There are significant challenges for end users in the transition to IBOR alternatives. The IBORs are ingrained across diverse markets, asset classes, and use cases. There is no single solution that can address all permutations regarding where and how the IBORs are used.
End users are particularly impacted by transition from the London Inter-bank Offered Rate (“LIBOR”), given the prevalence of financial instruments tied to it. Of particular concern to end users is the transition from U.S. Dollar (“USD”) LIBOR, given the tremendous volume of commercial and financial activity denominated in USD. The Alternative Reference Rates Committee (“ARRC”) of the Federal Reserve Board (“FRB”) and New York Fed, has endorsed the Secured Overnight Financing Rate (“SOFR”) as an alternative to USD LIBOR. SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight.
Regulators and ISDA must remain cognizant of the fact that efforts to promote SOFR in the U.S. represent a significant reengineering of financial markets that may impose significant costs on end users and frustrate sound risk management practices.
While SOFR is more robust than USD LIBOR, in the sense that it is based on a significant pool of actual transactions, it is a rate that is untested in markets. Regulators and the International Swaps and Derivatives Association (“ISDA”) must remain cognizant of the fact that efforts to promote SOFR in the U.S. represent a significant reengineering of financial markets that may impose significant costs on end users and frustrate sound risk management practices.
In addition, there may be substantial costs and risks to transitioning the cash and derivatives markets if divergent paths are chosen for triggers, replacement benchmarks, and spread adjustments amongst the underlying cash markets that give rise to financial risk and the derivatives markets used to hedge that risk. These costs and risks are being foisted upon end users because of a series of market abuses that amounted to manipulation of the IBORs, rather than because of any wrongdoing on the part of end users.
Many smaller end users are further challenged in that they do not have staffs of lawyers, lobbyists, or regulatory compliance specialists who can participate in or track the many workstreams related to transition. Many end users likely realize neither the extent of the challenges they face nor the risks they face if they do not have appropriate fallbacks in place, let alone the impact USD LIBOR unavailability could have on their hedges and legacy positions.
The following list of items represent principles and potential actions that can facilitate the transition and protect end users against unnecessary costs, risks and disruption.
- SOFR Term Rates: Consideration of the viability of SOFR term rates should be prioritized, not left until 2021.
- Market Available Rates: Regulators and ISDA should explicitly recognize that any market available rate used in a cash instrument is permissible for use in a derivative used to hedge that cash instrument.
- Regulatory Concerns with Rates in the U.S.: The ARRC should not be used to determine the regulatory acceptability of a term SOFR. Instead, the U.S. Commodity Futures Trading Commission (“CFTC”) should make this determination because the CFTC is in the best position to evaluate compliance of interest rate benchmarks with International Organization of Securities Commissions (“IOSCO”) principles and the susceptibility of a benchmark to manipulation through the use of derivative markets.
- Accountability for Rate Determinations: If it is deemed necessary to refer to a government entity for the purpose of making a rate determination, the FRB or CFTC should be referenced as they have members nominated by the President and confirmed by the U.S. Senate.
- Term and Compounded Rate End-User Working Group: A working group should be created to evaluate the relative costs/utility of compounded and term rates from a practical/operational perspective in terms of end users (including the lack of a credit component).
- Accounting and Financial Reporting Impacts for Legacy and New Instruments: Hedge accounting, debt issuance costs, embedded derivatives, and leasing all require transition guidance and amendments to existing guidance to allow for a smooth transition.
- Availability of LIBOR for Legacy Contracts: Regulators should be aware that in some situations involving legacy instruments, there may be no effective alternative to the use of LIBOR and that complete LIBOR unavailability may cause substantial legal uncertainty and economic harm.
I. Term Rates
Consideration of the viability of SOFR term rates should be prioritized, not left until 2021.
While the ARRC process has focused to date on compounded SOFR, the availability/liquidity of SOFR term rates is a critical issue for end users planning for transition to USD LIBOR alternatives. Regulators and the ARRC appear to have expressed willingness to support SOFR term rates for use in certain types of cash products but have been less clear about whether SOFR term rates will be supported for use in derivatives used to hedge cash instruments referencing term SOFR.
The SOFR landscape has evolved sufficiently that it is possible to consider how SOFR term rates might be constructed and gain sufficient liquidity to be viable. Likewise, it is possible to begin assessing the alignment of potential SOFR term rates with IOSCO principles and the susceptibility of such rates to regulatory concerns such as manipulation.
SOFR term rates that are derived from Designated Contract Market (“DCM”) or Swap Execution Facility (“SEF”) market transactions, for example, offer safeguards against manipulation. Provided the underlying markets had sufficient liquidity, such rates might be competitively priced when compared to potential compounded SOFR rates. On the other hand, if there are wide trading spreads for derivatives tied to term SOFR, it may be that such costs would outweigh the operational advantages of SOFR term rates.
These questions must be prioritized so that end users can focus their transition preparations on the most likely market scenarios for alternative rates and how they will be used for hedging.
II. Market Available Rates
Regulators and ISDA should explicitly recognize that any market available rate used in a cash instrument is permissible for use in a derivative used to hedge that cash instrument.
End users are concerned that the differences in the currently proposed fallback language for cash instruments published by the ARRC and for derivatives by ISDA create a divergence that will result in basis risk, operational difficulties, and accounting challenges that will need to be navigated. When entering derivatives transactions to hedge loans, best practices are predicated on having close alignment between LIBOR cessation triggers, replacement indexes, and spread adjustments.
Since fallbacks to term rates are currently being contemplated for cash instruments and retail products, 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. The lack of current knowledge of potential costs associated with using term rates for cash instruments, however, could offset a perceived administrative advantage. Alternatively, even if ISDA does not include SOFR term rates in its fallback waterfalls, end users may prefer to negotiate fallbacks to term rates for derivatives contracts, provided they exist and are robust enough to be viable.
Likewise, it is possible that other LIBOR alternative rates, such as AMERIBOR or the ICE Bank Yield Index, may be created by market participants and could have utility as USD LIBOR replacements for cash instruments and derivatives used to hedge them. End users may seek to negotiate the use of these rates in cash instruments and derivatives used to hedge them as they offer both term structures and a measure of credit exposure.
While end users understand the desire of the FRB to encourage the creation of liquidity alternative risk-free rates such as compounded SOFR, the FRB and ISDA should state clearly to the public that market participants are free to develop and adopt other USD LIBOR alternatives. In fact, given the uncertainties of how SOFR-based rates will work in practice, the FRB and ISDA should encourage end users’ ability to choose the rates that best suit their needs.
III. Regulatory Concerns with Rates in the U.S.
The ARRC should not be used to determine the regulatory accessibility of a term rate for SOFR. Instead, the CFTC should make this determination because the CFTC is in the best position to evaluate compliance of interest rate benchmarks with IOSCO principles and the susceptibility of a benchmark to manipulation through the use of derivatives markets.
Consideration of SOFR term rates involves difficult and complex public policy issues that are best handled by a regulatory body that is accountable to the public. The CFTC is best situated to lead such consideration, as the CFTC is likely to oversee the markets from which a SOFR term rates would be derived. The CFTC has responsibility for policing the manipulation of rate markets and overseeing the listing of new rate products on DCMs and SEFs. Lastly, the CFTC played a critical role in the development of the IOSCO benchmark principles and, in the absence of the benchmark regulator in the U.S., is best situated to offer guidance on the meaning of IOSCO compliance for USD LIBOR alternative rates.
IV. Accountability for Rate Determinations
If it is deemed necessary to refer to a government entity for the purpose of making a rate determination, the FRB or CFTC should be referenced, as they have members nominated by the President and confirmed by the U.S. Senate.
While it could be positive for the ARRC, the New York Fed, or ISDA to recommend rates or spread adjustments for consideration by market participants, end users do not believe spread waterfalls should reference ARRC, the New York Fed, or ISDA recommendations.
Spread adjustments should be negotiated, given the uncertainties about how they will work for all products and in all market conditions. Spread adjustments will be critical to minimize undue value transfer in transition scenarios. Therefore, until more is known about how spread adjustments will be calculated and managed, end users should maintain the right to consent to rate changes and spread adjustments.
Given that significant work remains to be done in defining and operationalizing USD LIBOR alternative rates, a threshold determination would indicate whether a specific spread methodology can adequately address a reasonable range of market conditions while preserving—to the greatest extent possible—the original economics of the contracts being transitioned. Given the unknowns, it is important for end users to maintain the flexibility to find the appropriate spread adjustment, rather than be locked into a currently unknown spread adjustment between USD LIBOR and a currently unknown rate.
V. Term and Compounded Rate End-User Working Group
A working group should be created to evaluate the relative costs/utility of compounded and term rates from a practical/operational perspective in terms of end users (including the lack of a credit component).
Derivatives markets exist to serve the needs of hedgers. The core purposes of derivatives markets are price discovery and risk management, which are essential to end users.
Risk-free rates that, like SOFR, are based on objective transactions have advantages over quoted rates such as LIBOR when it comes to preventing manipulation. However, they lack the credit risk component embedded in LIBOR, creating intrinsic challenges for borrowers, lenders, and hedgers — the very people for whom the markets exist — that need to be a priority consideration for the ARRC. It is anything but clear that SOFR will be ideal for hedging, or whether other alternative rates may be created that have greater market acceptance.
As noted above, the lack of a credit component and its impact on hedging must also be considered early in the transition process. Even if RFRs become dominant, it is highly likely that hedging methods will need to evolve to address the lack of a credit component. A common use case that indicates the challenge of incorporating a non-term rate is a construct where the payment due under the loan might be due mid-interest period. For example, a bilateral business loan may have interest periods that roll on the 15th calendar day of the month, while having payments due on the 9th calendar day of the month. The underlying reason for this is that it allows the payment under the loan to be collected by the servicer and processed through any waterfall prior to distribution to investors. The use of this construct is only possible with a rate that allows the parties to know the payment amount on the first day of the interest period.
Of the replacement benchmarks presented so far in the various consultations by the ARRC and ISDA, only compounded SOFR in arrears would align with ISDA’s current proposal for derivatives fallbacks. Compounded setting in arrears is attractive to end users because it reflects the actual rate conditions of the period. Rate movement during the period is appropriately reflected in the cash flows that follow, allowing market changes to be reflected in the final rate.
It is important to identify the practical needs of end users in navigating a transition. What the ARRC might find to be economically optimal might not be operationally optimal. In fact, there are likely circumstances where there can be insurmountable operational or contractual hurdles.
VI. Accounting and Financial Reporting Impacts for Legacy and New Instruments
Hedge accounting, debt issuance costs, embedded derivatives, and leasing all require transition guidance and amendments to existing guidance to allow for a smooth transition.
FASB and IASB are currently working on transition projects. While these projects are encouraging, there is much to be done to ensure a smooth transition. We appreciate the challenge of granting relief for a series of events that have a myriad of moving parts in already complex areas of accounting.
End users are not seeking to alter their risk management strategies due to this transition and expect that hedge accounting will continue uninterrupted and without undue additional cost.
Legacy embedded derivatives and lease classification conclusions should not be impacted upon transition to a RFR. Similarly, debt modification and extinguishment analysis should be qualitative and indifferent to the nature of the amendments to debt agreements.
IFRS poses unique challenges due to the recognition of ineffectiveness. Hedge accounting is inherently based on assumptions that often drive recognition of gains and losses. The assumptions that drive the modelling of the hypothetical derivatives and measurement of ineffectiveness will directly drive amounts recognized in earnings.
VII. Availability of LIBOR for Legacy Contracts
Regulators should be aware that in some situations involving legacy instruments, there may be no effective alternative to the use of LIBOR and that complete LIBOR unavailability may cause substantial legal uncertainty and economic harm.
In some instances, particularly with retail products such as student loans and mortgages, the ability to transition legacy products to a new rate faces significant operational and contractual challenges. Regulators must recognize that any declaration of USD LIBOR’s ineffectiveness or other regulatory actions that could effectively render USD LIBOR unavailable could have significant, potentially devastating, knock-on effects.
The situations should be identified now, so that regulators can be adequately informed of the risks of USD LIBOR unavailability for particularly vulnerable markets segments.