It's the end of the LIBOR era. Are you prepared for SOFR?

Last week, the Alternative Reference Rates Committee (“ARRC”), the group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York to help ensure a successful transition from U.S. dollar LIBOR, conducted its sixth and final symposium on the transition away from the use of LIBOR. Along with its regulatory partners, the ARRC was very clear in its top-line message to the market: there shall be NO NEW LIBOR exposures created, in any market (loans, derivatives, securitizations), after December 31, 2021.

Or else.

The top questions being asked by corporate borrowers include:

• When is LIBOR really going away?
• What is SOFR?
• Are the spread adjustments between LIBOR and SOFR negotiable?
• Is the message of “no new LIBOR contracts” only for cash products (loans) or does it apply for other transactions, especially derivatives?
• When is my non-bank lender required to transition away from LIBOR?

Is LIBOR really going away?

The LIBOR transition is a complicated discussion, but the bottom line is that authorities believe sufficient warning and time has been provided to market participants to replace LIBOR with a more “robust” rate. Their chosen replacement rate is the Secured Overnight Borrowing Rate (“SOFR”). SOFR is considered to be more robust as it mirrors the overnight repurchase agreement (“repo”) rate that finances about $1 trillion in U.S Treasury securities. It has taken longer than expected to realize meaningful liquidity in SOFR, especially in the loan markets, but today most new transaction volumes are SOFR based.

It is time to give up any outside hopes that the LIBOR transition will be prolonged, delayed, canceled, or that there may be some form of “zombie LIBOR” that will continue LIBOR availability indefinitely. This is not a regulatory change; it is a broad market change. And it has already commenced – December 31^st is a mere formality.

The ARRC and regulators are clear on SOFR being their LIBOR replacement for certain types of financing, such as derivatives, but they have not definitely said no to alternative replacement rates for loans, such as the Bloomberg Short Term Bank Yield Index (“BSBY”) or AMERIBOR. But their actions suggest that they are not much in favor of anything but SOFR, even in the loan market.

How is SOFR different?

There are three major versions of SOFR, those being (i) overnight, or daily (compounded) SOFR; (ii) daily averaged (simple) SOFR; and (iii) Term SOFR which has been structured very much like LIBOR with one-, three-, six-, and twelve-month term alternatives. Term SOFR is determined and licensed (for free if you register) by the CME and endorsed by the ARRC for loan transactions. Exactly which SOFR calculation method is best should be determined by borrowers, according to Michael Hsu, the Acting Controller of the Currency.

So, the switch to SOFR should be easy, right?

This is not a set it and forget it prospect, it requires management. Banks have actively been conducting internal training and have engaged in internal and external dialogue on the matter for the past several months. Banks have been working with outside groups, such as the ARRC, and forums in conforming to the year-end cessation of the use of LIBOR. However, do not expect to be able to reach out to your bank on December 30^th and have this issue laid to rest. It is a process, and it takes time and effort to accomplish.

The market’s focus now is on the transition, and after December 31st it will be on the monitoring of legacy contracts, even though most will expire prior to June 2023 when calculation and publication of USD LIBOR will be terminated. Operational soundness by all parties, not just banks, is another major current emphasis.

Even after the ARRC’s sixth symposium, many questions and open issues remain, including:

• Will regulators continue to steer market participants to SOFR as opposed to credit-sensitive rates as many middle market banks prefer as opposed to SOFR?
• What does the future of SOFR based options look like?
• Will there be federal legislation guiding the LIBOR transition, especially for “tough legacy” contracts, as is being called for by regulators to provide a universal safe harbor and avoid certain litigation?
• What does the basis risk between Term SOFR and daily SOFR look like – banks will provide interest rate hedges against Term SOFR but hedge their positions in the interbank derivatives market that is based on daily SOFR, thus taking on basis risk that will likely show up in the bid/offer spread on derivatives prices.

What should I do to prepare for the transition from LIBOR?

It’s all about the details, and the extent you need help with these details. Borrowers don’t need to understand every little nuance of the LIBOR transition, that’s the job of the banks. But corporates do need to be educated on how the transition effects them, what alternatives and solutions are available, and how they can make the transition go smoothly. AEGIS has the expertise and is ready to help navigate this transition.

For more information on the cessation and transition away from LIBOR, and further detail and links regarding these new updates, please visit the AEGIS LIBOR Transition FAQs post here.

If you have any questions, concerns, or issues with anything regarding this set of events or anything you read in the post, please email rates@aegis-hedging.com.