NEW YORK, Nov 18 (LPC) - The US$1.2trn US loan market has been slow to adopt to a new lending benchmark as the London Interbank Offered Rate (Libor) is set to be phased out in two years, but a US trade group is offering investors a way forward with a new sample credit agreement.
Libor, which trillions of dollars of investments are pegged to, is set to be retired by the end of 2021. Unwilling or unprepared to be the first to test a new short-term reference rate, participants in the US loan market have been slow to transition to Secured Overnight Financing Rate (SOFR), the recommended benchmark.
“It seems most loan market players are taking a ‘wait and see’ approach; trying to manage what exposure they have by making sure policies are in order and they are prepared to transition instead of leading the transition,” said Judah Frogel, a partner at law firm Allen & Overy.
The Federal Reserve-backed Alternative Reference Rates Committee (ARRC) suggests moving to a forward-looking term SOFR rate plus a spread adjustment and if not available to compounded SOFR plus a spread adjustment. If neither are available, an agreement can be amended to choose an alternative.
To bring more clarity to the process, the Loan Syndications and Trading Association (LSTA) last month released a draft ‘concept credit agreement’ that references a compounded average of daily SOFRs calculated in arrears. The agreement does not set a standard market practice, the group said, and was developed to familiarize market participants with replacement benchmark alternatives.
Companies currently peg payments to one-month or three-month Libor; there is currently no similar SOFR term option.
“We made some decisions around conventions in order to put together a fully developed credit agreement,” said Tess Virmani, associate general counsel at the LSTA. “This is just one option for SOFR; it doesn’t represent a choice we made for the market. We started with compounded in arears because it’s the most challenging and biggest change to current market practice.”
The LSTA included a sample compounded formula within the credit agreement to give a sense of how the rate is calculated and included a look-back period consistent with what some SOFR floating-rate notes and SONIA bilateral loans have used.
The trade group is seeking feedback on the agreement from members and plans to hold an informational webinar in December, with the potential to publish a final document incorporating suggestions in the first quarter of 2020.
“The question of whether markets will be happy with SOFR compounded in arrears is more a function of whether the market can achieve the level of operational efficiency, swiftness and flexibility that exists in the Libor loan market,” Frogel said. “SOFR compounded in arrears is more complex operationally than Libor, but, as a benchmark, as long as people are confident SOFR has stability” they may be comfortable making the switch.
While firms are focused on the transition, most admit they are not prepared.
Only 47% of respondents said they have the necessary talent and capabilities to transition away from Libor by the end of 2021, according to an Accenture survey of 127 financial institutions and 50 corporates globally.
Eighty-four percent of respondents said they had Libor transition plans in place, but four in 10 admitted to lacking a unified approach across business lines. Only 14% are confident their risk management teams have a detailed understanding of the upcoming transition activities and impact on risk management.
“The disparity of answers [to the survey] points to a lack of real readiness and a lack of detailed planning and understanding of all of the different things that need to come together,” said Samantha Regan, global lead for the regulatory remediation & compliance transformation group within Accenture’s Finance & Risk practice.
“Our guidance to clients is to start preparing,” she said. “It’s an event that is coming and anything they can do to think through plans would be time well spent.” (Reporting By Kristen Haunss; Editing By Michelle Sierra)