FAQ: USD LIBOR Transition to SOFR

September 17, 2019 Chatham Financial

The transition from the London InterBank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) looms over the capital markets as 2021 approaches, when LIBOR may no longer function as a benchmark rate. Chatham’s experts on financial risk, hedge accounting, and regulatory matters answered some of the questions our clients have asked to prepare themselves for the upcoming changes. As this transition is constantly evolving, we will continue to update this document to reflect these changes. Please note the publish date for reference.

Preparing for transition

SOFR basics

Fallback language

Market logistics

Term Structure/Rates

Hedge accounting


Preparing for transition

When is the transition from USD LIBOR to SOFR happening?

There is no concrete date at which the transition must occur, however, the FCA (Financial Conduct Authority), which is the overseer of LIBOR, announced back in the summer of 2017 that LIBOR is at risk of discontinuation after 2021. This past August, the FCA reiterated their position that: “the FCA has not changed its position that it is not going to use powers of compulsion towards submitters”… after 2021 and that, “My best guess is that some panel banks would already have departed were it not for the voluntary agreement to stay in until the end of 2021 that we were able to obtain.” The FCA’s statement refers to the possible use of their compulsory powers for a period of up to two years should they need LIBOR to continue as a critical benchmark. U.S. regulators have used similar rhetoric around the end of 2021 as an end date for LIBOR. (Back to top)

What do we need to do to prepare for the transition? When will I need to act and how?

Organizations should act now primarily by following the status of the USD LIBOR transition, incorporating more robust fallbacks into cash instruments and taking stock of fallbacks or lack thereof in their “legacy” contracts.

Currently, the transition’s focus is on educating the market on the topics of fallback issues (triggers, replacement index, and spread adjustment) and on the ARRC's (Alternative Reference Rates Committee, convened by the Federal Reserve Board) preferred replacement index, SOFR. This ongoing education process is occurring simultaneously with public and private sector participants taking steps to develop market infrastructures and methodologies to support both trading in new indices, like SOFR, and supporting a fallback from LIBOR through the development of more robust fallback language and methodologies to address changes in valuation. (Back to top)

What strategies are we seeing clients use to hedge through the IBOR transition?

With the markets where they are today, LIBOR borrowing/hedging is by far still dominant in the real estate, private equity, and corporate client bases. Most of the focus is on ensuring flexibility for LIBOR fallbacks and cessation events in loan documentation.

Some clients have included trigger-event and cessation-event language in trade confirmations for longer-dated trades (again focused on flexibility and commercial reasonableness). 

As for financial institutions, we’ve seen many of our clients move away from LIBOR-based balance sheet hedging programs to Fed-funds based programs. (Back to top)

How will SOFR be calculated, and what are the benefits and challenges of the transition?

In June 2017, the ARRC identified SOFR as its preferred alternative replacement rate to USD LIBOR. SOFR is calculated by taking the volume-weighted median of transaction-level data from three sources: 1) tri-party repo data, 2) GCF Repo (General Collateral Finance repurchase agreements) transaction data and 3) bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).

The primary benefit of SOFR is that it is fully transaction based. There are approximately $800 billion of underlying transactions supporting the daily calculation of SOFR. Whereas, USD LIBOR relies primarily on expert judgment of the panel submissions to calculate this rate. The most active tenor of USD LIBOR is 3 months, and less than $1 billion of transactions support the calculation of this rate. There is a much more robust market supporting the calculation of SOFR.

For end users, one of the biggest challenges associated with SOFR in its current form is the lack of a term structure for SOFR. SOFR currently is published daily but does not have the term structure (e.g., tenors of 1 month, 3 months, 6 months, etc.) that many end users have become accustomed to borrowing under. (Back to top)

 

SOFR basics

What is the current status of the replacement rate? Is SOFR going to be the replacement rate? Is SOFR an alternative or a replacement?

The ARRC identified SOFR as the recommended replacement to LIBOR in the U.S. It is not certain that all market participants will use SOFR across all floating-rate indexed products. There are other indices contending to replace LIBOR, such as ICE Bank Yield and AMERIBOR. No other index has the broad-based support from the ARRC (cash markets) and ISDA (derivative markets) that SOFR does which is why SOFR is viewed as the likely replacement to USD LIBOR. (Back to top)

What are the key challenges of moving to SOFR?

The key challenge facing SOFR adoption is that SOFR is an overnight, secured, and risk-free rate, where existing floating-rate products in the U.S. are generally structured in a manner that best fits the characteristics of LIBOR which include being an unsecured, forward-looking term rate.

Overnight SOFR is generally viewed as being more challenging to deal with from an operational perspective as it requires systems to take in multiple observations of the index and perform compounding or averaging computations that are not prevalent today.

Other challenges include:

  • Cash Management – the potential for less time to budget for payments.
  • Hedge Accounting – de-designations may be required.
  • Legal – fallback issues may be litigated.
  • Regulatory Concerns – derivative fallbacks may trigger margin and clearing considerations. (Back to top)

How will SOFR be calculated, and what are the benefits and challenges of the transition?

In June 2017, the ARRC identified SOFR as its preferred alternative replacement rate to USD LIBOR. SOFR is calculated by taking the volume-weighted median of transaction-level data from three sources: 1) tri-party repo data, 2) GCF Repo (General Collateral Finance repurchase agreements) transaction data and 3) bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).

The primary benefit of SOFR is that it is fully transaction based. There are approximately $800 billion of underlying transactions supporting the daily calculation of SOFR. Whereas, USD LIBOR relies primarily on expert judgment of the panel submissions to calculate this rate. The most active tenor of USD LIBOR is 3 months, and less than $1 billion of transactions support the calculation of this rate. There is a much more robust market supporting the calculation of SOFR.

For end users, one of the biggest challenges associated with SOFR in its current form is the lack of a term structure for SOFR. SOFR currently is published daily but does not have the term structure (e.g., tenors of 1 month, 3 months, 6 months, etc.) that many end users have become accustomed to borrowing under. (Back to top)

 

Fallback language

What fallback language does Chatham recommend be included in loan documents and ISDAs?

Chatham does not have specific fallback language that it currently recommends since there is still no market consensus regarding a standard substitute rate definition, although the ARRC has been advocating for the transition to SOFR. Chatham has not yet seen many clients incorporating fallback language into derivatives documentation, but we have seen some movement in loan documentation, with clients preferring a couple of different approaches.

Some clients have preferred to take a hardwired approach to fallback language in their loans by including a specific rate, index, or the future determination of a substitute rate by a specific committee or organization (such as the Fed, the ARRC, or ISDA).

Other clients, however, have preferred to retain flexibility in their loans and have included language incorporating whatever fallback rates are ultimately adopted by the marketplace. Whichever approach a client prefers though, Chatham recommends that clients and their advisors take a close look at the trigger and fallback language (or lack thereof) in their loans and their derivatives used to hedge those loans. If the trigger and/or fallback language in a derivative document and the underlying loan agreement do not match, the client should carefully consider the potential risks that a mismatch in the trigger timing and/or the fallback rate between such documents could have for them. While Chatham has not yet seen many clients or counterparties including trigger and fallback language in derivatives documentation, this may change after ISDA releases their amended Definitions and a protocol or as we get closer to the discontinuation of LIBOR.

In addition, since LIBOR, SOFR, and other proposed replacement rates are not directly comparable, to avoid or reduce any value transfer arising solely from the transition from LIBOR to the replacement rate, Chatham recommends that clients try to negotiate a fair spread adjustment in their loans and derivatives. Many loan documents include a spot-spread adjustment methodology; however, Chatham would advise clients to carefully consider the potential results before agreeing to this methodology since variations in SOFR create the potential for significant value transfer as a result of the selection of an arbitrary calibration date. (Back to top)

What are the common changes in documentation (i.e. ISDA) for clients to consider in relation to SOFR for existing trades? Is there a Chatham-standard language?

We have not yet seen clients adjust documentation regarding the change to SOFR for existing trades since there is not, at this time, a definitive market consensus regarding a standard substitute rate definition. However, such a transition would involve the parties agreeing to amend the relevant trade confirmations to reference SOFR. Parties would also, at this time, likely have to define SOFR within the relevant confirmations, since ISDA has not yet updated the 2006 ISDA Definitions to include any definition for SOFR. 

ISDA is currently working on amending the Definitions to include fallback rates that will apply to new derivatives trades that incorporate the Definitions after the amended Definitions are released. ISDA is also planning to release a protocol that will allow adhering parties to incorporate the fallback rates into existing derivatives trades.

We expect that many clients will likely incorporate ISDA’s amended Definitions into their new trades, but it is not yet clear whether most clients will address their existing trades through the protocol or through bilateral agreements. Regardless of the method by which clients incorporate fallback language, Chatham suggests that clients try to align the trigger and fallback language in their loans with the language in the derivatives used to hedge those loans to avoid a potential mismatch in timing or the fallback rate. (Back to top)

 

Market logistics

Will the cash and derivatives markets match up?

There are differences between the cash and derivatives markets at this stage, and both markets are still developing. As an example, the cash markets are currently contemplating fallbacks to forward-looking term rates whereas ISDA seems to be exclusively focused on SOFR compounded in arrears for their protocol fallback.

In July 2019, Chatham responded to ISDA’s consultations regarding fallback methodology and pre-cessation triggers, flagging both as significant concerns. If the differences persist through implementation, Chatham’s concern is that the mismatch could drive market participants to negotiate bilateral adjustments to their derivative transactions (to match their hedged items) rather than adhering to the new protocol.

End users need to be aware of the potential for mismatch and what that could mean from a risk perspective, advocating and pushing for change where necessary to minimize the gap. (Back to top)

How will the derivatives market (specifically caps) be treated?

Chatham expects the market to use SOFR compounded in arrears (with a lookback to the SOFR from X days earlier) for the derivatives fallback rate. Unfortunately, it’s too early to tell how the volatility markets will develop; data necessary to calculate volatility and convexity isn’t readily available given how new SOFR is. Nearly all the regulators’ focus at this stage has been on determining rates and calculating payments with seemingly little concern for related issues like volatility markets. This presents problems not only for caps but also for calculating XVA (Credit Valuation Adjustments, Debit Value Adjustments, Funding Value Adjustments, etc.) on other products like swaps. CME recently announced that they will begin offering SOFR options on 3-month SOFR futures on January 6, 2020. The availability of option products will allow for volatility markets to develop. (Back to top)

How will the spread be determined and implemented when LIBOR goes away and SOFR comes into place?

This is yet to be determined. Chatham responded to ISDA’s July 2019 consultation with a preference for the forward-looking approach over the historical mean/median approach for USD LIBOR. The forward approach would allow for price discovery and the spread to evolve with market forces rather than remaining static based on historic spread calculations.

ISDA released the preliminary results of their consultation for USD LIBOR in early August 2019. The majority of respondents preferred the “compounded setting in arrears rate” for the adjusted risk-free rate and the “historical mean/median approach” for the spread adjustment. ISDA expects to proceed with developing fallbacks for inclusion in its standard definitions based on the compounded setting in arrears rate and the historical mean/median approach to the spread adjustment. (Back to top)

What happens to existing trades when LIBOR goes away?

End users have significant concerns about how existing trades will be treated if LIBOR is permanently discontinued. If LIBOR is unavailable, the current fallback methodology included in the 2006 ISDA Definitions is to request quotes from other banks and then to take the average of those quotes depending upon how many banks provide quotes. The concern is that this methodology is not sustainable in the event of a permanent cessation of LIBOR, which is why ISDA is undergoing a process to revise its Definitions to include more robust fallback language in the ISDA Definitions. To the extent that the updated fallback methodology is incorporated into the terms of the existing trade, once one of the conditions mandating fallback to the replacement rate is triggered, the derivative will be updated to begin referencing the new fallback rate. If an entity does not incorporate the revised ISDA Definitions into the terms of its derivative, it remains to be seen how this will play out in practice.

Under the terms of the ISDA, the calculation agent will be required to request quotes from other banks. However, many if not all banks, likely will be unwilling to provide a quote on a permanently discontinued rate. So, it is unclear what will happen if an entity does not, or refuses, to incorporate the updated fallback methodology into the terms of its transaction. (Back to top)

What will regions outside of the U.S. use as the replacement rate? What’s the latest with other currencies and jurisdictions?

IBOR Rate Replacement Table

 

Term Structure/Rates

Will there be a term structure for SOFR?

Eventually, we expect there to be a term structure for SOFR. Currently, the SOFR swaps and futures markets are not liquid or deep enough to reliably generate a SOFR term rate. Amongst risk-free rate markets, the SONIA (Sterling Overnight Index Average rate) market is a couple of years ahead of SOFR and is much more liquid/deep. It is just approaching a point where term rates may be possible.

The ARRC expects there to be a term structure for SOFR by the end of 2021, but this could easily slip. There is hope in the market that the move to SOFR for cleared swap discounting in 2020 could be a step-change catalyst for the necessary liquidity. 

Additionally, the Fed is expected to publish compounded in arrears SOFR rates for 30, 60, and 90 days in the first half of 2020 to help with bank system constraints around independently calculating compounded in arrears rates. (Back to top)

Does Chatham recommend waiting until term rates are available before transitioning cash and derivative contracts from LIBOR to SOFR?

No, Chatham recommends being as proactive as possible with respect to the LIBOR transition. Many organizations are just beginning their LIBOR transition plans, however, 2021 (when LIBOR could no longer be a benchmark rate) doesn’t leave much time for the massive transition, especially with key details yet to be determined. At this point, Chatham recommends our clients assess/inventory their risk to LIBOR/fallbacks and staff teams as necessary to monitor and facilitate the transition. The market has not yet developed to offer SOFR-based loans and liquidity for SOFR hedges, but this will change over time.

The transition may accelerate but, for now, it appears the availability of a term structure could very well be after the end of 2021. If the markets develop sufficiently to borrow and hedge at SOFR compounded in arrears prior to term structure availability, for example, it would be safest not to wait for the term structure. (Back to top)

 

Hedge accounting

How will accounting be impacted?

Current GAAP requires extensive analysis of contract modifications, the results of which can lead to current P&L impacts and loss of hedge accounting. Revenue, leasing, debt, loans and derivatives are all impacted by these analyses. FASB recently proposed Topic 848 which disregards these analyses as long as the modifications relate solely to reference rate reform. Additionally, hedged accounting is allowed to continue while there is still uncertainty about how the contracts will ultimately transition to an alternative reference rate. Without this guidance hedge accounting for interest rate exposures would be lost by all market participants. (Back to top)

Accounting impacts:

FASB and IASB are working on projects to reduce the amount of analysis that needs to be performed when legacy contracts are modified to support reference rate reform. FASB released an exposure draft of Topic 848, Reference Rate Reform on September 5, 2019. Topic 848 is a set of exceptions and practical expedients to current GAAP for contracts that are affected by reference rate reform. These exceptions and practical expedients treat the amendment of these contracts as a modification or continuation of the contract, as opposed to a termination. Additionally, Topic 848 extends practical expedients to allow hedging relationships to continue and to temporarily ease certain of the effectiveness assessment requirements.

IASB expects to issue Phase 1 of its relief during Q4 2019 while the deliberations for Phase 2 will begin in Q3 2019.

Hedging

For derivatives designated in hedge accounting relationships, a modification to the critical terms of a derivative requires that the hedge accounting relationship be discontinued.  A new hedge accounting relationship can be established for the modified derivative if new accounting documentation is put in place. However, this revised hedge accounting relationship is more complex to account for and typically requires a more sophisticated approach. The standard setters are expected to grant relief on this topic.

Fundamental to cash flow hedging relationships is the expectation that the future hedged transactions are probable to occur. Given the current definitions of hedged transactions, amended contracts that reference a new index would not qualify and hedge accounting would need to cease. The standard setters are expected to grant relief in this area, allowing an entity to assume that the derivative and exposure will transition to the replacement rate at the same time.

For fair value hedges, the value assigned to the hedged debt will need to be updated for the change in the reference rate, though no specific approach will be mandated.

Effectiveness assessments are also impacted. There are several simplified approaches that would become invalid upon amendment of the derivative or hedged exposure. The standard setters are expected to grant relief in this area. Quantitative effectiveness assessments may require market data that is not available and reasonable proxy data may be appropriate.

Debt and loans

When a debt contract is modified it must be analyzed to determine whether the change in cash flows indicates that the modification is in substance an extinguishment of the old contract. If deemed extinguished, any unamortized debt issuance costs must be recognized in current period earnings. Standard setters are expected to provide relief in this area and waive the requirement to assess modified debt if the only modification is to make changes as a result of reference rate reform.

All contracts – embedded derivative review

Upon issuance and modification, all contracts must be analyzed for embedded derivatives. Both qualitative and quantitative factors are considered to determine whether the embedded derivative should be accounted for separate from the host contract.

The standard setters are expected to grant relief so that amendments related to reference rate reform will not trigger analysis of embedded derivatives.

New contracts will pass through the existing requirement to analyze embedded derivatives, though the market data for a new reference rate may not be robust enough initially to complete the analysis. In this case, a reasonable proxy may be appropriate.

Leases

Most leases are carried on the balance sheet as a liability with an associated right-of-use asset, while certain leases are off balance sheet. A modification in the contract requires a reassessment of this classification. The standard setters are expected to grant relief in this area.

Revenue

Certain long-duration construction contracts are recognized in earnings based on a percentage of completion. Amendment of the contract requires a reassessment of the amount recognized in earnings and possibly a new pattern of recognition in the future. The standard setters expect to provide relief for this analysis if the modification is solely due to replacement of a reference rate.

Disclosure

Over the last two years, the Securities Exchange Commission (SEC) has encouraged entities to include additional disclosure in their filings to discuss the impact of reference rate reform. This disclosure should likely reside in the Management Discussion and Analysis section of financial statements. The SEC suggested the following disclosure:

  • Population of contracts that extend past 2021 that reference LIBOR and the plan to convert those contracts.
  • The actions that are needed to mitigate the exposure to LIBOR cessation.
  • The expected impact on profitability.
  • The expected impact on the effectiveness of the company’s hedging strategy.
  • Disclosure that allows investors to see the issue through the eyes of management.
  • The impact on business, systems, processes, risk management, and clients.

The SEC welcomes pre-filing consultation so companies can get the level of disclosure right.

(Back to top)

 


Disclosures

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 19-0239

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