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21 June 2021

Banknotes in different currencies

The discontinuation of LIBOR is just around the corner. For several decades, a significant proportion of financing transactions denominated in Swiss franc (CHF), Euro (EUR), sterling (GBP), US dollar (USD) and Japanese yen (JPY) have used LIBOR as a reference rate to determine interest payable under the relevant transaction. Transitioning away from LIBOR remains a top priority for many financial institutions in Europe, the US and beyond. Nevertheless, it took until November 2020 for the first Swiss law governed syndicated loan referencing to SARON with a switch mechanism to be reported.

With a global loan market of USD 6875.5 bn in 2019, a rather small decline due to the COVID-19 pandemic in 2020 but with expected growth in the following years, the loan market is crucial. The syndicated loan market was the birthplace of LIBOR and, as a rule, CHF LIBOR was used in virtually all CHF denominated syndicated loan agreements as reference rate for the calculation of interest. Furthermore, LIBOR has been highly relevant in Switzerland in the retail loan market, in particular for mortgage financing. 

The LIBOR replacement poses a major challenge to both the Swiss syndicated and the retail loan markets. The National Working Group on CHF Reference Rates ("NWG"), which leads the efforts to reform benchmark interest rates, has recommended using the Swiss Average Rate Overnight (SARON) as alternative reference rate ("ARR") for CHF denominated lending. SARON represents the overnight interest rate of the secured money market for CHF and in contrast to LIBOR it is a risk-free rate with a term of only one day. This means that for an economically neutral switch from LIBOR to an ARR, SARON as such may not be used as LIBOR replacement rate in CHF dominated loan agreements without adjustments. The NWG recommends using a compounded SARON. It is noteworthy that in the past, compounded SARON closely followed the 3-month LIBOR based on CHF and therefore tends to be relatively predictable. Compared to 3-month LIBOR based on CHF, the compounded SARON is, however, less volatile. 

LIBOR Transition Roadmap of FINMA

On 4 December 2020, the Swiss Financial Market Supervisory Authority (FINMA) published a LIBOR transition roadmap (FINMA Guidance 10/2020) . FINMA considers the end of LIBOR as one of the principal operational risks facing its supervised institutions. The roadmap contains target dates for their supervised institutions' transition to alternative reference rates in order to be prepared for a discontinuation of the LIBOR by the end of 2021. With respect to loan agreements, FINMA recommends adhering to the following transition roadmap:

  • Since 31 January 2021, loans granted by affected supervised institutions should be based on ARR and no new contracts without legally and operationally robust fallback clauses or written agreement regarding an ARR ("tough legacy contracts") should be entered into;
  • Since 31 March 2021, the lenders should have formulated detailed project plans with steps to be taken and progress monitoring in order to reduce the volume of tough legacy contracts; 
  • By 30 June 2021, new loan agreements with variable interest in CHF, EUR, GBP, USD and JPY should, in general, be based on an ARR. Regarding existing tough legacy contracts, lenders should be able to assess whether the objective of reducing the volume of such contracts is achievable; and 
  • By 31 December 2021, all new loan agreements with variable interest in CHF, EUR, GBP, USD and JPY should be based on an ARR.

How to Address LIBOR's Discontinuation in Legacy Loan Agreements

The following are the main options for addressing LIBOR's discontinuation in legacy LIBOR loan agreements (i.e. loan agreements that extend beyond 2021) which do not already contain a clause regarding the switch from LIBOR to an ARR: 

  • Amend the loan terms in a way that the interest is calculated by reference to an ARR. 
  • Amend the loan terms by including a switch from LIBOR to an ARR: This can be achieved by including a mechanism to switch from LIBOR to an economically equivalent risk-free reference rate (i) at a specified future date before the end of 2021 (so-called 'hard-wired switch'), or (ii) if a specified event occurs connected to the discontinuation of LIBOR (so-called 'hard-wired fallback'). The functionality of both options is similar but in contrast to the hard-wired switch, there is no automatic move away from LIBOR on a specified date with the hard-wired fallback.
  • Rely on the existing fallbacks in the loan agreement and thus, not implement any of the above approaches. Failing to take active steps to address LIBOR discontinuation, would – after the LIBOR discontinuation – likely result in an interest rate consisting of the lender's own cost of funds (instead of LIBOR) plus the margin. This approach seems to only be attractive for lenders but neither for borrowers nor for agents (who would need to calculate different interest rates for several lenders). This means that relying on the existing fallbacks could adversely affect the relationship of lenders with its customers and regulators. 

Another important issue to be considered is the level of consent needed to make changes in legacy loan agreements to address LIBOR's discontinuation. This means that the majority lenders' consent might not suffice and other third party consents (e.g. guarantors and security providers) might also be required.

NWG Recommendations - Syndicated Loans 

For the Swiss market NWG recommends using a cumulative compounded SARON with a five banking days' look-back with an observation shift. In this method, SARON is compounded daily throughout the observation period and the interest rate calculated for the last day of the interest period is applied to the entire interest period. In contrast, the Loan Market Association (LMA)'s model documentation provides for interest calculated using non-cumulative compounded rates. In this method, an interest rate is calculated for each day during the interest period. The daily interest rate is used rather than the interest rate per annum. Then, for each day during the interest period, the interest to be paid for that day is calculated. Finally, all interest calculated in this way for an interest period is added together and is payable at the end of the interest period. Hence, the most significant difference between the method recommended by the NWG and the method recommended by other currency working groups such as the Sterling Working Group on Risk-Free Reference Rates is the use of the cumulative rather than the non-cumulative approach. Although, the mechanism contained in the LMA model documentation addressing the replacement of LIBOR is slightly different than the mechanism recommended by the NWG, it does not raise particular concerns under Swiss law.

On 1 February 2021, the NWG published a Model Rate Switch Amendment Agreement which aims at having a standardized amendment agreement for syndicated CHF single currency credit facility agreements in English governed by Swiss law, prepared on the basis of the most recent LMA recommended forms of investment grade facility agreements using CHF LIBOR as a base rate for the calculation of interest. This Model Rate Switch Amendment Agreement adopts a cumulative, compounded in arrears methodology for the calculation of the interest rate with a five business days' look-back with observation shift and, if applicable, a floor at the level of the compounded reference rate (rather than at the level of the daily SARON). Hence, the Model Rate Switch Amendment Agreement contains a mechanism to switch from CHF LIBOR to compounded SARON in accordance with the recommendations of the NWG. Regarding the time for the rate switch this model agreement contains several options. One option provides for fixing a specified date (such as the effective date or any later date before the end of 2021). As an alternative, the rate switch date is not specified in the agreement but agreed mutually by the agent and the borrower.

Swiss Retail Loan Market

The model agreements addressing the replacement of LIBOR (such as the above mentioned Model Rate Switch Amendment Agreement) which have been developed for the syndicated loan market are typically not suitable for the retail loan market. Fallback clauses in retail loan agreements should be easier to read than model clauses drafted for institutional markets and should contain, in principle, the following major elements: (i) A trigger event needs to be specified (by way of either a hard-wired switch or a hard-wired fallback) for the transition from LIBOR to an ARR, and (ii) the ARR, such as the compounded SARON as successor reference rate for CHF LIBOR (including its calculation), which will apply after the occurrence of the specified trigger event, needs to be determined. Furthermore, a credit adjustment spread should be taken into account to address the differences with respect to the credit risk and thus to achieve a result that is as economically neutral as possible.

Conclusion

The LIBOR transition is still a top priority for affected participants in both the Swiss syndicated and retail loan markets. In order to handle this immense challenge as effectively as possible, parties to loan agreements that refer to CHF LIBOR and end after 2021 are well-advised to follow the recommendations of the NWG. For participants in the Swiss syndicated loan market a model rate switch amendment agreement exists which contains a mechanism to switch from CHF LIBOR to compounded SARON in accordance with the recommendations of the NWG. Although, the mechanism contained in the LMA model documentation addressing the replacement of LIBOR is slightly different than the one contained in the model documentation of the Swiss syndicated loan market, this does not raise particular concerns under Swiss law. To date less standardised model documentation exists for the Swiss retail loan market. Nevertheless, there is agreement on the principle content of successor reference rate clauses in order for them to be suitable for retail clients. Finally, to be prepared for a smooth LIBOR transition process, we recommend the affected supervised institutions continuing to follow FINMA's LIBOR transition roadmap. 

Regarding the LIBOR replacement's impacts on derivatives contracts see blog post LIBOR Replacement for Derivatives Contracts: The Time to Act is Now 

For further information, please contact the Banking & Finance Team.

Authors: Adrian Dörig, Christian Schneiter

Category: Banking & Finance

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