November 2022 LIBOR update

In transitioning a loan hedged with a derivative, what should I keep in mind?

Market conventions for the use of alternative risk-free reference rates have not been synchronised across asset classes.

As you transition both the loan exposure and the derivatives hedge from USD LIBOR to SOFR, you should carefully consider the contractual features across both asset classes and the actual execution of the transition.

As we had noted in our previous communications, given limitations on its usage in the derivatives market, you may find that the execution costs of Term SOFR hedging differ from those of hedging a compounded SOFR exposure.

If I transition my loan, what kind of transition pricing may I expect?

If your loan contract is amended to reference SOFR instead of USD LIBOR, and that is the only amendment in the contract, you will find that a ‘credit adjustment spread’ or CAS is likely to be added to the margin. That is done to limit net present value transfer, given that SOFR is typically a lower rate than LIBOR which encompasses bank funding costs. Commonly used methods to determine the CAS are to use the CAS that ISDA uses in its IBOR fallback protocol (‘ISDA CAS’), or to base it on the forward pricing of the difference between LIBOR and SOFR: the so-called ‘basis’.

When will the remaining LIBOR rates cease publication?

Synthetic JPY LIBOR will cease after 31 December 2022. Synthetic Sterling 1 and 6 months LIBOR will continue until 31 March 2023. Synthetic Sterling 3 months LIBOR may continue beyond that date but that is yet to be confirmed. All remaining panel-based USD LIBOR tenors will cease after 30 June 2023.

Will a ‘synthetic LIBOR’ be published in USD as it currently is in JPY and GBP? 

LIBOR’s supervisor, the Financial Conduct Authority (FCA), has stated that

‘for US dollar LIBOR, in due course we will need to assess whether the remaining settings can be wound down in an orderly fashion when the panel ends on 30 June 2023, and if not, whether a synthetic US dollar LIBOR rate might be appropriate for certain contracts’.

In the US, Federal legislation (the Adjustable Interest Rate (LIBOR) Act) passed earlier this year provides a replacement rate for certain US law-governed financial contracts (including derivatives) that mature after the cessation of LIBOR in June 2023 and do not have appropriate fallbacks or otherwise an agreement to transition to an alternative benchmark. As a result, contracts governed by US law are likely to be either within the scope of that legislation, which provides a clear mechanism to transition to alternative rates at end-June 2023, or are beyond its scope because they contain robust fallbacks that provide for LIBOR’s cessation as a representative rate.

Therefore if a temporary synthetic USD LIBOR, which would not be a representative rate, becomes available, it could provide an orderly transition for contracts and transactions falling outside of the scope of the Adjustable Interest Rate (LIBOR) Act which do not contain robust fallbacks or have not otherwise been transitioned.

We emphasise that supervisory bodies have made it clear that the possible publication of synthetic USD LIBOR is not a reason to delay the transition of contracts from USD LIBOR to SOFR.