This article is sponsored by SANNE
Sanctions have been imposed on several banks during the last few years for the manipulation of the IBOR prices. This, and the reluctance of banks to continue contributing to the IBORs, has dictated the need for a change.
Currently, benchmark rates are calculated on a forward-looking basis. In contrast, the new risk-free reference rates, to be fully implemented by the end of 2021, will be calculated daily, referencing the real unsecured interbank funding values of the previous day. The rate will then be published the following morning. This mechanism is the equivalent of the previous day’s EONIA (Euro OverNight Index Average), based on actual data.
The RFR methodology avoids the potential manipulation of the interest rates, as it would be based on real information as opposed to forecasts. However, the mechanics of setting interest rates at the beginning of the current period (T-2 EURIBOR/LIBOR USD and T for LIBOR GBP) will not be feasible in these circumstances, as the settlement at the end of the period would be unknown.
The current reference rates are published for different durations (daily, weekly, monthly, quarterly, six-monthly and annually). However, the RFRs are based on overnight values from the previous day and applied daily over the period. This means interest applicable to any period longer than one day must be constructed by combining daily references.
As a risk-free concept, the RFR is a credit premium free rate. As a result, the rate does not reflect the real cost of funds to financial institutions, nor does it include an additional credit premium for the duration of the funding, since they are daily references. And it’s important to note that the methodological approaches and timing of implementation vary considerably from country to country.
The RFR wave is certainly starting to get bigger as it approaches the shore. It is increasingly evident that the market, systems, contracts and – in general terms – the culture of which bonds and loans are oriented towards is completely inverse to the current mechanics. The revision of reference interest rates requires adjustments along the entire value chain, from market segments to downstream units such as settlement, risk and finance. It directly affects almost all variable-rate products.
Despite multiple problems and huge transition costs that the change of references will bring, there is no turning back. Nevertheless, as financial institutions prepare for the rollout, the Loan Market Association has proposed several modifications:
1 Interest calculation methodology
Interest shall be calculated as a result of compounding the RFR for the elected duration of the period. There are several ways in which rates can be compounded (for example, including weekends and/or rounding conventions) and will be clarified within the loan agreement. There is no doubt that a standard will be created soon, however, we do risk having different market practices as we do today for calculation basis (ie ACT/365 GPB and ACT/360 EUR).
The ideal scenario would be for Reuters or Bloomberg to publish the compounded rates at different tenors and with different compounding criteria, straight after the publication of the daily RFRs early each morning. In any case, the agents and banks should have the capacity to generate automatic calculations of the compounded interest rates and it is therefore imperative that they adapt their systems accordingly.
In fact, the linear interpolation for the calculation of interest rates for non-published durations will no longer be applicable, as it is mathematically incorrect (unless the market practice accepts this simplification).
2 Interest fixing dates
Interest will no longer be calculated at the start of an interest period, as is the market practice today. This does not necessarily mean that it will be calculated precisely at the end of the period (in arrears), as it is not practice for syndicated loan calculations to be made on the date of payment.
The LMA is working on a solution to fix the interest rates well in advance of the interest payment date in order to allow both borrowers and lenders to record and manage cash reconciliations. The proposal would be around five to 10 natural days, although it would depend on the type of facility in question. For example, an RCF may require shorter periods. A business day convention will not work in this case. The calculation day should always be the same to ensure that the calculation period has the same length as the period of interest and there should be no overlapping with the previous period.
Banks accommodate their funding to the advanced fixing of rates on rollovers with similar tenors, ensuring a perfect match between their cost of funds and the revenues. The substantial change with RFR will require the banks to modify their funding mechanisms accordingly, with funding remuneration to be based on arrears calculations. The debt funds are a different animal. They may not need to change their funding mechanics through capital calls, although they may need to adapt their hedging instruments.
3 Credit prime
While being conscious that the RFRs are prime free rates, the LMA can only suggest that a credit premium should be considered in the loan agreements, to be added to the calculation of the applicable interest. This credit prime will vary depending on the currency and duration of the interest period. Hopefully, the calculation will be objective and purely mathematical, and will not require the agents to consult the credit premium applicable for each lender on each fixing date.
In summary, market participants (and, more importantly, agents, banks and funds) need to start making big changes before the big wave arrives. The LMA has alerted the market that all changes should be fully implements by Q3 2020, even though the IBORs are likely to be discontinued sometime after this. We believe that it may become even more urgent, as it is likely that some US transactions will be structured on this basis and the rest of the market will follow.
How can the industry adapt to RFRs?
Loan administration and accounting systems should be adapted to deal with ‘in arrears’ calculations, with compounding capabilities.
This is a major challenge, as the banks, funds and agents will need to review their existing portfolio of loans and ascertain the best and most efficient way to novate agreements to the new calculation rationale. We have yet to see any loans being novated for this very reason, as most entities are simply waiting for a market standard. It is highly advisable that the entities start classifying the loans of their portfolio, before the market is flooded with novation and waiver requests.
The LMA has also prepared a draft novation agreement aiming to simplify the novation process, where the parties will just need to tick in the boxes of the agreed terms, making reference to the frame revised loan agreements published for each type of loan. This is of course helpful as it reduces the legal costs of the transition of the LMA based loans.
This is probably not a complex change conceptually, but a game changer mechanically. The appropriate teams should be properly trained on the methodology and various consequences of the rate change, and we anticipate that there will be many seminars in the coming months on this topic.