ISDA has announced the results of its consultation on pre-cessation triggers for the replacement of LIBOR in derivatives. 

The FCA and the Bank of England declared that they do not expect the impact of the coronavirus to delay the deadline of Q4 2021 for the cessation of LIBOR, but have confirmed that certain interim milestones will be extended. 

In April 2020, the ARRC – the Alternative Reference Rates Committee, a New York trade body convened to oversee the transition from USD LIBOR – agreed a recommended spread adjustment methodology for calculating the difference between USD LIBOR and compounded SOFR. The ARRC is recommending a five-year historical median, which follows the approach agreed by ISDA, following ISDA's own consultation last year. 

One of the key issues in transitioning from LIBOR to risk-free-rates is agreeing a mechanic that allows for the economic terms of the LIBOR product to be retained as the floating rate is replaced by SONIA or SOFR. This is because there will inevitably be a difference between the LIBOR value used in the interest calculation and the value of its replacement. The solution to this discrepancy is for parties to agree to adjust the margin or spread, to compensate for the difference. Therefore, it follows that agreeing a market-standard spread adjustment will help the LIBOR transition immeasurably.

ISDA's most recent consultation asked its members to feed-back on whether they want to see a pre-cessation trigger in the amended 2006 ISDA definitions for LIBOR. The results showed that a majority of respondents favoured including both a pre-cessation trigger and a permanent cessation trigger. If those results are reflected in ISDA documentation, which ISDA now expects to happen with the introduction of the amended 2006 ISDA Definitions, it would mean that derivatives counterparties could trigger the move from LIBOR to the replacement benchmark rate earlier than LIBOR actually ceases to be published by IBA. The pre-cessation trigger would apply if, for example, the FCA declared that sterling LIBOR was no longer a 'representative' rate.

Finally, on 29 April 2020, the FCA announced that, despite the widespread disruption caused by COVID-19, market participants still cannot rely on LIBOR being published after the end of 2021, and this should remain the target date for all firms to meet. However, following on from the March 2020 announcement that some of the interim milestones may change as a result of the coronavirus, the deadline for ceasing new issuances of LIBOR products was extended from Q3 2020 to Q1 2021.

Timeline

End of Q3 2020

• FCA recommendations: "Include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives."
• Action to be taken by lenders: Both new loans and re-financings linked to LIBOR should include clear fallback arrangements that provide for the cessation of LIBOR and the transition to an alternative benchmark rate, whether through an automatic conversion or a specified process that governs how the documentation is renegotiated by the parties.

End of Q4 2020

• FCA recommendations: "Lenders should be in a position to offer non-LIBOR linked products to their customers."
• Action to be taken by lenders: Lenders must develop products linked to non-LIBOR benchmark rates through loan documentation and putting in place the necessary back-office processes to be able to calculate and administer the replacement rates.

End of Q1 2021 (previously Q3 2020)

• FCA recommendations: "New issuances of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease."
• Action to be taken by lenders: Lenders must not write new LIBOR-linked loans that will mature after 31 December 2021.

The recent developments should help to provide participants with greater confidence to transition to SONIA in advance of the current FCA deadline at the end of 2021. Ensuring that the economic terms of LIBOR contracts are not changed when transitioning to risk-free rates and consensus on the trigger for when LIBOR is replaced by the new rate, are two key issues in the transition from LIBOR to replacement risk-free-rates. The results of the ARRC and ISDA consultations on credit adjustment spreads and trigger events are welcome developments, and will hopefully be the catalyst for consensus in the wider market.

Amid the widespread market disruption caused by the coronavirus, the extension of the deadline for ceasing new LIBOR-linked to Q1 2021 will provide much-needed breathing space for lenders and borrowers dealing with more pressing issues. It is telling that one respondent to the Bank of England's recent consultation on the SONIA compound index stated that "due to these unprecedented times" it had "not had an opportunity to discuss this with our smaller members". This demonstrates the impact of COVID-19 on the priorities of many market participants, and the need to balance the acceleration of the transition to risk free rates with the reality of current market conditions.

Get in touch

Please reach out to a member of our Banking and Finance team if you would like to discuss any of the information covered in this article in greater detail. Taylor Wessing acted for Deutsche Bank on one of the first adoptions of a loan referencing a compounded SONIA rate.