Change is coming to the markets. The Federal Reserve, various domestic and international regulators and agencies, and market participants are engaged in extensive efforts to transition the market away from U.S. Dollar ICE LIBOR (“LIBOR”) to an alternative rate. With over trillions of global financial instruments tied to LIBOR, across both derivative and funding markets, the transition is an enormous undertaking for market participants across derivative and cash markets. Notably, other international jurisdictions are also transitioning to new reference rates as well.
The Run-Up to Change
LIBOR is a well-entrenched rate and has been in use since the mid-1980s. It is a submissions-based rate calculated by taking the trimmed mean of 16 banks’ estimates of their wholesale funding costs. ICE Benchmark Administration (BA) publishes daily LIBOR across different maturities, including for one-, three- and six-month rates.1
In the early 2010s, following findings of manipulations of the benchmark and qualms over structural elements in wholesale funding markets, several domestic and international bodies raised concerns over the robustness and long-term viability of LIBOR.2
The Alternative Reference Rates Committee (ARRC) was formed in 2014 in response to these concerns. The ARRC is a private sector group, convened by The Federal Reserve Board and the Federal Reserve Bank of New York. Originally formed in 2014 to select alternative risk-free rate(s) for LIBOR in derivative contracts, the ARRC was reconstituted in 2018 to expand its scope and address a transition away from LIBOR in other markets as well.
This expansion followed an announcement by the primary regulator of LIBOR in 2017 that it would not compel panelist banks to submit to the LIBOR panel indefinitely. Instead, the regulator announced it would only help sustain LIBOR until the end of calendar 2021. This underscored a potential end-date for LIBOR for all financial products which use LIBOR.
The Selection of the Alternative Rate
The ARRC began to identify reference rates that were transaction-based and that also complied with international financial benchmark standards. In March 2018, the ARRC selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight secured by U.S. Treasury securities (commonly referred to as “the repo market”).
SOFR and LIBOR differ in their construction in several ways. SOFR is a transaction-driven rate, based on trades in the repo market with volumes that average almost $1 trillion, while LIBOR is based on the funding submissions of 16 banks. SOFR reflects the broad cost of borrowing cash overnight secured by US Treasury collateral, while LIBOR is reflective of costs to borrow in unsecured term wholesale markets.
All else equal, secured transactions with shorter terms should result in lower rates than unsecured term transactions. However, on-going market dynamics could affect this relationship given differences in the markets underpinning both rates. For example, quarter- and year-end liquidity needs have contributed to increases in repo rates in the past, which in turn drive increases in SOFR.
Notably, SOFR is a domestic rate, published and calculated by the Federal Reserve Bank of New York. In contrast, LIBOR is published and regulated in the United Kingdom.
Major steps include the launch of SOFR-based futures in 2018, the first execution and clearing of a SOFR-linked over-the-counter interest rate swap, and the addition of SOFR as a benchmark interest rate by the Financial Accounting Standards Board. Additionally, numerous ARRC-related working groups have published suggested language covering fallback language across numerous markets, including best practices for syndicated loans, bilateral business loans and securitization products.
Key milestones that the market awaits include final fallback language from the International Swaps and Derivative Association (ISDA) which would cover interest rate derivative markets. ISDA publishes standardized contract templates (the ISDA Master and Schedule) which are used in almost all domestic derivative contracts. ISDA is expected to publish a protocol, which would update its standardized documentation for interest rate derivatives to implement fallback language for what triggers a fall back to an alternative rate and how that alternative rate is calculated.
A recent ISDA consultation shows that LIBOR is expected to be re-defined, under specified trigger events, as a compounded risk-free rate (i.e. SOFR) plus a credit spread component. These adjustments are needed to compensate for the shift from an unsecured index to a secured index in existing and future contracts. Compounding of the risk-free rate will be in arrears and will reflect the underlying tenor of the applicable LIBOR (e.g. 1-, 3-, 6- month). The credit spread adjustment will be based on the median of the historical differences between the relevant tenor LIBOR and the corresponding fallback rate compounded for the relevant tenor over a five-year period-of-time prior to the announcement that triggered a fallback to the alternative rate.
It is important to note at least one ARRC consultation differs in its suggested fallback language from the expected ISDA fallback language. The recommended language for the syndicated loan market includes a fallback to “daily simple SOFR” plus a credit spread adjustment. The consultation for the bilateral loan market includes fallback language alternatives covering both compounded and simple averaged SOFR. Entities could encounter basis risk as the result of any differences between a hedging instrument and the instrument being hedged (i.e. differences in fallbacks language could affect the ultimate cost of funds on a hedged loan).
The market also awaits forward-looking term SOFR rates, that would be based on SOFR-derivatives markets. However, liquidity in SOFR-based derivative markets needs to grow in order to produce a robust, forward-looking rate. The ARRC has set a target timeline of the first half of 2021 for these forward-looking term rates to be delivered. The New York Federal Reserve Bank has already begun publishing SOFR averages covering a rolling 30-, 90- and 180-day calendar periods for those in need of a backward-looking term SOFR.
The Impacts for Corporate and Commercial Clients
While the announced end-2021 timeline accelerated market participants’ work on the transition away from LIBOR to SOFR, and progress has been made, there remains much work to do. Given this, clients should begin to assess their LIBOR-based exposures and prepare for changes in the future. End-2021 is in sight and companies should begin preparing now. This preparation will also help if LIBOR unexpectedly ceases prior to end-2021.
As a corporate or commercial entity, consider reviewing your loan and derivative contracts. Where do you have LIBOR-based exposure? How much do you have? Do you need to appoint internal stakeholders to manage the transition? Do any systems need upgrading or adjustments? Are changes needed to maintain on-going reports? Are there any differences in fallback language across contracts?
As the end of 2021 deadline approaches, all these issues will become more pressing for banks and corporates alike. Fifth Third will continue to work with our clients to help them better understand and plan for the expected LIBOR transition.
Please visit our LIBOR to SOFR transition page for further information.