THE IMPACT OF LIBOR REPLACEMENT ON PF LOANS AND THEIR INTEREST RATE SWAPS . BY OLIVER IRWIN , PARTNER , AND BAGYASREE NAMBRON , SENIOR ASSOCIATE , AT BRACEWELL ( UK ) LLP , AND BILL APPLEBY , FOUNDER AND MANAGING DIRECTOR OF ALDERBROOK FINANCE .

As market commentators and regulators have been highlighting for many months , the scale and complexity of the London interbank offered rate ( Libor ) replacement exercise requires all market participants to prepare for a coordinated transition as soon as possible .

As we approach the end-game of this exercise , new project finance debt facilities and their interest rate hedging agreements continue to use Libor as a benchmark rate , albeit with various fall-back regimes depending on the governing law of the loan agreements and associated interest rate hedging agreements .

This article explores some of the risk allocation issues that arise in connection with English law governed Loan Market Association ( LMA ) based project finance loan agreements and their associated ISDA interest rate swaps , as well as some of the recent positions being adopted on transactions .

So long Libor ... Libor ’ s creation is widely credited to Minos Zombanakis , a Greek banker who arranged a US $ 80m syndicated loan for the Shah of Iran in 1969 that contained a floating interest rate that was , at the time , uniquely priced on a formula that was linked to each syndicate bank ’ s cost of funds .

Under Zombanakis ’ s structure , the banks charged the borrower an interest rate that would be periodically recalculated every few months and funded their loans with a series of rolling deposits . Pursuant to this simple formula , the various syndicate banks would report their funding costs before each loan-rollover date . The weighted average , rounded to the nearest eighth of a percentage point plus a spread for profit , became the price of the loan for the next interest period .

Libor soon became the linchpin for a flourishing syndicated loan and derivatives market , and the accepted benchmark for floating interest rates . Often referred to as “ the world ’ s most important number ”, Libor is now used as the reference interest rate for a range of US dollar-denominated commercial and financial contracts worth around US $ 200trn , and more than US $ 370trn if other currencies are taken into account .

Libor is intended to produce a rate that is representative of the rate at which financial institutions could fund themselves in the wholesale unsecured funding market for a particular currency and tenor . However , even though around US $ 200trn worth of US dollar financial contracts reference Libor , the wholesale unsecured funding market is a , comparatively , tiny US $ 500m , which means that these activity levels are insufficient and therefore not a reliable sample for the underlying transactions that are underpinned by Libor .

Partly as a consequence of the changing nature of financial markets , and partly as a response to high profile rate-rigging scandals , the UK ’ s Financial Conduct Authority ( FCA ), the body that regulates the administrator of Libor , announced in 2017 that it did not expect Libor to remain as an acceptable benchmark for the setting of interest rates beyond 2021 .

For some years regulators in various jurisdictions have been grappling with the problem of how to transition the financial markets to an appropriate replacement benchmark rate . Notwithstanding the recent turbulence in the financial markets due to the impact of the ongoing Covid-19 global pandemic , the FCA , the Bank of England and members of the Working Group on Sterling Risk-Free Reference Rates – the primary coordinating body for the objective of achieving market-led transition in sterling markets – continue to advise that market participants should prepare for transition to a new benchmark rate well in advance of the official target of the end of 2021 for the discontinuance of Libor .

In fact , regulators in jurisdictions such as the US and Hong Kong are encouraging financial institutions not to provide any Libor-linked products after the first half of 2021 . One interesting outcome of the effect of Covid-19 on the financial markets was that , at the peak of its impact , the importance of the transition from Libor to RFRs was in fact underlined by a further decline in actual interbank transactions – making Libor even less of a reliable representative rate .

Regulators in UK and Hong Kong have been encourgaging financial institutions not to provide any Libor-linked products after H1 2021

60 Project Finance International September 23 2020