Progress in LIBOR transition continues to unfold, with cessation dates of December 31, 2021 in the UK and June 30, 2023 in the US. Those dates are now are extremely unlikely to move given the latest announcements from the UK’s FCA (for a guide to acronyms used in this article, see below) and ICE. Simply put, SOFR and SONIA are rapidly coming into force.
Progress on USD LIBOR in recent months has included ARRC recommendations around hardwired fallback provisions and triggers. Recent ARRC updates have provided emerging clarity that spread adjustments will be set on a static basis at LIBOR cessation. By necessity, the UK is further along, with recommendations from the GBP Working Group and the LMA on conventions for handling the transition and for the use of post-transition rates.
But from our perspective as providers of loan market solutions, we believe there are still many devils in the details.
Critical aspects of the emerging consensus remain ambiguous, including elements that directly impact what borrowers, lenders, and other loan market stakeholders can expect from Loan Agents. The market is generally willing to leave internal operational elements, such as systems and training, to the discretion of individual Loan Agents. Other operational details, such as how to interpret loan agreements or determine specific fallback rate calculations, should not be left to the discretion of Loan Agents. Rather, it will be important to ensure that the conventions desired by the lenders are discussed and determined to be operationally feasible at origination.
Variability may also easily result in wide information disparities within the industry. Such gaps would affect the dissemination of rate set information, the management of loans within CLOs and other loan vehicles, and the translation of fallback interpretations into rate calculations.
Rate Set Notices: A Compounding Problem
Rate set notices are an easy-to-understand example of such disparities. Some Loan Agents may choose to include each applicable daily SOFR or SONIA rate for the full 30- or 90-day period covered by the notice. We strongly believe this detail offers the better option for borrowers, lenders, trustees, and other stakeholders, including CLO managers. This approach will make loan notices more complex to manage, distribute, and read, but it provides transparency. It better supports the handling of interest due on loan trades within the period, trade reconciliations, delayed compensation, and similar common exceptions.
Other Loan Agents may choose to include only the calculated rate set for each rate set notice’s payment period. This approach has the advantage of simplicity for most recipients of rate set notices, but it will increase the need for follow-up inquiries in exceptional cases where historical daily rate calculations are needed.
In practical terms, the impact of these differing approaches will compound for people who receive rate set notices. Borrowers with multiple loans and agents, direct lenders with a portfolio of syndicated loans, and trustees of CLOs will find even more inconsistency in rate notices than there is today.
These differences for CLOs and other loan vehicles go beyond the variations in format and taxonomy that the market has learned to live with. They will introduce discrepancies at the most fundamental level of providing information about interest rates. Each format will require a learning curve for human readers of the notices. Systems that support some degree of automated ingestion of rate data will also need to “understand” this wide range of formats and rate notice conventions.
Loan Vehicles Face an Uncertain Future
CLOs and other loan vehicles face additional challenges because of a key difference between LIBOR and ARRs. LIBOR is forward-looking while ARRs are either point-in-time or backward-looking. The problem is that governing documents assume that many tests and calculations, such as Interest Coverage Tests and Weighted Average Spread, will be forward-looking, not backward-looking. Therefore, governing documents that specify forward-looking calculations will require amendments.
Additional differences between ARRs and the conventions for using them create challenges for multicurrency loan vehicles. SONIA rate conventions are now live. The GBP Working Group and the LMA have recommended one such convention for syndicated loans: compounded in arrears with five-day lookback and no observation shift. Other broader SONIA conventions may become available for other contexts, but it remains unlikely that the loan markets would choose to support or adopt them. For SOFR, there are conventions for calculating Daily Compounded SOFR and Simple SOFR with lookback in arrears. While others, too, may become available, it is uncertain whether they would be appropriate for syndicated loans.
Finally, because of the gaps between LIBOR and ARRs (which could otherwise be higher or lower than originally expected), calculated fallback rates will include fixed spread adjustments that vary by underlying LIBOR currencies and tenors. This added complexity introduces the risk of additional inconsistencies across multicurrency vehicles. In addition, Euro denominated loans will continue to use the forward-looking EURIBOR.
This range of uncertainties comes together for CLOs as follows. Suppose Loan Agents use different methodologies in the data they calculate and provide forward looking data to Trustees and Collateral Managers. Trustees and Collateral Managers would have to understand those differences on a case-by-case basis and figure out how to operationalize new and complicated ways to consume loan data. In this case, it is not yet clear who, if anyone, would own the responsibility and expense for gathering the requisite asset information to satisfy CLO investors’ needs and compliance requirements.
It is also unclear what will happen with loans in a CLO where fallback provisions are triggered prior to the existence of a satisfactory replacement for forward-looking rates. SOFR in Advance and the SONIA equivalent are simply a point in time. A range of stakeholders have been discussing term rates for some time but cautions about credit risks and liquidity mean slow progress. Such concerns may ultimately result in a decision to abandon term rates in general. Even if current calculation methodologies result in a numerically equivalent rate to a potential term rate, they would not explicitly meet the requirement to calculate on a forward-looking basis. As a result, CLO agreements or contractual terms with CLO service providers may need to be amended and agreed, a lengthy and complex process.
Word Problems: Turning Fallback Language into Calculations
As we have discussed, even with recommended hardwired fallback provisions built into many of today’s loan documents, the loan market will need to contend with a range of rate calculation methodologies during this transition. In addition, loans have not yet universally adopted such provisions, so the likelihood of variations increases with legacy loans. Finally, the provisions themselves allow room for interpretation, whether in amendment language, for older loans, or in fallback language, for those loans using it during the transition period.
The eventual calculation depends on two factors: first, the agreed convention for making the calculation based on the language of the fallback provisions for rates and triggers (there are two recommended for SOFR in addition to the one recommended for SONIA, while others also exist or may emerge in the interim), and second, the specific approach of the Loan Agent (based on what Loan Agents deem operationally feasible) agreed in consultation with the lenders.
Wilmington Trust is ready for this change with upgraded live systems and fully trained teams on the variety of calculations relating to SONIA and SOFR. We have come to understand two essential things in this process: the difficulty and complexities of these calculations and the likelihood that the entire market is not ready for LIBOR transition.
While we have been able to update our loan system, other market participants may still struggle to do so, from legacy technologies to dependencies with other systems to multiple operating platforms. So, it is critical for all market participants from lenders to borrowers to agents and downstream users of loan data to have common standards for interpreting legal language and performing calculations. It is also vital for the systems that support such transition activities to be interoperable.
Lender and Borrower Views
The impact of these critical factors becomes clear when taking the point of view of lenders and borrowers.
Without converging standards and interoperability, lenders with multiple loans in their portfolio and several Loan Agents across the portfolio may see the same underlying language interpreted and then delivered in different ways by each Agent. As a result, their portfolios and underlying risks are more challenging to understand and manage. Further downstream from the lender, end investors lose some of the inherent consistency they previously expected by investing in direct lending funds.
Borrowers may also face unpredictability. They currently have a clear understanding of LIBOR-based calculations and interest payments based on the way interest is calculated across all of their loans. They also have a consistent way of modeling future scenarios based on rate changes. As rates transition, corporate treasury teams will need to ensure that the new methods of interest calculations are identified clearly, so that their models and systems can accommodate any new methodologies for the calculation and payment of interest. Moreover, it arguably becomes much harder for borrowers to predict future interest expenses and coverage ratios when forward-looking rates do not exist, when rates fluctuate, and worse, if at the same time calculation methods differ across various loans. There is even the potential that some lenders will select different spreads from the published spreads set at transition dates. As a result, borrowers will likely have to take a more active role in cash management towards the end of interest periods to ensure that there are enough funds to meet interest payments.
What Happens Next?
What happens next depends on what people do now. Smoothing the transition requires proactive steps by each market participant, and continuous education along the way to highlight challenges and the steps needed for effective operational solutions. Industry groups including the LMA and LSTA have pointed out the need.
As service providers within the loan markets, we are paying very close attention to the way that awareness and education should translate into day-to-day operational implications in order to be workable for our clients and the market overall. Loan Agents play an essential role in executing the transition and ongoing administration afterwards, but ultimately, lenders must take the lead in making the decisions.
We are also hopeful that other loan market participants will pick up the pace of translating broad guidance on transition into detail that can serve as a consensus in standards and interoperability. Additional guidance and clarification of overly broad principles will help mitigate the risk of needless complexity and variety in approaches to transition and industry norms for handling rates once the transition deadlines have passed. It may also be beneficial for work on ARR term rates to accelerate given their functional similarity to LIBOR for loan administration.
While the ticking of the transition clock is getting louder, we look forward to continuing the discussion with our Agency and Trustee clients and the industry as a whole. A coherent and holistic approach will go a long way to reducing challenges for all involved and will help mitigate the risk for unintended consequences.
About the Authors:
Medita Vucic, Administrative Vice President, heads Wilmington Trust’s U.S. Loan Agency Services and is based in Chicago. Elaine Lockhart, Administrative Vice President, heads Wilmington Trust’s Europe Loan Agency Services and is based in London. Richard Britt, Vice President, is head of CLO and Loan Administration and is based in New York.
ARRC: Alternative Reference Rates Committee
ARRs: Alternative Reference Rates
CLO: Collateralized Loan Obligations
EURIBOR: Euro Interbank Offered Rate
FCA: The Financial Conduct Authority (UK)
GBP Working Group: The Working Group on Sterling Risk-Free Reference Rates
ICE: Intercontinental Exchange (the company that manages British pound sterling LIBOR)
LIBOR: London Interbank Offered Rate
GBP LIBOR: British pound sterling LIBOR
USD LIBOR: U.S. Dollar LIBOR (ARRC)
LMA: Loan Market Association
LSTA: Loan Syndications and Trading Association
SOFR: Secured Overnight Financing Rate
SONIA: Sterling Overnight Index Average