When borrowers execute interest rate swaps to hedge their interest rate risk associated with their debt financing, they ensure that the variable rate on their loan agreement (typically the London Interbank Offered Rate, or “LIBOR”) is the same as in the swap agreement in all respects – the definition of the rate, when the rates are determined and effective, and so on. If there are differences, borrowers will have imperfect coverage – also known as basis risk.

By now you’ve probably heard that LIBOR will be phased out by the end of 2021. So what happens to the variable rate in a loan and swap agreement when LIBOR is replaced? Ideally, they would be replaced at the same time and at the same rate. Many savvy borrowers have indeed asked their banks to assure them that this will be the case. Much to the frustration of these borrowers, we are not aware of any bank that has accepted this request. Why is this the case when the bank is both the lender and the swap counterparty? Why can’t he agree that he will treat them the same when LIBOR is phased out? The reason is that banks do not control the benchmark interest rates or the swap market. In fact, three different groups are working on the LIBOR transition, which increases the likelihood that different results will be achieved.

The main organization working on the LIBOR transition is the Alternative Reference Rates Committee (“ARRC”), which is a group of private market players sponsored by the Federal Reserve Board that has made recommendations on a more robust alternative reference rate. , transition practices. The ARRC has identified the guaranteed overnight rate (“SOFR”)¹ as the most robust replacement rate (i.e. difficult, if not impossible to handle). The other two organizations working on LIBOR’s transition are the Loan Syndications and Trading Association (“LSTA”) and the International Swaps and Derivatives Association (“ISDA”). These organizations serve different groups and may have different recommendations. LSTA and ARRC focus on the loan market while ISDA focuses on swaps and other derivatives. Accordingly, loan agreements are subject to change in accordance with ARRC and LSTA recommendations, while interest rate hedges will be changed in accordance with ISDA guidelines. Fortunately, these organizations have worked hard to harmonize their approaches, although they still have work to do. The remainder of this article will focus on the main areas where potentially different results could mean that the interest rates on a borrower’s loan and their swap are different, and the current state of recommendations from different organizations.

The first and most obvious risk is that a borrower’s loan and swap choose different replacement rates. We know that the ARRC chose SOFR. What is the position of the LSTA and ISDA on replacement rates? The good news is that everyone agrees that SOFR will replace LIBOR. The bad news is that there are different SOFRs. Looking back, fundamentally LIBOR and SOFR work very differently. LIBOR is a term rate. Typically, LIBOR is set at 30, 60, or 90 days (called an “interest period”), and a borrower knows their interest rate for that interest period. SOFR is currently only an overnight rate and is reported by the Fed on its website at 8:00 a.m. for the day before. See https://apps.newyorkfed.org/markets/autorates/SOFR. Thus, borrowers will only know their interest rate after borrowing money. Since SOFR is currently only a daily rate, there are different methods (simple or compound) to calculate interest payments. A full explanation of these differences is beyond the scope of this article, but the ARRC has published a “SOFR User Guide” that explains the differences and challenges of each approach.² The important point is that the loan market and the swap market may not choose the same method of calculating SOFR. The most recent ARRC recommendations provide a cascade of replacement benchmarks. The first recommended fallback option is “Term SOFR” which does not currently exist, and may never exist.³ The second recommended fallback option is “Daily Simple SOFR”. ISDA, for its part, has chosen a third alternative, the “Daily Compounded SOFR” also called “compound in arrears”.⁴ In all fairness, the ARRC acknowledged that borrowers with swaps might wish to fall back on the daily compounded SOFR to better match the ISDA pullback rate.⁵ None of the rate definitions recommended by the ARRC include the actual conventions when rates are selected etc. In addition, the ARRC currently believes that the loan market is likely to have different conventions than those used by ISDA, “thus generating differences between the two if both used SOFR made up of arrears.” “⁶

Another risk is that even if the loan and swap agreements select the exact same replacement rate, they may not come into effect at the same time. Events that require the implementation of the new benchmark rate are called “triggers”. Currently, LIBOR will only be replaced in a swap when the LIBOR ceases to exist (referred to as a “permanent cease”).⁷ Conversely, the ARRC has published a recommended LIBOR alternative language for inclusion in loan agreements that includes “pre-termination triggers”.⁸ This means that a loan can be converted into a replacement rate before the LIBOR actually disappears. ISDA, recognizing that consistency between markets is important, recently sought advice from the market on whether to implement a specific pre-cessation trigger called ‘non-representativeness’ – which it has defined as’ the date on which the UK FCA declares LIBOR ‘can no longer be representative’ in swaps.⁹ This is a promising step because if the ISDA in fact incorporates such a non-representativeness trigger, the mandatory pullback triggers in swaps and loans will align.^ten There are other triggers included in the ARRC language, but they require the borrower’s consent when implementing the fallback rate.

On the good news side, another potential difference between the swap and loan market – spread adjustments – appears to have harmonized. Since SOFR is an overnight guaranteed loan rate and LIBOR is an unsecured loan rate, there must be an adjustment to SOFR to make the replacement rate similar to LIBOR. Obviously, if they use different spread adjustments, the rates will be different. Fortunately, both ARRC and ISDA have decided to calculate the spread adjustment based on the historical five-year median difference between LIBOR and SOFR,¹¹ which means that this potential basis risk appears to have been eliminated.

We are a little over a year away from the demise of LIBOR, and while some differences between the lending and swap market approaches to benchmark replacement remain, the different groups are working hard. to eliminate, or at least reduce, these differences.