For several decades, IBORs have been used as a benchmark rate to determine interest and other amounts payable in a significant portion of financing transactions. After the LIBOR regulator announced in 2017 that it would no longer support LIBOR after 2021, moving away from IBORs is a top priority for many financial institutions in the GCC and beyond. The US $ LIBOR is a particular focus in the GCC context as many financing transactions are denominated in US dollars. In this press release, we look at the current timeframe for the discontinuation of IBOR, as well as market trends and documentary options. We are also touching on the status of IBORs in the local GCC jurisdictions.
This note focuses on the IBOR transition in the credit markets. While the impact of the IBOR transition also needs to be considered, other funding markets (such as derivatives and debt markets) are at a different stage and, in some cases, have slightly different approaches.
And while IBOR is mostly used in finance contracts, we also come across commercial contracts related to IBOR (e.g. default interest clauses). Although references to IBORs in these contracts often do not go to the heart of such commercial contracts, they can occasionally occur. As a result, the tentacles of the IBOR transition are likely to spread well beyond financial markets. Therefore, internal business lawyers are advised to review their exposure to IBORs if they have not already done so.
Will LIBOR definitely go away by the end of 2021?
No, at least with the US $ LIBOR. Until recently, December 31, 2021 was the crucial date for all LIBOR currencies to end LIBOR. In anticipation of this date, there were recommendations (by the Alternative Reference Rate Committee in the US and the Financial Stability Board in the UK) that companies should stop using LIBOR for new transactions from mid-2021. Regulators have repeatedly stressed that the market shouldn’t assume that LIBOR will still exist after 2021.
At the end of November 2020, however, the administrator of LIBOR (ICE Benchmark Administration Limited) announced that he would be aware of the further publication of the most important US $ LIBOR terms (overnight and one, three, six and 12 months) by June 30th We assume that such an extension will be accompanied by restrictions on the use of the US $ LIBOR for new transactions after the end of 2021 so that the extension period can be used to embed alternative pricing mechanisms in the US $ market and the old US $ LIBOR reduce books. This is intended to enable those affected to refinance their short-term LIBOR commitments when they fall due in order to ensure an orderly transition. The consultation is expected to be completed by the end of January 2021.
Approaches to credit documentation
Market participants who have taken out new IBOR-based loans with a term beyond 2021 in recent years did so knowing that IBOR could potentially disappear during the term of the loan. Different banks still have significantly different documentary preferences and the LMA is in a market consultation phase with their recommended forms still based on IBOR rather than RFR. By and large, four approaches to managing transitional risk have emerged in the market to date:
- The approach of change (limited consent). The parties rely on the fact that they can change the pricing terms at any time as necessary. To facilitate this approach, the LMA has published a revised “Screen Rate Replacement” clause. This provides for the reduction of the lender approval threshold (from unanimous to majority approval) that is required for the corresponding changes to the facility agreement in the event of an actual or expected imminent discontinuation of a relevant IBOR.
The corresponding changes in the terms of the loan would provide that the interest be calculated with reference to an RFR-based interest rate (or any other benchmark acceptable to the relevant regulatory authority). Although few Alt-IBOR loans have changed so far, most banks with significant Alt-IBOR books are actively planning to adopt this approach by carrying out large “bulk” repapering projects.
- The approach of change (mandatory negotiation). This is based on the change approach set out above (reduced consent), but (in addition) the LMA has also added an option to include an obligation to renegotiate if IBOR is still being used to calculate interest under the funding at some point. We have seen this on occasion, but not very often in GCC transactions, and we are aware of a number of regional banks that specifically instruct us not to include this provision.
- Hard-wired switch. This is a mechanism to automatically switch from IBOR to an economically equivalent RFR-based rate on a certain future date before the end of 2021. Early high-profile bill deals included British American Tobacco’s March 2020 multi-currency revolving credit facility. These are now commonplace in the UK credit market, and the LMA has published exposure drafts for multi-currency facility agreements that include an exchange mechanism.
- Hardwired fallback. This is a mechanism to switch from IBOR to an economically equivalent RFR-based tariff if an event related to the discontinuation or other unavailability of IBOR occurs. This is similar to a hard-wired switch, but without an automatic departure from IBOR on a specific date. There has been limited use of this approach in the EMEA credit markets.
To what extent have GCC credit markets turned away from IBOR on new transactions?
The transition away from IBOR (and towards rates based on virtually risk-free overnight rates, or “RFRs”) has been much slower in the credit markets than in other markets that have traditionally used IBOR, such as derivatives and bonds. Progress in 2020 has no doubt been hampered by disruptions related to COVID-19.
While RFR, hardwired switch and hardwired fallback facilities have become widespread in the UK market, our experience has shown that IBOR remains the default option for loans denominated in currencies other than sterling in most cases, an alternative rate calculation mechanism.
Who will initiate the amendment of the existing IBOR loan agreements?
We anticipate that lenders will generally initiate this process for both bilateral and syndicated transactions. For syndicated transactions, a lender wishing to initiate a change process must first make a proposal to the agent and ask him to forward it to the syndicate for discussion and agreement before making a proposal to the borrower.
What happens if old IBOR loans are not converted by the relevant expiry date?
The lenders would rely on the existing fallbacks in the facility agreement. In typical fallbacks, after the IBOR is permanently suspended, the interest rate is likely to equal each lender’s own funds cost plus margin (rather than IBOR plus margin). This is clearly unattractive to a borrower. With a syndicated loan agreement, it is also unattractive for an agent who has to charge different interest rates for different lenders. As such, it is unlikely to be a viable long-term solution.
How does this affect Islamic financial transactions?
Islamic finance is an important and essential part of the GCC financial market. It will also be affected by the discontinuation of IBOR, but in a much deeper way. Islamic finance is essentially based on the security of payment obligations at the time the payment obligations are agreed. The backward RFRs pose a much greater challenge to Islamic finance than to conventional credit markets. Although there has been some discussion of forward-looking RFRs the Islamic financial market could focus on, regulators have been reluctant to prioritize or encourage this for fear of letting conventional credit markets benefit, as well as the general view that this is effectively a number of Inheriting traits that were the reason regulators wanted to move away from IBOR in the first place.
What is the status of local IBORs in the GCC?
At this time, there appear to be no plans to discontinue the major local IBORs – EIBOR, SAIBOR, OMIBOR and QIBOR – used in GCC markets for local currency financing transactions, and to keep them publicly available for the foreseeable future. However, since the underlying currencies to which these local GCC benchmarks apply are pegged to the US dollar, the discontinuation of the US $ LIBOR may still affect their further use.
Lenders at the GCC have worked to update their operating systems, financial modeling, and documentation to be able to convert their loans in due course if necessary. For some, the potential extension of key US $ LIBOR maturities through mid-2023 could be a welcome respite. Meanwhile, the use of RFRs in the credit markets is not sufficiently regulated for the LMA to waive standard provisions, and different banks continue to have different documentary preferences.