LIBOR Transition FAQs
The end of LIBOR as a reference interest rate index comes with market risks that must be managed. LIBOR is being discontinued and will need to be replaced. All references to LIBOR in loan and derivative trade documentation must be addressed.
LIBOR (an acronym for the London InterBank Offered Rate) is the primary benchmark interest rate set for various durations and currencies each business day in London.
LIBOR is a hypothetical rate based on a daily survey of banks as to where they would lend to other banks for the various term periods from overnight to one year, on an unsecured basis. LIBOR is hence not based on actual transactions and financing rates, and it includes an implied credit component.
LIBOR is a so-called “term” rate, meaning once it is set, it applies for the full term of the LIBOR maturity chosen, for example for one, three, or six months. At the end of the chosen maturity, interest payments are paid, applying the LIBOR rate that was set in advance for the entire calculation period. Thus, interest expense for the payment period is known with certainty at the beginning of the calculation period but paid at the end, or “in arrears.”
U.S. dollar (“USD”) LIBOR is used as a reference interest rate index for more than $200 trillion in notional amount of financial contracts in the cash and derivatives markets. Though 78% of USD LIBOR-referenced instruments mature before the EOY 2021 scheduled LIBOR cessation deadline, that leaves tens of trillions of dollars in legacy notional value to be remedied across numerous forms of financings.
In the wake of the 2008 Great Recession financial crisis, regulators discovered that the very banks trusted to set LIBOR rates, underpinning hundreds of trillions of dollars of financial assets in several currencies, had been manipulating LIBOR to their own advantage. In 2012, this unfortunate LIBOR scandal was exposed. The scheme involved bankers at many major financial institutions manipulating LIBOR surveys for the purposes of profit. This corrupt plot undermined LIBOR as a major benchmark for interest rates and financial products.
Even before this scandal, regulators had been pushing to replace LIBOR as a reference-rate benchmark, with a more objective, market-based rate.
The current reference rate reform is an international effort, and the need to transition away from LIBOR to alternative reference rates is not limited to just USD LIBOR. Most major currency jurisdictions have identified a need for reforming their major interest rate benchmarks.
An entity with any financial transaction that references USD LIBOR will have to transition away from it as LIBOR will most likely cease to be calculated and published after 2021, potentially sooner. This puts the entity into a legacy position and in need of a fallback language provisions to replace any reference to USD LIBOR.
“Fallback language” refers to the legal provisions in a contract that apply if the underlying reference rate in the financial transaction is discontinued or unavailable. Fallback provisions are essentially instructions on how to convert and apply one reference rate to another.
The Financial Conduct Authority (“FCA”) in the U.K. is the regulatory entity calling for the cessation of all LIBORs. The termination is tentatively planned for the end of 2021.
In the U.S., the Federal Reserve (“Fed”) convened the Alternative Reference Rates Committee (“ARRC”) with representatives from the Fed and a diverse set of private-sector entities that have an important presence in the USD LIBOR markets (such as banks, clearing houses, insurance companies, and the International Swaps and Derivatives Association, or “ISDA”) and a wide array of official-sector entities, including banking and financial-sector regulators.
The ARRC was established to identify an alternative reference rate based on a robust underlying market with actual transactions and strong volumes and activity; take into consideration the plight of end-users of USD LIBOR; develop standards; and, to enable a smooth-as-possible transition.
The rate chosen by the ARRC to replace LIBOR is the Secured Overnight Financing Rate (“SOFR”).
SOFR is the repurchase rate (“repo rate”) at which money can be borrowed overnight by posting a Treasury note or bond as security. Given the short tenor (overnight) and high quality of collateral (Treasuries), the rate deemed to be risk-free and track the Federal Funds rate.
The ARRC selected this rate because of the depth of the secured, overnight lending market and its resiliency to closely track the Federal Funds rate in various economic environments and shocks.
In terms of the transactions underpinning SOFR, it has the widest coverage of any Treasury repo rate available. The transaction volumes underlying SOFR are far larger than the transactions in any other U.S. money market. It is widely believed that SOFR will properly reflect an economic cost of lending and borrowing relevant to the wide array of active market participants.
The New York Fed is the administrator and producer of SOFR. The New York Fed publishes SOFR daily on it’s website at approximately 8:00 a.m. ET.
In summary, SOFR is:
- Fully transaction-based;
- Encompasses a robust underlying repo market with more than $700 billion in daily transactions (and growing);
- Is an overnight, risk-free reference rate that correlates closely with other money market rates; and,
- Covers multiple market segments, allowing for future market evolution.
- SOFR is a risk-free rate that tracks very closely to monetary policy. LIBOR is a bank risk rate that tracks very closely to credit events, specifically relating to banks. In times of financial stress, SOFR may decrease and LIBOR may increase, for example, because LIBOR better tracks a bank’s liabilities and risks. Banks have enjoyed this extra security and may find it challenging to replace.
- SOFR is an overnight rate and LIBOR is a term rate. LIBOR sets in advance and is paid in arrears. Hence, both counterparties to the transaction know in advance what interest will accrue in the current period. SOFR can be averaged or compounded, but either way, it will be calculated and set in arrears, thus not offering the same upfront certainty as LIBOR until the end of the current calculation or payment period.
- No term market exists in the repo market, but this is starting to develop through SOFR futures contracts, long-dated SOFR interest rate swaps, and SOFR-based bonds. The Treasury is considering issuing SOFR based notes and bonds. The more that longer-dated SOFR transactions get issued, the more data there will be to build a term structure, or a forward curve, for SOFR. We would be amiss not to mention that this is currently a major market concern and one of the reasons that many market participants are calling for a delay, or a complete discontinuation, with this transition.
- As discussed in the question and answer above, there is not a deep, liquid forward market for term SOFR rates.
- Systems that capture, calculate, and provide rate related information (as they do now for LIBOR) will all have to be modified to account for SOFR. This endeavor is not expected to equal the amount of effort nor cost as seen with the global Y2K project prior to the year 2000, for example, but nevertheless the estimated cost to the world’s largest 14 banks alone for this LIBOR transition will be over $1.2 billion.
- Timing is of great concern, as well. While all financial institutions are working on the LIBOR transition at various stages, it is unknown whether everyone, both financial institutions and end-users, will be prepared by the beginning of 2022. For any party that has not transitioned away from LIBOR and LIBOR ceases to exist, they will find themselves in a “zombie” position to which the answers are not clear today on how to deal with such a scenario.
- There is a real chance of losing, or gaining, from the LIBOR-to-SOFR basis for those who do transition. All interested bodies that are overseeing and/or playing a role in the LIBOR transition are doing everything they can to eliminate this basis risk, but there will undoubtedly be some amount of transfer of value when LIBOR transitions to SOFR.
- SOFR is considered by some to be too volatile a rate to be used as a benchmark. SOFR has been volatile at times when the underlying U.S. Treasury repo market has been volatile. However, comparing an overnight rate to a term rate is not a like comparison. While it clearly is the case that SOFR and other overnight repo rates are inherently more volatile than term rates on a day-to-day basis, it is important to remember that contracts referencing SOFR will be based on averages and/or compounding of these daily rates. Therefore, SOFR would be smoothed across a longer period, diluting any large single day variances. The ARRC’s Second Report (Figure 5 of the report) emphasizes this point, showing that a three-month average of overnight Treasury repo rates has historically been less volatile than three-month USD LIBOR over a wide range of market conditions.
Possible? Yes. Likely? Not so much, at least for now.
USD LIBOR may be replaced by a fallback rate that already occurs in existing financial contracts, for example with a lender’s prime rate, which is often contained in many loan agreements.
Alternatively, the U.S. Dollar ICE Bank Yield Index was introduced by LIBOR’s administrator, the Intercontinental Exchange (“ICE”). ICE’s Benchmark Administration (“IBA”) introduced this alternative in a January 2019 white paper. This new index, developed specifically as a potential replacement for lending activity tied to USD LIBOR, has multiple tenors (one-month, three-month, and six-month terms) as well as the credit component SOFR lacks. Since the IBA created the U.S. Dollar ICE Bank Yield Index, it has since published four updates to inform market participants on the details of it’s proposed methodology as it has evolved, to provide testing results, and to seek feedback.
Many small and midsize banks are pushing for Ameribor as a potential alternative, as SOFR is seen by these banks as being too complicated for their clients and too difficult and costly to administer. Ameribor is calculated from the actual borrowing costs between the banks that are members of the American Financial Exchange. Thus, Ameribor includes a credit component and better represents these banks’ actual funding costs. While the ICE Bank Yield Index isn’t set to launch until late this year, Ameribor futures are already trading on the Cboe Futures Exchange.
Nevertheless, to date neither of these alternative indices have much momentum with the ARRC, which has soundly decided on SOFR as the replacement rate to USD LIBOR, nor with many other influential, major market entities or representatives.
The United Kingdom’s Financial Conduct Authority (“FCA”) is responsible for regulating LIBOR. FCA Chief Executive Andrew Bailey has made clear that the publication of LIBOR is not guaranteed beyond 2021.
The fallback from LIBOR is triggered when there is a public statement that the relevant administrator ceases to provide LIBOR permanently or when it’s regulatory authority (FCA) deems LIBOR to no longer be representative. Such events are referred to as “trigger events” and are anticipated to be further defined for derivatives in the pending ISDA definition amendments.
A one-page statement on how the FCA would announce LIBOR cessation trigger events can be found here.
Currently, there are three primary methods being developed to transition from LIBOR:
- For legacy derivative transactions that reference USD LIBOR, ISDA is working on an amendment to the 2006 ISDA Definitions to provide for fallback provisions to replace USD LIBOR with SOFR. Fallback provisions are essentially instructions on how to convert and apply one reference rate (e.g., USD LIBOR) to another (e.g., SOFR).
- In these amended definitions, a spread would be applied to SOFR to make the updated transaction as equivalent as possible to the counterparties’ respective positions of value when USD LIBOR was being applied prior to the transition, as daily, risk-free SOFR rates trade below term, credit-based LIBORs.
- Adhering to the ISDA protocol means agreeing to the updated floating-rate option definition with its fallback provisions per the ISDA amendment. Both counterparties will have to adhere to the ISDA protocol for the newly updated ISDA definitions’ fallback provisions to be applicable.
- Any new derivative transaction that takes place after the date of the ISDA 2006 Definitions amendment will automatically include the new fallback provisions and counterparties will not have to take any additional steps long as their ISDA Agreement applies the 2006 Definitions, and almost all do.
- • The 2006 ISDA Definitions amendments and related protocols were originally expected to be released in July. However, they were delayed while ISDA awaited sign-off from the U.S. Justice Department and global competition authorities. On October 9th, 2020, ISDA released that it will publish these highly-anticipated updates on October 23rd, 2020, after finally receiving approval from the Justice Department. The supplement and the amendments made by the protocol will take effect on January 25, 2021. Derivative contracts existing as of this date will incorporate the new fallback provisions if the counterparties have both adhered to the protocol or bilaterally agreed to include the new fallbacks into their contracts.
- For non-derivative legacy transactions (such as loans), or for derivative counterparties that do not dually adhere to the ISDA protocol for legacy derivative transactions, another method of transitioning from LIBOR would be through a bilateral agreement among the counterparties. In the case of many loans, a fallback to a Prime rate is common and can be a LIBOR transition solution instead of negotiating a bilateral agreement or transitioning to SOFR.
- If the ISDA protocol is not applicable, no bilateral transition agreement is decided upon, and no other fallback provision is already provided for, any transaction that applies New York law as its jurisdiction according to ARRC will default to the provisions of New York state’s commercial laws. ARRC’s recommendations to amend New York commercial law for the LIBOR transition can be found in the ARRC’s “Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition.”
- Currently, New York commercial laws do not provide for any fallback provisions in the case of the cessation of LIBOR. New York lawmakers were expected to amend their laws, as recommended by the ARRC, by May to accommodate for the LIBOR transition. Many LIBOR-related financial contracts will fall into limbo without such legislation. However, this new legislative change was taken off the docket as New York lawmakers in Albany became preoccupied with COVID-19 and racial-justice issues, so no progress has been made. To date, no state legislator has stepped forward to re-introduce nor sponsor the draft legislation. To compound matters, the New York state legislature is not expected back in session until January.
The transition from LIBOR is an undertaking which many will need specialized expert support. The AEGIS Interest Rate Advisory team is available to provide the guidance needed with these transition related concerns as well as with all interest rate risk and hedging related needs.
The impact of COVID-19 may have delayed some of the interim steps of the transition (such as the anticipated changes to New York commercial law, as discussed in the above question and answer), but it has also shown the markets that LIBOR did not behave in the way it should during a crisis. When central banks were cutting rates to support the pending economic crisis, LIBOR spreads were widening, as seen in March-April 2020. If anything, this reinforced the case for a transition away from LIBOR without delay.
Global and U.S. regulators and other transition related authorities are all still moving ahead with plans for a cessation in LIBOR and a transition to alternative reference rates, such as SOFR for USD LIBOR, by the end of 2021, or perhaps even earlier if certain events occur sooner.