LIBOR, Banking Partners, Treasurers Plan for Change

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 active 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 (IBA) 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.

Recent announcements note that there is discussion underway which could extend the life of certain USD LIBOR settings until end-June-2023. On November 30, 2020, IBA announced a consultation in early December 2020 on its intentions to cease publishing 1-week and 2-month USD LIBORs at end-2021 and to cease publishing other USD LIBOR settings (such as overnight, 1-, 3- , 6- and 12-month rates) at end-June-2023.

A same-day statement by the Financial Conduct Authority (FCA, IBA’s regulator) supported the announcement. Additionally, another same-day joint statement by the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, noted that this extension of time would allow most legacy contracts to mature before LIBOR’s end. This joint statement also noted that the agencies “believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly.”

As such, this announcement appears to facilitate the rolling of off legacy LIBOR-based transactions that are more difficult to modify or amend within an end-2021 time frame and does not grant additional time to enter into new LIBOR-based contracts. For that reason, post-2021 new activity in cash and derivative markets is expected to price off of alternative reference rate(s). This is recent information at the time of this article’s publication; we will continue to update this article as new information develops.

The Selection of the Alternative Rate

The ARRC worked 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 generally 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.

SOFR Developments

The ARRC released an initial Paced Transition Plan in 2016, and since then the ARRC has accomplished many steps to prepare the market for the cessation of LIBOR.

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.

Another milestone for the market includes the publication of the final fallback language from the International Swaps and Derivative Association (ISDA). ISDA publishes standardized contract templates (the ISDA Master and Schedule) which are used in almost all domestic derivative contracts.

The IBOR Fallbacks Supplement amends ISDA’s standard definitions to incorporate robust fallback language, with the amended definitions becoming effective on January 25, 2021 for all cleared and non-cleared derivatives that reference ISDA standard definitions. The IBOR Fallbacks Protocol allows market participants to incorporate the changes into existing non-cleared derivative trades with other counterparties that have signed the Protocol. The Protocol is available to be signed today, but it becomes effective on January 25, 2021.

Under these documents, 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. These changes were previously detailed in a ISDA consultation. 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 a few ARRC consultations differ in their suggested fallback language from the expected ISDA fallback language. Their recommended language for the syndicated loan market and the bilateral loan market includes potential fallbacks to Term SOFR plus a spread adjustment and to “daily simple SOFR” plus a credit spread adjustment. Term SOFR does not yet exist, though it is defined as “as the forward-looking term rate based on SOFR that is selected or recommended by the Relevant Governmental Body” in the papers outlining these recommendations. 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).

A milestone the market awaits is the creation and publication of this forward-looking Term SOFR. The ARRC has set a target timeline of the first half of 2021 for these forward-looking term rates to be delivered and has issued a request for proposal seeking an potential administrator for such rates. 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 initial 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. The proposed end-2023 timeline gives some breathing room to legacy contracts, but does not appear to be slowing down an overall market transition to SOFR for new transactions or for transactions that mature outside of end-June-2023. Given this, clients should begin to assess their LIBOR-based exposures and prepare for changes in the future. The end of LIBOR is in sight and companies should begin preparing now. This preparation will also help if LIBOR unexpectedly ceases prior to end-2023.

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?

The ARRC has published a “SOFR Best Practices” guide and a checklist that companies might find helpful as they prepare their organization for change.

Conclusion

As the transition to a new rate 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.