On July 27, 2017, the U.K.’s Financial Conduct Authority (FCA) announced that banks would no longer be compelled by the FCA to support LIBOR past the end of 2021. The administrator for the LIBOR Benchmark, ICE Benchmarks Administration (ICE), has said they will continue to publish LIBOR after 2021. However, regulators have signaled that continued reliance on LIBOR could present a systemic risk. According to the regulators, this systemic risk exists because LIBOR continues to suffer from a lack of real transactions underpinning the construction of the LIBOR indexes and, beginning in 2022, LIBOR could be further undermined as a benchmark as many banks may drop out of the LIBOR submission pool.
The threat of banks exiting after December 31, 2021 means that regulators will likely continue to push market participants, particularly large banks, to transition away from LIBOR. The December 31, 2021 date provides a relatively short timeframe for transitioning to LIBOR alternatives.
The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) in 2014 in order to develop contract robustness, identify best practices for LIBOR alternatives, and create adoption and implementation plans for LIBOR alternatives. The ARRC recommended the Secured Overnight Financing Rate (SOFR) as the alternative reference interest rate for USD LIBOR and began publishing the rate in April 2018. The ARRC created a Paced Transition Plan comprised of steps to encourage market adoption of SOFR. The ARRC has generally been meeting the Paced Transition Plan’s objectives ahead of schedule, but important issues remain unanswered for end users.
As a benchmark index rate, SOFR has some fundamental differences from LIBOR. SOFR is representative of general funding conditions in the overnight Treasury repo market, while LIBOR is a measure of unsecured bank borrowings for a given tenor (e.g., one-month, three-month, six-month). If not handled correctly, the fundamental differences inherent in a secured overnight rate and an unsecured forward-looking term rate, coupled with the massive amount of economic activity tied to LIBOR, creates the potential risk that significant value transfer could occur between buy-side and sell-side participants in a transition from LIBOR to SOFR.
ARRC Consultations for USD LIBOR Fallback Contract Language
In order to make recommendations addressing transitional risks in contract language, the ARRC released an initial set of consultations in September regarding the fallback language for Floating Rate Notes (FRNs) and syndicated business loans. On December 7, 2018, the ARRC published in full the comments received in response to these consultations representing feedback from a broad cross-section of the market.
Symmetry Between Cash Instruments and Derivatives
The ARRC consultations specifically requested feedback regarding fallback provisions for FRNs and syndicated business loans. However, for end users hedging their cash instruments, it is necessary for the fallbacks for cash instruments to align with fallbacks for derivatives. One current proposal by the ARRC contemplates the use of term rates for cash instruments. In support of this proposal, the Federal Reserve Bank of New York is expected to publish an indicative forward-looking term SOFR in early 2019. In contrast, the International Swaps and Derivatives Association (ISDA) has not endorsed term rates for derivatives. If the ARRC and ISDA continue with their current fallback proposals, there will be a divergence between the rates for these products, assuming forward-looking term SOFR is ultimately published and incorporated as a fallback for cash instruments.
The lack of term rates in the derivatives fallback waterfall appears driven by regulators’ concern that allowing term rates to be used in derivatives could create a situation analogous to that which exists for LIBOR. Like LIBOR, term-SOFR may be more vulnerable to manipulation because there may be large volumes of transactions priced off a term-SOFR index that is based on insufficient actual transactions. There are important differences between SOFR and LIBOR, however, and concerns of manipulation need to be considered in conjunction with the disruption that many end users may face if they did not have access to term rates for derivatives, particularly given that, term rates are proposed to be the primary fallback in the ARRC’s waterfalls.
At a practical level, since fallbacks to term rates are currently being contemplated for cash instruments, end users face a dilemma in their consideration of what may be the best option for incorporating fallbacks into cash instruments that may be hedged now or in the future. End users may be in favor of term rates for their cash instruments due to their familiarity and the fact that current systems and market practices are based on term rates—conceivably making a transition to term rates easier to administer than a transition to compounded rates. However, the lack of current knowledge of potential costs associated with using term rates for cash instruments could offset a perceived administrative advantage. Alternatively, even if ISDA does not include term rates for SOFR in its fallback waterfalls, end users may prefer to negotiate fallbacks to term rates for derivative contracts, provided they exist and are robust enough to be viable.The majority of respondents to the ARRC consultations shared similar concerns regarding the divergence between fallback language for cash instruments and derivatives and encouraged the ARRC to consult with ISDA to align practices across products.
Considering the ARRC may recommend term rates as the proposed fallback language for cash instruments, the ARRC and ISDA need to recognize the reality that a divergence between fallback rates used for cash instruments and those used in derivatives to hedge such cash instruments will cause market disruption and potential operational disruption for end users. The ARRC and ISDA, along with other regulators and market participants, should consider the potential for market abuse as well as the impacts to end users of losing access to derivatives that match cash instruments. Given the need to allow end users as much time as possible to adapt to new rates and market standards, this consideration must be a top priority and should not be put off until later in the transition process.
Hardwired versus Amendment Approaches
One critical debate currently occurring is between hardwired and flexible, amendment-based approaches. Hardwired approaches to fallback language would create fallbacks to specific rates and spread adjustments in the event of LIBOR unavailability. Hardwired approaches have the advantage of providing contractual and legal certainty as to what happens if LIBOR is no longer available. Amendment-based approaches contemplate negotiation or, at a minimum, reasonable consultation between counterparties to determine a successor rate and spread adjustment. They do not provide contractual or legal certainty, but they do provide counterparties with the flexibility to protect themselves from value transfer through negotiation. As with any negotiation, a risk inherent in the amendment approach is that one party may have leverage over the other at the time of negotiation resulting in an outcome that diverges from the originally negotiated intent.
In the current environment, alternative rates and spread adjustments are still being developed and substantial uncertainty exists regarding how these rates and spread adjustments will work in practice. As the market infrastructure develops around SOFR-based rates and products, Chatham expects that hardwired approaches could come to benefit both end users and dealers. One significant factor that would facilitate this development would be the convergence of fallback approaches for cash instruments and derivatives. This would drive markets to begin developing those products and help mitigate the current market uncertainty regarding mismatches in rate structure between cash instruments and derivatives discussed above.
These are some of the issues that should be considered as market participants prepare for the unavailability of LIBOR and the resulting impact on cash instruments and derivatives. As it will take a concerted effort to align the fallback provisions for cash instruments and derivatives, it is important for end users to provide feedback to the ARRC and ISDA surrounding the operational and economic challenges—in particular potential value transfer—which may occur from the lack of symmetry in the current proposals.