The benchmark rate for ship finance — Libor — is to be phased out within two years. To smooth the transition and mitigate financial and legal risks, shipowners should begin their preparation as early as possible.
After widespread manipulation of the interbank rate by lenders, regulators have decided to initiate a transition away from the 50-year-old benchmark, which is estimated by the International Monetary Fund to be used in US dollar contracts totalling at least $200trn at any one time.
Although this has been a costly, painful task due to its scale, the UK Financial Conduct Authority — which regulates Libor — has stated that firms must find alternatives by the end of 2021.
This is no small feat for shipping companies. Most shipping loans, bonds and derivatives are pegged to Libor for the greenback.
Challenges abound. For one, new benchmarks have yet to fully emerge, so banks are slow in determining the alternative rates they would opt for with clients.
And as ship finance deals can last for years, the transition will prove a headache for companies engaged in existing and prospective finance deals that extend beyond 2021.
Until now, loan agreements have often included clauses that would allow banks to use the last published Libor or the so-called “cost of funding” as interest rates, should Libor become unavailable.
However, both can result in heightened financial risks post-2021. Using the last publication mechanism would in effect convert floating-rate loans to a fixed rate, while banks could fix the cost of funding arbitrarily.
“Normally the replacement rate relates to the actual funding cost by the banks involved,” Avance Gas chief financial officer Peder Simonsen said. “The top-tier banks have a fairly transparent and stable funding base, which will not impact the transition materially.
“The smaller, weaker or more niche banks may have more volatile funding, which may impact the financing cost. [That is,] it may contribute to increase the cost of capital for tier-one and other shipowners.”
The Alternative Reference Rates Committee (ARRC), set up in 2014 by the US Federal Reserve and the New York Federal Reserve, has picked the secured overnight financing rate (SOFR) as the replacement for the US dollar Libor — which should in theory become the new benchmark for ship finance.
SOFR is designed to be “risk-free”, as it is determined by actual transactions of overnight loans backed by the US Treasury. In contrast, Libor is based on banks’ opinions over the unsecured wholesale loan market for forward periods, and is therefore prone to manipulation.
But this also suggests that SOFR will, by its nature, be backward-looking until a forward derivative market can be developed. And that, according to the ARRC, is not expected to occur before the fourth quarter of 2021.
There is talk that new finance deals may be settled against the compounded SOFR for certain periods, before each payment is due. But this would create more difficulty for borrowers to estimate their financing costs, so such a payment mechanism may need to be refined further.
“Forward-looking rates is what ship finance is used to and comfortable with,” Epic Gas chief financial officer Uta Urbaniak said. “Depending on the individual transaction, it should be possible to make a backward-looking rate work with the right calculation method.”
For now, shipowners may need to become more meticulous in the wording of financing deals, where the terms would probably need to be amended as Libor’s replacement emerges.
Aside from Loan Market Association’s standard, the ARRC has provided guidelines on when the amendments would be needed and how they would be carried out.
In particular, Norton Rose partner Davide Barzilai said the terms of syndicated loans — often seen in ship finance — should allow amendments on the consensus between the borrower and lead bank, rather than all participants.
“This will make things easier than going out to all banks to ask for amendments,” he said.
