Regulators, trade associations, and policymakers are actively engaged in dialogue and activities that will facilitate the transition in U.S. cash (lending) and derivatives markets from primarily using the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) or an alternative risk-free rate (RFR). End users should be aware that they will face distinct challenges during this transition — the size and scale of which are unprecedented. Regulators, trade associations, and policymakers have identified these challenges but have yet to fully address or resolve them.
According to a recent Chatham survey, two thirds of over 500 surveyed end-user derivatives market participants are unsure of how to prepare for the LIBOR transition. The objective of this piece is to raise awareness and understanding of the LIBOR transition by providing a brief background and state of play, as well as the key aspects of this transition and the challenges that end users will face.
Background and State of Transition
Regulators around the world have articulated a consistent and unambiguous expectation that global interest rate markets transition from interbank offered rates (IBORs) to RFRs. Most notably, in July 2017, the UK Financial Conduct Authority (FCA) indicated that it will no longer compel banks to support LIBOR past the end of 2021. The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board (FRB) and Federal Reserve Bank of New York (New York Fed), has identified SOFR as an alternative to USD LIBOR. SOFR is based on a large pool of transactions in the overnight Treasury repurchase (repo) market, where banks and investors borrow or lend Treasuries overnight. LIBOR, on the other hand, is not based on actual transactions but rather on banks’ expert judgment and estimates of borrowing costs. Regulators and many industry experts consider SOFR more robust and less manipulable than USD LIBOR because it is tied to so many market transactions; but because of this, SOFR is more volatile than USD LIBOR on a daily basis.
In October 2017, the ARRC put forth its paced transition plan to encourage adoption of SOFR. Pursuant to that plan, the New York Fed began publishing SOFR in April 2018, with futures and cleared swaps beginning to trade by the end of 2018. Further to the ARRC’s paced transition plan, the CME Group and LCH, the market-leading clearinghouses, or central counterparties (CCPs), will update various valuation-related calculations to incorporate SOFR into discounting and valuation of collateral in October 2020.
In addition to the ARRC, several trade associations, industry groups, and regulatory bodies, most notably including the International Swaps and Derivatives Association (ISDA) and the Commodity Futures Trading Commission (CFTC), have been engaged around the LIBOR transition. In addition, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are working to reduce the amount of analysis required to modify instruments on account of benchmark reform, with the U.S. Treasury also taking steps to minimize the tax impact of the LIBOR transition.
LIBOR underlies hundreds of trillions of dollars in financial instruments. While SOFR volumes continue to grow, volumes in USD LIBOR markets remain greater by orders of magnitude. More recently, public offerings and other financial instruments have begun to include language addressing the potential impact and risks associated with the LIBOR transition.
Key Elements of Transition and Challenges for End Users
The LIBOR transition will impact both legacy (existing pre-transition) and future financial instruments (e.g., loans, derivatives, and floating-rate notes) and will present challenges for end users that have yet to be resolved.
Legacy Instruments: Value Transfer, Lack of Consistency, “Zombie LIBOR,” and Synchronization
Legacy financial instruments must include “fallbacks” to address (a) what will trigger a transition away from LIBOR; (b) what the replacement rate will be; and (c) how to determine a spread over the new rate to preserve the transaction’s original economics (to the extent that counterparties do not voluntarily close out or amend the contracts prior to fallbacks being triggered and applying).
- The intention behind the spread adjustment is to minimize “value transfer” when replacing LIBOR with another acceptable rate. End users risk finding themselves worse off economically by virtue of the transfer.
- In many cases, the LIBOR transition will require amendment of loan and derivatives documentation, as pre-existing language largely is not fit for purpose. Industry participants have been actively engaged in developing robust fallback language to facilitate the mass transition away from LIBOR. However, due to the customization and lack of consistency in language across financial products and, in some cases, within the same financial product (e.g., loan agreements), end users must track, manage, and comply with differences in fallback language across products and counterparties.
- End users are also faced with the risk of the “Zombie LIBOR” scenario, where LIBOR continues to be published but the relevant regulator has determined that it no longer represents the underlying market it is intended to measure. In this case, fallback provisions may not be triggered, but depending on how badly LIBOR degrades, the viability of contracts based on LIBOR could be questioned.
- While ARRC and ISDA have largely finalized their recommended fallback language, there remains a risk of inconsistent outcomes between loans and the derivatives designed to hedge them. This presents risk to end users because of the importance of aligning hedges with underlying risks and eliminating basis risk that would otherwise result from an asynchronous transition between loans and derivatives.
SOFR-Based Loans and Derivatives: Lack of Term Structure, Volatility, and Impractical Substitutions
Transitioning from the term structure of LIBOR, a forward-looking rate with an embedded credit component, to SOFR, an overnight risk-free rate, requires operational changes by market participants.
- Due to LIBOR’s term structure, end users are accustomed to calculating LIBOR-based cash flows well in advance of payment. To date, SOFR remains an overnight rate, and there is insufficient liquidity in futures and OTC derivatives markets to facilitate the development of meaningful SOFR‐based forward curves. Accordingly, end users will need to adopt new technology, processes, and infrastructure to support this fundamental change.
- SOFR is more volatile than LIBOR on a daily basis because it is based on overnight Treasury repo market transactions. End users must negotiate SOFR-based financial instruments and adopt systems and processes that mitigate risk in the face of this daily volatility.
- Certain retail products (e.g., student loans, residential mortgage, et al.) likely cannot practically or easily accommodate a transition from LIBOR to SOFR or any other variable rate. With that, holders of bonds linked to these loans risk economic impact that they never contemplated when purchasing, which also subjects issuers and trustees to litigation risk; and borrowers risk less access to credit historically accessed through these and other non-bank lenders.
End users must recognize and understand the complexity of the challenges facing the market, so they can act in advance of the transition to mitigate its impact. Collective engagement may increase the likelihood that the transition is equitable and no more cumbersome than necessary.