Loan markets

  • Various working groups and industry groups have been developing recommendations for conventions to be used in RFR-referencing loan documentation. These include documentation materials incorporating:

    • Recommendations for RFR facilities agreements
    • Recommendations for RFR multi-currency facilities agreements
    • Recommendations for facilities incorporating rate switch provisions
    • Recommendations for multi-currency compounded rate/term facilities agreements.

    Industry associations, including the Loans Market Association (LMA), Asia Pacific Loans Market Association (APLMA), and the Loan Syndications and Trading Association (LSTA) have published sample facility agreements reflecting the above recommendations.

    Adoption of RFRs is progressing at different speeds in respective jurisdictions and is most advanced in the Sterling market.

    In the loans market the prevalent formulation for calculating RFRs differs across jurisdictions. For example, in the Sterling market, SONIA compounded in arrears is now being actively used across billions of pounds of Sterling facilities, whilst in the USD market the use of ‘simple interest’ has become relatively more widely used. In contrast to the RFRWG, the ARRC has not specifically recommended the use of a compounded rate.

    Some considerations when moving to RFRs include:

    Calculation of interest: simple rate and cumulative vs non-cumulative compounded rates

    Interest can be determined by reference to simple or compounding formulae.

    A cumulative compounded rate calculates the compounded rate at the end of the interest period and it is applied to the whole period. It allows calculation of interest for the whole period using a single compounded rate. A non-cumulative compounded rate is derived from the cumulative compounded rate – i.e. the cumulative rate as of the current day minus the cumulative rate as of the prior banking day. This generates a daily compounded rate which allows the calculation of a daily interest amount. The non-cumulative compounded rate can vary from day to day.

    Since the cumulative compounded rate calculates the applicable compounded rate at the end of the interest period, complexity is added if accrued interest needs to be calculated before the end of an interest period – e.g. for the pricing of a loan trade. The non-cumulative compounded rate being a daily compounded rate enables a more accurate calculation of interest during the mid-interest period.

    The RFRWG explains in its paper on loan market conventions, while cumulative and non-cumulative compounded rate methods are different implementation approaches, if the same rounding convention is adopted the interest amount over an interest period should be the same.

    Interest rate floors

    Rate floors may be calculated daily or at the end of the interest period. The most commonly used method is likely to be a ‘daily floor’ but there are different ways in which it can be calculated. 

    Lookback mechanism for determining interest

    In contrast to LIBOR which is a forward looking rate, a RFR-based interest rate calculation relies on the daily observations throughout the interest period to determine the overall interest payable. Under a lookback mechanism the observation period for the interest rate calculation starts and ends a certain number of days prior to the interest period.

    This permits the entity with responsibility to determine the rate of interest for the interest period before the period ends and the interest payment is due. It provides time to invoice the borrower and for the borrower to pay the interest in a timely fashion.

    Lookbacks may vary in the number of business days that they ‘look back’, although 5 business days is a commonly used convention. There are different ways of calculating the ‘lookback’ given that the ‘observation period’ diverges from the actual ‘interest period’. The applicable RFR for each day within a loan period can be weighted based on the number of calendar days in the interest period (‘observation lag’) or the number of calendar days in the observation period (‘observation shift’). 

    A difference between LIBOR and RFR benchmarks

    RFRs, unlike LIBOR, are overnight rates and do not incorporate a bank credit risk premium. This means that they may react differently to financial market conditions. This difference was highlighted by the Bank of England in its May 2020 Interim Financial Stability Report. Their report noted that in March 2020 market volatility had seen LIBOR rates, and hence the cost to borrowers, rise as official rates fell.

Derivatives markets

  • Recent data as of June 2021 suggest that a little more than 10% of all derivatives (as measured by ‘DV01’, which is a measure of risk) is now traded referencing an RFR. In the Sterling market, that percentage is over 50%.

    On 8 June 2021, a Subcommittee of the Commodity Futures Trading Commission’s Market Risk Advisory Committee recommended a market best practice for switching interdealer trading conventions from LIBOR to SOFR for USD linear interest rate swaps. Specifically, it recommended that on 26 July 2021 and thereafter, interdealer brokers replace trading of LIBOR linear swaps with trading of SOFR linear swaps. The switch is expected to increase the volume of derivatives transactions in SOFR and has been welcomed by the ARRC.

    In our previous communication, we had explained that the International Swaps and Derivatives Association (ISDA) has amended certain ‘floating rate options’ in the 2006 ISDA Definitions to include fallbacks that would apply upon the permanent discontinuation of certain key IBORs and upon a ‘non-representative’ determination for LIBOR.

    Derivatives transactions incorporating the 2006 ISDA Definitions that are entered into on or after 25 January 2021 include the amended floating rate option – i.e. the floating rate option with the applicable IBOR fallback. IBOR fallbacks were introduced by a supplement (ISDA Supplement) to the 2006 ISDA definitions. Transactions entered into prior to 25 January 2021 continue to be based on the 2006 ISDA Definitions as they existed before they were amended pursuant to the ISDA Supplement, and therefore will not include the amended floating rate option with the ISDA Supplement’s applicable IBOR fallback unless they are separately amended. Legacy contracts may be amended by bilateral agreement or through adherence to the ISDA Protocol by both parties to the transaction. See a list of adherents to the ISDA Protocol, which includes CommBank. As of 15 June 2021, over 14,200 parties have adhered to the ISDA Protocol.

    The ISDA Protocol does not apply to derivatives cleared by Central Counterparty Clearing Houses (CCPs). However major CCPs have voiced support for the ISDA Protocol, and are following suit with their own conversion processes on similar terms.

    You are encouraged to undertake your own due diligence in relation to the ISDA Protocol and the amendments to the 2006 ISDA Definitions and we encourage you to seek independent advice.

    In April 2021, the RFRWG published a paper on ‘Operational Considerations for Fallbacks in Uncleared Linear Derivatives’ and one on ‘Active transition of legacy GBP LIBOR contracts’. The latter document includes an overview of considerations between reliance on ISDA’s IBOR fallbacks and active transition for GBP bilateral swaps which may be helpful in your considerations of suitable transition options. 

Transition in the US market

  • As discussed in our previous communication, the FCA has announced that USD LIBOR will continue to be published until 30 June 2023 for all tenors other than 1-week and 2-month.

    US regulators have stated that "extending the publication of certain USD LIBOR tenors until June 30, 2023 would allow most legacy USD LIBOR contracts to mature before LIBOR experiences disruptions”. The US regulators also stated that the extension of these quotes will only be available for legacy contracts. Specifically that “entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks…Therefore, the agencies encourage banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021”.

    Subsequently, the US Federal Reserve issued a letter recommending that examiners consider other supervisory actions if a supervised institution is not ready to stop issuing LIBOR-referencing contracts by 31 December 2021.

    Term rates and other LIBOR alternatives

    In the USD market, a number of LIBOR alternatives that are forward looking rates and that encompass a credit component have been developed. For example, Ameribor and BSBY are reference rates that function similarly to LIBOR, and may be a suitable alternative in some cases. This means that in the USD market, you may have a choice of LIBOR alternatives that is not available in other markets. However, some regulators have voiced concerns that these alternatives may have some of the same flaws as LIBOR.

    To date, the ARRC has not formally recommended a SOFR term rate. However, with the CFTC recommending, as market best practice, that interdealer brokers switch USD linear trading conventions from USD LIBOR to SOFR on 26 July 2021, the ARRC expects that it will be in a position to recommend a SOFR term rate shortly thereafter. The ARRC plans to recommend ‘best practices’ for the use of the term rate in the near future.

    In contrast, the RFRWG, the Bank of England, and the FCA have made clear that they anticipate that the large majority of Sterling markets will be based on SONIA compounded in arrears, to provide the most robust foundation for the overall market structure.

Things you should know

  • As nothing in this document should be taken to be advice, we encourage you to seek independent advice on these matters and you should reach your own conclusions and decisions, in consultation with your own advisors. The information in this document might change and we are not undertaking to update it.

    This information is published solely for information purposes. It is not to be construed as a solicitation, an offer or recommendation by the Commonwealth Bank of Australia (CommBank). As this information has been prepared without considering your objectives, financial situation or needs, you should before acting on the information, consider its appropriateness to your circumstances. It must not be relied upon as investment research. CommBank believes that the information is correct and any opinions, conclusions or recommendations are reasonably held or made, based on the information available at the time of its compilation, but no representation or warranty, either expressed or implied, is made or provided as to accuracy, reliability or completeness of any statement made. Commonwealth Bank of Australia ABN 4‌8 1‌23 1‌23 1‌24. AFSL and Australian Credit Licence 234945.