The London Interbank Offered Rate (“LIBOR ”) will soon begin his long goodbye. The currencies for which LIBOR will initially be phased out include GBP and JPY. In this regard, the Financial Conduct Authority (“FCA ”) in the UK has already issued a press release in which it has confirmed that in order to avoid disrupting old contracts which refer to the one, three and six month GBP and JPY LIBOR parameters, it will require the administrator to LIBOR reference that it publishes these parameters under a “synthetic” Methodology, based on forward risk-free rates, for the term of 2022. These six LIBOR parameters will only be available for use in certain existing contracts and are not intended to be used in new business.
The question on most lips in South Africa, however, is what options are available to market participants in place of USD LIBOR and do we really need to use this retrospective rate. Two things are true:
- USD transactions in number and volume constitute the greatest hard currency exposure in South Africa (and probably in most other jurisdictions in Africa), and
- the US domestic market seems, at this stage, to favor a multi-rate environment (notwithstanding the recommendations of its working group on risk-free rates).
The widespread but informal approval of different rates has allowed parties to start thinking more broadly about what rates they want to apply to their own products.
To recap; USD LIBOR will continue to be published until the end of June 2023, which means that existing loans can continue to use USD LIBOR for the time being. New loans should not refer to USD LIBOR or if the loans use USD LIBOR, in the case of most new South African hard currency loans these new loans should contain rate change language that will incorporate into a document the chosen alternative rate. This will also set, among the change and economy related items, the date on which the rate change will take place or at the very least the replacement of the screen rate language (adjusted for bilateral loans).
aggravated in arrears SOFR
As in the UK, the structure of arrears, using the guaranteed overnight rate (“SOFR ”) is an option for USD loans and remains the rate recommended by the Alternative Reference Rate Committee (“ARRC ”). The ARRC was created in the United States to deal with the transition from USD LIBOR. This rate remains recommended on the basis that it:
- complies with IOSCO principles,
- is based on transaction data, and
- is incapable of manipulation.
With this structure, the overnight SOFR rates are compounded over the relevant interest period and the interest payable at the end of the term is not known in advance, although some visibility may be offered by calculating the interest rates. rate over an observation period. The risk-free rate agreements recommended by the LMA use this rate methodology. The compounding in arrears is a methodology that composes the daily values of the overnight rate, throughout the relevant period.
Simple daily SOFR
The ARRC recommended the Simple Daily SOFR for its simplicity. For the overdue daily SOFR, the SOFR is drawn daily and multiplied by the principal outstanding on the loan. In general, the composition of arrears is chosen rather than the simple daily SOFR because it reflects the practical reality that a borrower would not pay interest daily but rather over a term.
SOFR averages (applied in advance)
Another option in the US loan market is to use SOFR averages (applied in advance), which reflect SOFR rates from a previous 30, 90 or 180 day period. These SOFR advance interest rates provide visibility into interest payments at the start of the interest period, similar to the LIBOR world in which we currently operate. However, because they are based on past rates, SOFR averages do not reflect movements in the real interest rate. period. So while this provides payment certainty for a borrower, for example, the borrower may need to cover any basis risk associated with using a historic rate.
In contrast, the SOFR term examines what the rate would be on a given term based on what is implied by the derivative markets for the term and is conceptually closest to LIBOR. On August 3, 2021, the ARRC formally recommended the forward looking SOFR forward rates of the CME Group. Along with this recommendation, the ARRC published the term SOFR – scope. The three key situations in which the ARRC has recommended the use of the term SOFR (along with other forms of SOFR) are:
- for business loans, in particular multi-lender facilities, and trade loans,
- certain securitizations that hold underlying commercial loans or other assets that refer to the term SOFR and where those assets cannot easily refer to other forms of SOFR, and
- derivative products intended for the end user intended to hedge treasury products referring to the SOFR term.
The term SOFR has much broader use cases than the term SONIA (the UK recommended risk-free rate). The ARRC continues to recommend that market participants continue to use overnight SOFR or SOFR averages rather than forward SOFR in other situations, including, among others, the derivatives market (except for the limited use case above), floating rate bonds and most securitizations. Such has been the demand for a forward rate in developing markets where switching to a retrospective rate is virtually difficult as the LMA is currently working on a forward rate document for developing markets. The draft document will initially be released as an exposure draft.
credit sensitive rates
In the US domestic market, some institutions encourage the use of credit sensitive rates, such as the Bloomberg Short Term Bank Yield Index (BSBY), and the American interbank offered rate (AMERICAN) instead of SOFR. This is strongly discouraged by UK and US regulators, mainly because these rates do not comply with IOSCO’s robustness principles, resulting in (potential) financial instability and the possibility of rate manipulation (much like the LIBOR). Parties that choose to use these rates should also consider the hedging risks associated with using an alternative rate like this.
This article began with two truths; here’s another – it’s a dynamic space. Be prepared, don’t wait to understand your best positions until your bank presents you with its best option.