UK task force publishes paper on credit adjustment spreads methodologies
As the end of LIBOR draws closer, the FCA, the Bank of England and the Pound Sterling Risk-Free Benchmark Working Group (the Work group) encourage market participants to actively switch from the reference to LIBOR rates in their loan agreements to risk-free rates (such as SONIA). In this regard, an important aspect that market participants should take into account is the adjustment of credit spreads (CASE) that will be needed. Market participants use CAS to mitigate value transfer risk when transitioning to risk-free rates due to the difference between LIBOR rates and risk-free rates, caused by the lack of credit risk premium in risk-free rates.
Although the working group recommended an applicable CAS approach in the fallback or replacement screens provisions, it did not cover CAS in active transitions prior to a termination or loss of representativeness (pre-termination) event. against GBP LIBOR. In light of this, the working group released a paper on December 17, 2020 on potential CAS methodologies to be used in the active transition from GBP LIBOR benchmark loans to SONIA (the CAS paper).
The CAS document presents descriptions, potential considerations and concrete examples of two potential methodologies for the CAS: the historical five-year median approach (similar to ISDA) and the prospective approach. It provides guidance to lenders, borrowers and investors who are actively modifying their documentation to refer to SONIA, rather than relying on the relevant fallback provisions with respect to SONIA. When market participants transition to multi-currency lending, they will need to consider their approach to any tranche other than sterling.
Historical five-year median approach
This approach examines the historical differences between GBP LIBOR and SONIA, compounded by the arrears rate over a five-year period. CAS is based on the difference between GBP LIBOR and SONIA over a given interest period, calculated using a median over a five-year retrospective period. The historical five-year median approach was adopted by the ISDA in its supplement to the 2006 ISDA Definitions here) and has been used in a number of loan agreements to date which have included a built-in switch to risk-free rates.
The CAS calculation is based on the prospective basic swap transaction market, which is used to calculate the implied future difference between GBP LIBOR and SONIA. It is calculated as the linear interpolation between the various tenors of the GBP LIBOR and SONIA swaps. This methodology has also been used in some lending operations.
Market players are free to choose which CAS methodology to apply during the active transition to SONIA. When determining which gap adjustment methodology to use, the working group identified a number of key considerations that should be kept in mind.
- Associated coverage: Market participants should carefully consider how the associated hedging instruments have been transferred and strive to avoid any mismatch between a loan and its hedge.
- Schedule: The timing of the CAS calculation will be important. Market participants should consider whether the calculation will be made on the trade date or (if later), when switching to SONIA. The date is important because the market prices used in the CAS calculation may change.
- Fair treatment of borrowers: The working group stresses the importance of equitable treatment of borrowers in the choice between CAS methodologies. Some borrowers may be able to assess the equity of conversion agreements, while other, less sophisticated borrowers may not. This should be considered by the lenders.
- Economic impact: Perhaps the most important consideration for parties to a financial transaction is the economic impact of the methodology chosen. The historical median approach does not necessarily represent the actual difference between GBP LIBOR and SONIA, and therefore using this approach may result in a CAS that does not reflect the difference between GBP LIBOR and SONIA on a given date and in the future. Indeed, this was evident in the early stages of the COVID-19 pandemic, as the gap calculated using a historical five-year median fell from significantly above to well below the gap. real GBP LIBOR – SONIA. In contrast, a CAS based on the forward approach will reflect the expected difference between GBP LIBOR and SONIA for the remaining term of the loan. This therefore incorporates market views on the path to GBP LIBOR ceasing.
- Consistency with market precedent: Both methodologies have been used in some transactions in the GBP loan market. However, the historical five-year median approach has not been used in bond or derivatives markets for an active transition.
- Transparency: Bloomberg currently publishes a historic five-year median CAS through accredited channels, as well as on its own website (offline). However, these releases come against the backdrop of ISDA pullbacks, and the terms and use of access to the Bloomberg CAS have yet to be confirmed with respect to the pound sterling lending market. Regarding the forward approach, GBP LIBOR – SONIA base screens are available from a number of suppliers. Market participants should consider the level of transparency offered to them in each of these methodologies, as well as the ease with which the borrower and lender (s) can access the CAS calculated for each of them. they.
- Existing GBP LIBOR Tenor (s): When there are multiple tenor choices under the loan, the borrower and lender (s) should agree on the GBP LIBOR tenor (s) (e.g. 1, 3, 6 months) to use for CAS calculation. The CAS will be different depending on the tenor (s) used.
- Stability of a long-term median: Using a long retrospective period rather than a single observation makes the historical five-year median less sensitive to market distortions over short periods.
- Operational considerations: Lenders should assess operational considerations of managing and sustaining EPS on an ongoing basis across a large portfolio of transactions. The term approach requires a tailor-made solution as it will include inputs subject to the loan profile. Using a historical five-year median approach could simplify the CAS calculation business process.
The US Alternative Reference Rates Committee has suggested an “ early opt-in ” CAS which, if the parties decide to trigger it, turns to an indicative CAS with respect to SOFR during the period until the CAS becomes fixed on a termination or termination event. This means that parties will be free to exit LIBOR prior to a termination or pre-termination event, and then have the CAS set on a termination or pre-termination event, aligning it with the one of their loans that they haven’t triggered. the “early opt-in”. However, this approach has not yet been used in the sterling lending market.
The working group strongly encourages players in the loan market to make an active transition, and the CAS document is a useful guide to key considerations in determining the most appropriate approach to apply a CAS to their transferred loans.