The phase out of the London Interbank Offered Rate ("LIBOR") continues apace and we are now approaching the finish line for transition away from LIBOR to reference free rates ("RFRs"). On June 30, 2023 USD LIBOR will no longer be published for 1-, 3- and 6-month settings. It may be the case that by the time you are reading this note, LIBOR may be consigned to history.
The June 30, 2023 LIBOR cessation date has long been looming over the international finance market and in order to help avoid a "pile up" towards the end of 2023 that could create market disruption, the Financial Conduct Authority (the "FCA") has announced they will require the publication of "synthetic LIBOR" until September 2024 – a rate that will, as announced, be determined by reference to the forward-looking term SOFR reference rate provided by CME Group Benchmark Administration plus the respective ISDA fixed spread adjustment for the relevant LIBOR tenor that is published for the purposes of the ISDA 2020 IBOR Fallbacks Protocol and the ISDA IBOR Fallbacks Supplement. However, this announcement came with the direct instruction that firms must continue to actively transition their financial contracts that reference USD LIBOR. Noting that unless unforeseen and material events were to happen, synthetic LIBOR would cease to be published on September 30, 2024.
Significant strides have been made in the US and a large number of European markets to effect transition before the cessation date. However, notwithstanding the transition that has been successfully achieved for a large number of contracts in the European and US markets it is illustrative that there is still a significant way to go in these markets, with the Financial Times reporting as late as May 31, 2023 that over USD700 billion of junk loans are still tied to LIBOR with cessation less than 30 days away. The pace of change has been glacial in comparison in the GCC and in particularly with regards to the GCC Islamic Finance market.
Within the GCC, there appears to be an overriding market sentiment among corporate borrowers that the announcement of "Synthetic LIBOR" from the FCA provides the freedom to avoid transitioning away from the use of LIBOR in loan agreements, with the deadline for LIBOR cessation effectively being pushed out until September 2024. This prevailing market feeling is dangerously incorrect. The Financial Stability Board have stressed that it is critical market participants act expeditiously to ensure legacy contracts are prepared to transition by the end of June 2023.
The message from the regulators is clear. Synthetic LIBOR represents a temporary stop-gap, designed to ease transition for the more difficult legacy contracts – and will not continue simply for the convenience of those who could have transitioned their contracts but have not done so. It is not to be relied upon (nor is it appropriate to be used) as "LIBOR lite" allowing for LIBOR-based contracts to continue through to 2024 with no changes being made to contracts to allow for this. GCC based corporates and licensed financial institutions should take note of this and work collaboratively to transition any LIBOR linked contracts as soon as is possible.
Islamic Finance markets face a slightly different issue with regard to LIBOR transition (as mentioned in our note published last year. These transactions are proving difficult and time consuming to amend not least as there is a lack of standardized approach across Islamic finance markets towards LIBOR transition. While Term SOFR has been widely embraced as the most appropriate alternative rate, the approach to implementation and amendment still differs on a largely case-by-case basis. Our experience to date has shown that, where Term SOFR is not appropriate (whether for reasons related to hedging, because it is tranched with a conventional piece, or otherwise) for most popular Sharia compliant corporate debt structures in the market (Ijara and commodity Murabaha), the following approaches to LIBOR transition are being adopted:
- Adopting daily rent over the Calculation Period – (rather than over monthly/quarterly periods). The daily rent is linked to a known overnight RFR. The lessee entity needs to log-in to a portal to confirm their acceptance of the daily rate (if no disagreement is provided, the rental period will be renewed daily on a deemed acceptance basis). If the lessee entity disagrees with the rate, the Bank can use their purchase undertaking to accelerate the obligations.
- Breaking the Calculation Period into two sub-rental periods – the calculation period is split into two sub-rental periods. The first rental period is based on an estimated rate through a lookback exercise. The second rental period begins once the calculation is certain and any delta will be recovered in this rental period.
- Spot Murabaha – This incorporates a unilateral undertaking from the purchaser to enter into an intra-day spot Murabaha contract at the end of each calculation period (which would be a "deferred payment date" in the context of a Murabaha structure) or close to that date for the financial institution to recover the benchmark component of its profit.
- Rebate Murabaha – Following this approach a single Murabaha contract is entered into which includes the principal, margin and a calculated rate designed to be reflective of the SOFR for the tenor of the facility. The Banks or the Purchaser would subsequently enter into a Murabaha contract to rebate the difference.
These approaches are by no means definitive or representative of the "correct" way to transition Islamic deals to risk-free rates. The divergence in approach is demonstrative of the challenges facing the Islamic Finance market and with so little time remaining to implement change, we encourage all market participants to finalize transition arrangements quickly.
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