will mean a further six months’ worth of facilities being written in LIBOR, which will increase the overall volume of LIBOR-linked loans in the market when the benchmark ceases.

The particular risks associated with fallbacks based on a requirement to renegotiate at the time of LIBOR cessation fall broadly within two categories:

1. Commercial difficulties. An agreed process for renegotiation will only take participants so far: each transaction will still need to be amended on a deal-by-deal basis, though the LMA hopes that its exposure draft form of reference rate selection agreement will smooth this process in some cases. Accordingly, the way in which negotiations unfold on a loan by loan basis will reflect the relative bargaining strengths of the parties at that time.
2. Practical difficulties. Continuing to increase the volume of loans which will subsequently require renegotiation upon the cessation of LIBOR (on top of legacy loans) will increase the practical challenges firms will face, and the time and cost burden, particularly for those with large books of bilateral loan facilities.

In summary, while pushing this interim milestone back by six months may provide some welcome breathing space in the cash market in the short term, it is not without cost. It will almost certainly increase the challenges firms face in the next stage of the process to achieve LIBOR transition in this market by the fixed deadline of end-2021. It is unlikely that this is the last adjustment to that timetable which will need to be made.

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