It is tempting, given the ubiquity of LIBOR, and the fact that ICE Benchmarks Administration (IBA) has committed to continue publishing LIBOR after December 31, 2021 (LIBOR Submission Zero Day--the date after which LIBOR submitters are free to stop submitting), to think that a transition to a new benchmark may not occur or may occur over a long period of time.
Recent remarks from regulators across the globe, evidence a coordinated and intensive effort to convince markets otherwise. Andrew Bailey--Chief Executive of the UK Financial Conduct Authority (FCA), Randall Quarles--Vice Chairman of the Federal Reserve Board of Governors (FRB), and Chris Giancarlo—Chairman of the US Commodity Futures Trading Commission (CFTC), have all recently stated that they view LIBOR discontinuation as a certainty. Andrew Bailey indicated that the FCA could, at some point after December 31, 2021, find that LIBOR was no longer compliant with the European Benchmarks Regulation if they judged LIBOR was no longer representative, meaning EU supervised entities could no longer use LIBOR for new contracts.
Regulators are keen to encourage market participants to transition to risk free rate (RFR) alternatives to LIBOR such as the USD LIBOR alternative Secured Overnight Funding Rate (SOFR) or Sterling Overnight Index Average (SONIA). What does this mean for end users?
End users can and should begin efforts to assess their exposure to LIBOR in their loan and derivatives documentation. Particularly, they should look at what LIBOR fallbacks exist in their contracts as Chatham outlined here.
While the infrastructure does not yet exist for most end users to begin the transition to these rates, industry efforts to build that infrastructure are ahead of schedule. SOFR began being published earlier this year and SOFR futures have begun trading at the Chicago Mercantile Exchange (CME). Cleared SOFR overnight index and basis swaps have begun.
Last summer, Chatham began articulating the need to regulators for term SOFR products that would be analogous to the term LIBOR products regulators would like to see market participants move away from. The advantage of having term SOFR replacements for term LIBOR rates is that it would allow end users to maintain existing operational practices that have evolved around term rates and provide the greatest predictability around calculating interest payments.
Although incremental, progress is being made. In a recent paper from the Financial Stability Board (FSB), the FSB recognized the need for term SOFR products for loans. The FSB did not express similar support for term SOFR rates in derivative products, although they acknowledged there could be a role for term SOFR derivatives in some instances. Regulators appear to be concerned that term SOFR rates may be susceptible to some of the concerns that plagued term LIBOR rates.
Having debt and derivative rates mirror each other as closely as possible facilitates efficient hedging. Chatham, therefore, has concerns about how a difference in rates could impact hedge effectiveness and/or the need to measure effectiveness and will continue to follow what happens in this area.
Based on the current transition pace and the pressure from regulators to move away from LIBOR, it is likely that term SOFR rates could begin being published in the second half of 2019. Regulators will very likely increase the pressure on dealers to begin offering and using SOFR products throughout 2019. This means that SOFR-based loans and swaps for end users could become available for use in the second half of 2019. Under the regulators’ current timetable, demand for SOFR products would increase during 2020 and regulators would encourage dealers to stop offering LIBOR related products during the course of 2021.
Chatham is engaged in several of the regulatory and industry work streams for transitioning to the new rates through its work with regulators and industry. Chatham participates in several of the working groups of the Alternative Rates Reference Committee (ARRC) and of the International Swaps and Derivatives Association (ISDA) that are addressing the transition to LIBOR alternatives. Chatham will continue to provide updates as these processes moves forward.