Navigating The LIBOR Transition
What is LIBOR and why is it important?
The London Interbank Offered Rate (“LIBOR”) is the most commonly used benchmark for short-term interest rates and often is referenced globally in documentation for derivatives, bonds, business loans and consumer financial products. The setting of LIBOR is made daily on London business days by submissions of indications of the average rates at which LIBOR panel banks can obtain wholesale unsecured funding in 5 currencies (USD, GBP, EUR, JPY and CHF) and 7 maturities (from overnight to 12 months). It is estimated that $200 trillion of financial instruments (loans, bonds, derivatives and consumer financial products) are tied to USD LIBOR and that matters to everyone – small businesses, corporations, banks, broker dealers, consumers and investors.
What is happening with LIBOR and why transition away from it?
In 2017, LIBOR’s regulator decided that it will not compel LIBOR panel banks to continue to make LIBOR submissions after 2021. Accordingly, it is very likely that LIBOR may no longer be available after the end of 2021 and therefore LIBOR is expected to be phased out of use by the end of 2021. Transition to alternative benchmark interest rates is well underway, but much work lies ahead in order to implement a successful reference rate change by the end of 2021.
What is the role of the ARRC?
In 2014, the U.S. Federal Reserve and the New York Federal Reserve Bank (“NY Fed”) established the Alternative Reference Rates Committee (“ARRC”) to lead the transition away from LIBOR. The ARRC continues to lead the transition in the US from LIBOR and has recommended the Secured Overnight Financing Rate (“SOFR”) as the replacement for USD LIBOR – as well as encourages the development of a SOFR futures market.
What is SOFR (Secured Overnight Financing Rate)?
In June 2017, the ARRC identified SOFR as the recommended alternative reference rate for USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities (each a “repurchase” or “repo” transaction). While LIBOR is not fully transaction based, SOFR is based on the overnight repo market with ~ $1 trillion of transactions per day. The NY Fed is the administrator and producer of SOFR. Publication of SOFR began in April 2018. Trading and clearing of SOFR based futures began in May 2018 and SOFR-based swaps in July 2018.
How is SOFR calculated?
SOFR is calculated as a volume-weighted median of transaction level tri-party repo transaction data, General Collateral Finance repo transaction data and data on bilateral U.S. Treasury repos cleared through Fixed Income Clearing Corporation's delivery-versus-payment service provided by DTCC Solutions LLC. SOFR is published each business day on the NY Fed’s website.
Does the ARRC have a timeline for the adoption of SOFR?
Yes. The ARRC published a Paced Transition Plan which outlines key milestones until the end of 2021 to promote SOFR’s adoption, which can be found at: https://www.newyorkfed.org/arrc/sofr-transition#pacedtransition. In 2019, the ARRC also issued a complementary Incremental Objectives document which outlines key priorities and milestones to be met in 2019 to support and prepare market participants for the transition. The 2019 Incremental Objectives can be found at https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/ARRC_2019_Incremental_Objectives.pdf.
For existing contracts referencing LIBOR and transitioning to SOFR, do any adjustments need to be made to SOFR to make the economics of the transaction comparable to those based on LIBOR?
A potential consequence of moving from LIBOR to SOFR is that an unintended “value transfer” could occur as a result of fundamental differences between the transaction types supporting the two benchmarks. The ARRC has sought to minimize the possibility of a value transfer by recommending that a spread adjustment be added to SOFR. The ARRC has indicated that it intends to conduct a consultation with market participants in order to recommend how that spread adjustment should be calculated. Some market participants expect that the ARRC may recommend the spread adjustment to be a static, one-time adjustment to SOFR going forward. Other market participants are exploring the development of a dynamic or credit sensitive supplement to SOFR that would make a SOFR-based transaction perform more like its LIBOR-based predecessor, further reducing the possibility of an unintended value transfer between the parties..
What happens to existing transactions and contracts?
A transaction that references LIBOR or another interbank offered rate (“IBOR”) and matures or expires after the time LIBOR is expected to be unavailable likely will need to be amended. This will be an expansive task given the large number of contracts referencing LIBOR. MUFG is working within its internal IBOR Transition Program to identify those contracts and prepare for their amendment.
What is happening to new transactions entered into now and in the near future?
Many continue to reference LIBOR. The ARRC, as well as trade associations and industry working groups, have developed and continue to work on contractual language to be included in contracts known as “fallback provisions” that specify what will happen when the benchmark rate it now references (such as LIBOR) is no longer available.
What is a fallback provision?
It is simply a contractual provision included in the contract for a loan, bond, derivative or another financial instrument that specifies what will be the applicable new benchmark interest rate or the negotiation process to be followed by the parties to determine a replacement rate in the event that the referenced interest rate used in that contract becomes unavailable. Accordingly, the ARRC has recommended fallback provisions for new USD LIBOR-dependent syndicated loans, bilateral loans, floating rate notes and securitizations to help prepare for the transition away from LIBOR when it happens. Those recommended provisions can be found at https://www.newyorkfed.org/arrc/fallbacks-contract-language. Including a fallback provision should simplify the transition from LIBOR to an alternative reference rate in the future.
Given that SOFR is an overnight rate, will forward looking term SOFR be available?
SOFR solely is based on overnight transactions and does not yet have a forward term rate structure. The ARRC’s Paced Transition Plan calls for the creation of a forward-looking term SOFR structure based on SOFR-linked derivative markets before the end of 2021. Without a forward term SOFR structure, the alternative SOFR interest calculation methods now prevalent in the market are a compounded or simple average of historical overnight SOFR set in arrears. One limitation in using these calculation methods is that the parties to a transaction will not know the interest rate to be applied during an interest accrual period before the period begins. Not knowing the amount of the next interest payment may create operational issues for some corporate treasurers and others. The NY Fed is now publishing indicative forward looking term SOFR on its website. However, these indicative rates are not intended to be used in financial instruments. See https://www.federalreserve.gov/econres/notes/feds-notes/indicative-forward-looking-sofr-term-rates-accessible-20190419.htm.
Where can I get updates regarding the ARRC and the IBOR transition process?
The ARRC periodically publishes a newsletter providing key news updates relating to the LIBOR transition in the U.S. and other markets. The ARRC’s current and past newsletters can be found at https://www.newyorkfed.org/arrc/announcements.
What is the current status of industry initiatives for fallback language supporting LIBOR transition for derivatives (non-cash products)?
The International Swap Dealer Association (“ISDA”) has proposed amendments to its definitions for derivative contracts to incorporate fallbacks to one or more reference rates (each a “fallback rate”) for certain key IBORs. The fallback rates will apply if the relevant IBOR now referenced in a contract is permanently discontinued, based on the occurrence of one or more defined triggers (each a “fallback trigger”). ISDA has determined that the fallback rates will be the applicable overnight risk-free rate (“RFRs”) identified by the relevant public-private sector RFR working group tasked to do so plus a spread adjustment. ISDA has recommended a compounded interest rate set in arrears and a historical mean/median method to determine a spread adjustment for derivatives that depend on other IBORs: GBP LIBOR, CHF LIBOR, JPY LIBOR, Euroyen LIBOR, TIBOR and BBSW While ISDA originally did not recommend any IBOR replacement trigger other than when the relevant IBOR is no longer published, ISDA has issued a report that summarizes the results of its benchmark fallback consultation on “pre-cessation” issues. See https://www.isda.org/2019/10/21/isda-publishes-report-summarizing-results-of-benchmark-fallbacks-consultation-on-pre-cessation-issues/.
How is the market reacting to SOFR?
Since the initial publication of SOFR in April 2018, total notional amount of SOFR-linked cash (loans, bonds, securitizations, consumer mortgages, etc.) and derivative products has continued to increase. See the ARRC’s current and past newsletters at https://www.newyorkfed.org/arrc/announcements for further information regarding market developments related to SOFR-linked products.
Is MUFG actively working on the transition away from LIBOR?
Yes. Even though LIBOR may continue to exist until December 31, 2021, planning has already begun to migrate away from LIBOR to one or more replacement rates. We are assessing impacts, managing LIBOR transition and seeking to mitigate risks. Our clients will hear more from us as transition tools, methods and timing become clearer.
What should my firm do right now?
(1) Learn more about LIBOR cessation, transition and replacement rate developments; (2) analyze its LIBOR exposure with a focus on financial instruments maturing beyond 2021 and what effect the discontinuation of LIBOR might have on that exposure; (3) engage with its counterparties, vendors and financial institutions to begin the process of identifying and amending LIBOR-dependent contracts to which it is a party; and (4) consider the impact that a change to a replacement rate may have on accounting, tax, IT, systems and operations.