LIBOR transition and loan hedging: basis risk and how to deal with it

The problem for loans and their hedges

Like all contracts that use a LIBOR reference rate, loans and the products that hedge them are vulnerable to LIBOR ceasing or becoming non-representative.  Timing remains on track for this to occur in December 2021 for all GBP and JPY settings, plus one-week and two-month USD LIBOR settings, and June 2023 for all remaining USD settings.  

The steps necessary purely to ensure contractual continuity in the face of these changes are burdensome enough.  However, market participants transitioning loans and their hedges must face up to an additional problem: to a greater or lesser degree, the two products need to transition in tandem in order for the hedge to remain effective.  Any mismatch in how the loan and its hedges transition, either in terms of the new reference rate or the time at which they switch to it, can mean that the derivative is no longer an effective risk management tool in relation to the loan.

The derivatives and loans industries have developed industry-standard solutions to address LIBOR transition. While these are along similar lines, there are some important differences that may or may not be material in the context of any particular deal.

Addressing contractual continuity – understanding the industry standard solution for derivatives 

IBOR-referencing derivatives typically incorporate the 2006 ISDA Definitions published by the International Swaps and Derivatives Association, Inc. (ISDA).  For these contracts, the solution takes the form of the IBOR Fallbacks Supplement (also referred to as Supplement 70 to the 2006 ISDA Definitions).  

The effect of the IBOR Fallbacks Supplement is to introduce contractual fallbacks, which apply upon the relevant LIBOR rate ceasing or becoming non-representative.  The LIBOR rate used in the contract will switch to a specified replacement rate published by Bloomberg, which comprises (i) a term-adjusted risk-free rate (SOFR, SONIA, etc.), compounded in arrears for the period corresponding to the designated maturity of the original rate and (ii) a credit adjustment spread.  The applicable credit adjustment spreads were fixed on 5 March 2021, in line with the derivatives industry-agreed methodology (being the five-year historic median of the difference between the relevant LIBOR and equivalent RFR for the relevant maturity).  These replacement rates have been designed to minimise any transfer of value between the parties as a result of the transition.

The IBOR Fallbacks Supplement has been automatically incorporated into new derivatives contracts entered into on or after 25 January 2021 that incorporate the 2006 ISDA Definitions.  For legacy derivatives contracts entered into before that date, the IBOR Fallbacks Protocol can be used to effectively incorporate the terms of the IBOR Fallbacks Supplement. When an entity adheres to the Protocol, it in effect amends all of its in-scope contracts with all other entities that have also adhered.  It is therefore an extremely efficient tool for remediating derivatives at scale.

Basis risk – where it comes from 

While the IBOR Fallbacks Supplement and Protocol present an effective and administratively welcome solution to the problem of contractual continuity, they may or may not be suitable given that the relevant loan may not be transitioning in the same way.

There are two main areas in which differences between the replacement rate on the loan and the replacement rate on the hedge could result in basis risk:

• Timing (for example, if a loan is actively transitioned by amendment in advance of LIBOR ceasing or becoming non-representative and the hedge only transitions upon LIBOR actually ceasing or becoming non-representative).
• Terms, i.e. the floating rate determined under each product might be substantively different, both in terms of
  • the methodology applicable for determining the RFR (for example, whether observation shift applies, the number of days’ lookback, and so on); and
  • the amount of the relevant credit adjustment spread (which may be calculated by a number of different methods).

As mentioned, the derivatives and loans industries have not arrived at the same conventions on each of the above points.  And further, practice in the loans market differs across geographies (particularly in relation to the US, where the Alternative Reference Rates Committee has recommended term SOFR for certain USD business loans).  To see where basis risk might arise, we can make a broad comparison between each solution’s approach to the key parameters applicable to the replacement RFR; in the table below we compare the industry-standard solutions provided by the Loan Market Association and ISDA: 

Loan Market Association recommended form in line with £RFR working group recommended conventions for sterling loans

• Active transition (i.e. amendment) ahead of LIBOR cessation required by regulator but flexibility regarding timing of switch to RFR
• Lookback without observation shift
• 5 Banking Day lookback
• Daily non-cumulative compounding
• Daily floor
• Credit adjustment spread up for negotiation

ISDA IBOR Fallbacks Protocol / Supplement

• Fallback kicks in on LIBOR cessation / unrepresentative
• Lookback with observation shift
• 2 Banking Day lookback
• Cumulative compounding
• No daily floor; floor can be applied to period
• Bloomberg numbers fixed on 5 March 2021

Basis risk – how to deal with it

However, merely establishing that there is, or might be, a difference between the RFR on your loan and your hedge is not the end of the story.

The key for market participants is to really understand the extent of that basis risk, and whether it is an issue for their particular deal.  There are four key areas to think about:

• Economic shortfalls.  If a borrower has different rates on its loan and hedge, the amount it receives under the hedge may not be enough to cover its liabilities on the loan.  So for example, in a limited recourse context, parties are more likely to shy away from mismatching terms or transition timing, and seek another solution.  Conversely, a borrower with limited hedging covenants and/or which generates actual cash may feel less inclined to insist on matching terms.
• Accounting.  This is an important area – any borrowers that rely on hedge accounting treatment will need to fully assess the impact of their chosen transition option, and seek advice where appropriate.
• Tax.  Again, a specialist area, but transaction parties should make sure there are no adverse tax consequences of their preferred approach.
• Legal covenants.  Parties should ensure that they continue to comply with their hedging covenants (for example, if you must “hedge” a certain percentage of the principal amount of your debt, are you comfortable that you are doing so if you have a SONIA loan but a LIBOR hedge for a certain period?).

The upshot of this is that it is not the correct approach to assume that the RFR on the hedge should mirror precisely the RFR on the loan.  Having assessed the impact, it may be totally acceptable to the transaction parties to have mismatching terms to a certain degree.  Conversely, there may be a good reason to insist on precise matching.  The key to finding the right solution lies in understanding where any basis risk might arise, its extent, and how it really affects a given deal.

Alternative solutions

Where parties are not able to wear the basis risk generated by the industry-standard solutions, they will need to look to a bespoke transition arrangement.  Whilst a bespoke arrangement has the benefit of enabling a more “perfect” hedge by allowing parties to tailor matching RFRs, negotiating this can be a time-consuming and labour-intensive process.  ISDA has helpfully published new definitions to allow market participants to “build your own” RFR, and so facilitate derivatives conventions that look more like those deployed in the loan market, but any bespoke solution will still need to work within the liquidity, operational and conduct constraints faced by the relevant parties.