With the end of LIBOR, the secondary debt trading industry needs new standard terms and conditions. Our Debt and Troubled Claims trading team reviews how the Loan Market Association has modified its documents to provide risk-free reference rates.
- What are the adjustments to the late settlement compensation that were made under the specialized technical committees?
- Two new options in the checkbox: Exclude credit settlement difference and apply zero limit
- The new default rate may be simple, but only if the parties agree to everything in advance
The Loan Market Association (LMA) recently published revised Subordinated Debt Trading Documents which will apply to bank debt trades entered into on and after January 4, 2022. Standard LMA Terms and Conditions for Matched and Troubled Trade Transactions (STCs) and LMA Trade Confirmation largely remain the same, but major revisions have been made to the language regarding late-settlement compensation for risk-free reference rates (RFRs). These changes were necessary by moving away from the London Interbank Offered Rate (LIBOR) in the corporate loan market to the RFR (such as the Sterling Overnight Average (SONIA) applied in the Sterling Market and the Overnight Funding Rate (SOFR) applied in the US dollar market).
Amendments to Late Settlement Compensation Under STCs
Under STCs, unless the parties expressly agree otherwise, late settlement compensation begins to accrue during the delay period, which, for nominal trades, is the trade date plus 10 business days (T + 10), and for distressed trades, is the trade date plus to 20 working days (T+20). Historically, the cost of the rollover rate applied during the delay period was based on the one-month Interbank Offered Rate (IBOR) for the relevant currency. As noted in the revised LMA User’s Guide, this carry-over cost approach is no longer appropriate for pooled loan facilities that have switched from using IBOR to RFR.1
loans based on IBOR
Under Section 11.1(a) of the updated STCs, if interest is accrued on the portion traded under a credit agreement by reference to the IBOR rate, the carry-over cost shall be calculated in the same manner as has been done historically by averaging the applicable one-month currency IBOR rate over the course of the currency delay period. If the relevant IBOR rate is no longer available for one month, the cost of the carry-over rate will be the simple risk-free daily rate of that currency.
loans based on RFR
Under Section 11.2(a) of the updated STCs, the default cost of the carry-over rate for the portions of the traded that had accrued interest under an RFR-based credit agreement is now a simple risk-free rate per day.2 For such transactions, the carryover cost is calculated by calculating the simple risk-free average daily rate over the delay period. In addition, the credit adjustment differential (CAS) equal to the CAS payable under the credit agreement must be added to the daily risk-free rate unless the CAS is not payable under the credit agreement or the parties to the confirmation specify that the CAS does not apply.
The risk-free simple daily rate is not mandatory, and the Parties may specify that a composite index, such as the SONIA composite index, will be used for carrying cost purposes in place of the risk-free simple daily rate. If the parties choose to use a composite index, that choice must be detailed in the confirmation along with the index applied to each currency. Given the operational complexities and limitations of the price-generating electronic settlement platform capabilities for market participants, we expect the majority of LMA bank debt transactions to follow the risk-free Simple Daily Default Rate (SDR) agreement for calculating the carryover cost of RFR-based loans.
Late settlement compensation provisions in STCs also cover cases where interest accrued on assets purchased under the credit agreement during the delay period is exchanged from IBOR on an RFR basis. Should this occur, the late settlement compensation will be based on the current IBOR 1 month per day methodology during the delay period in which the assets purchased are subject to the IBOR rate, and the remainder of the delay period will be paid on the basis of the new simple daily RFR (plus credit adjustment spread, if any).
Very useful examples of how to calculate delayed compensation in relation to the new risk-free rate methodology have been added in the table to the revised LMA User’s Guide. In addition to understanding the new methodology, for anyone looking to better understand how delayed compensation is generally calculated, a review of such examples will be a useful learning tool.
Trade Confirmation LMA (Bank Debt)
Other terms of trade
The major revisions for confirmation are located under the Other Terms of Trade (OTOT) section.3 Under this section, the parties may choose, as before, to forgo the delayed compensation, but they now have two new checkbox options to select which will affect the economics of trade.
Exclude CAS for transportation cost?
The first of these new checkbox options is the ability to exclude the credit adjustment difference for posting cost purposes. In determining whether to exclude a CAS for the cost of carrying purposes, each party should be aware that CAS is typically used to settle economic differences between IBORs and RFRs, which, in turn, is intended to reduce value transfer between parties during the transition to RFRs. However, parties should not take this at face value because although LIBOR is sensitive to credit (unlike SONIA and other RFRs), it is still trending alongside other RFRs, such as SOFR. Thus, when a CAS transaction involves, the parties should carefully study the applicable IBOR and RFR trends to determine whether the CAS inclusion of cost for transportation purposes, in fact, limits the transfer of value between the parties. In practice, buyers prefer to exclude CAS in the account as this will reduce the cost of the listed amount owed to the seller for the delay period. Market participants must determine at the time of trading whether CAS will be excluded from the cost of carry accounts.
Does zero apply?
The second new option in the checkbox is to apply the “minimum cost” for transportation purposes. By checking the zero-ground square, both parties make sure that the cost of the load cannot be a negative number and therefore must be paid by the seller to the buyer. As stated in footnote 3 of the new confirmation, if this is agreed, “a lower bound will be applied to the cost of the carry rate when computed for RFR currencies on a daily RFR (and compound RFR) basis before adding CAS if applicable and on currencies at an IBOR basis Relevant IBOR Rate.” A zero-ground check box can be a point of contention between parties. Of course, sellers will prefer a zero floor because it ensures that they will not have to pay buyers in situations where the cost of calculating the load leads to a negative number. On the flip side, buyers won’t prefer not having a zero floor, which allows them to reap the benefits of a negative interest environment.4 In order to avoid such disputes, the parties must determine at the time of trade whether a minimum is to be applied when calculating the cost of carrying.
Other tweaks – default interest under LMA مشاركة participation
The transition from IBORs to RFRs also requires the LMA to change how the default interest provisions are calculated in the standard LMA form for share agreements. Prior to the revised trading documents, the default interest payable by the grantor to a participant or by a grantor for late payments was 2% Plus The relevant interbank market for overnight deposits offered by leading banks in the applicable currency and in an amount equal to the unpaid balance. Under updated LMA share trading documents, default interest will now equal 2% Plus The price at which the party owes money can be obtained by depositing an amount equal to the unpaid balance with a leading bank.5
Buyers and sellers should be aware that the hypothetical cost of the carry-over price for the traded parts that have accrued interest under an RFR-based credit agreement is now a simple risk-free price. Along with this new default rate comes the ability to exclude CAS or apply a minimum cost for transportation purposes. Since the exclusion of CAS and the applicability of ground zero has economic implications for the buyer and seller, these elections must be agreed upon at the time of trade. Otherwise, this economic election may become controversial and disrupt the settlement of open trades.
1 Documenting the circulation of subordinated debts (nominal and non-performing) – User’s Guide at 10, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.
3 Trade Confirmation LMA (Bank Debt) In Section 14, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.
4 Since the global financial crisis between mid-2007 and early 2009, many central banks around the world, including the European Central Bank, have added the use of negative policy rates to their tools. The Swedish Central Bank, in July 2009, was the first to move one of its policy rates into negative territory. The European Central Bank introduced its policy of negative interest rates in 2014. Negative interest rates have now been in place for nearly eight years in the Eurozone, and markets expect such rates to be in place for the foreseeable future. Gregory Claes, “What are the effects of the European Central Bank’s negative interest rate policy?” 8-9 hours, Department of Economic, Scientific and Quality of Life Policy (June 2021).
5 Principal LMA Funded Participation Agreement (Nominal / Distressed) In Section 4.5, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.
Download the guide in PDF format