IMPORTANT: Regulators Announce Updates to End Date for USD LIBOR
Given recent regulatory developments, we wanted to provide a London Interbank Offer Rate (LIBOR) update regarding the anticipated timeline for the transition. Click here for more information.
What you need to know
This is a brief update of impending changes to the London Interbank Offered Rate (LIBOR). LIBOR has been a long-standing index for financial transactions and is currently the most commonly used variable interest rate index for short-term interest rates, business loans, variable-rate loans, financial derivative contracts, and other commercial lending products.
Frequently asked questions
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 the average rates at which LIBOR panel banks believe they 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 regulators decided that it will not compel LIBOR panel banks to make LIBOR submissions after 2021 and beyond. 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 financial market participants. Transition to alternative benchmark interest rates is well underway, but much work lies ahead in order to implement a successful reference rate change.
For the most recent regulatory announcement, click here.
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. It recommended the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR and encouraged the development of a SOFR futures market.
For the most recent ARRC FAQs, please visit here.
What is SOFR?
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 an 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 and SOFR-based swaps began in 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?
In April 2020, the ARRC unveiled a set of key objectives for 2020. Those goals and anticipated milestones were built on the ARRC’s then existing work and underscored the important progress that the ARRC had made during the preceding year in achieving market readiness and supporting the voluntary adoption of SOFR. It can be found at https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Press_Release_2020_Objectives.pdf.
Thereafter, the ARRC released in May 2020 its recommended Best Practices for Completing Transition From LIBOR, which subsequently were updated in Sept. 2020. The ARRC’s Best Practices were intended to clarify the timelines and interim milestones for floating rate notes, business loans, consumer loans, securitizations and derivatives that the ARRC believed were appropriate for transitioning away from LIBOR in order to minimize market disruption and support a smooth transition to SOFR.
For key target dates by product and more information regarding the ARRC’s, see https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Best-Practices.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?
As noted by the ARRC, LIBOR and SOFR are different rates and the transition from LIBOR to SOFR will require a spread adjustment to make the rate levels more comparable. Therefore, the ARRC-endorsed fallback language provides for a static spread adjustment that would be fixed at a specified time at or before LIBOR’s cessation and make the spread-adjusted rate comparable to LIBOR by minimizing the expected change in value arising from the move to a replacement benchmark based on SOFR.
Based on the feedback from two market consultations conducted by the ARRC, the ARRC recommended a spread adjustment methodology based on the historical median difference between LIBOR and SOFR over a five-year lookback period prior to the occurrence of the LIBOR cessation trigger event. For consumer products, the ARRC additionally recommended a one year transition period to the five-year median spread adjustment methodology.
The ARRC additionally advised that its recommended spread adjustment values for cash products will align with the spread adjustment values that the International Swaps and Derivatives Association (ISDA) plans to implement in its standard definitions for derivatives.
However, even with a credit spread adjustment, no replacement benchmark is likely to be neutral to all parties; some will benefit and others will not. Additional information from the ARRC regarding spread adjustments can be found here https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Recommendation_Spread_Adjustments_Cash_Products_Press_Release.pdf.
Has the ARRC recommended a spread adjustment methodology for cash products referencing LIBOR?
The ARRC recommended a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between LIBOR and SOFR. The ARRC’s methodology matches the methodology recommended by ISDA for derivatives.
According to the ARRC, this would make the spread-adjusted version of SOFR comparable to LIBOR and consistent with ISDA’s fallbacks for the derivatives markets. The ARRC previously advised that its spread adjustment would be static, and it would be fixed at a specified time at or before LIBOR’s cessation.
For consumer products, the ARRC is recommending a one-year transition period to this five-year median spread adjustment methodology.
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 will possibly 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 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. Such provisions reflect industry standard terms and will also be incorporated into new contracts, unless parties explicitly agree otherwise.
What is a fallback provision?
It is a provision in the agreement for a loan, bond, derivative or another financial instrument specifying a new interest rate benchmark or negotiation process to be followed by the transaction’s parties to determine a replacement rate if the interest rate used in that contract becomes unavailable. The ARRC has recommended fallback provisions for new USD LIBOR-dependent syndicated and bilateral loans, floating rate notes, securitizations, and residential adjustable rate mortgages to help transition away from LIBOR when it becomes unavailable. Those recommended provisions can be found at https://www.newyorkfed.org/arrc/fallbacks-contract-language.
Given that SOFR is an overnight rate, will forward looking term SOFR be available?
SOFR is solely 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 published newsletter with key news updates relating to the LIBOR transition and can be found at https://www.newyorkfed.org/arrc/announcements.
What is the current status of initiatives of the International Swaps and Derivatives Association (ISDA) for fallback language supporting LIBOR transition for derivatives (non-cash products)?
ISDA has published a Supplement to its 2006 Definitions for derivatives contracts that become effective on January 25, 2021, that incorporate fallbacks to one or more “risk free” reference rates (each a fallback rate) for certain key IBORs (relevant IBORs). ISDA also published the 2020 IBOR Fallbacks Protocol (the Protocol) on October 23, 2020 to enable market participants to amend their legacy uncleared derivatives and certain other contracts to include the new fallback rates. The Protocol generally covers relevant IBOR transactions governed by ISDA master agreements, ISDA credit support documentation, subject confirmations, certain local law swaps and derivatives master agreements, repurchase agreements and securities lending agreements. ISDA has also published templates that parties may employ to bilaterally incorporate Protocol terms or to otherwise amend, include or exclude certain master agreements or transactions from the scope of coverage of the Protocol.
Once agreed, the new fallback rates will apply in the event the relevant IBOR is officially announced to have been permanently discontinued.
ISDA has published its ISDA 2020 IBOR Fallbacks Protocol FAQ. The FAQ and additional information is available by ISDA on its website. [https://www.isda.org/protocols]
Is MUFG actively working on the transition away from LIBOR?
Yes, planning is in process to migrate away from LIBOR. We are assessing impacts, managing the 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 company or business do right now?
(1) Learn more about LIBOR cessation, transition and replacement rate developments; (2) analyze your 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 your counterparties, vendors and financial institutions to begin the process of identifying and amending LIBOR-dependent contracts; and (4) consider the impact that a change to a replacement rate may have on accounting, tax, IT, systems and operations.
Follow these links for news and other resources from some of the key industry participants in LIBOR transition:
Recent Industry Updates
ARRC Applauds Major Milestone in Transition from U.S. Dollar LIBOR
Proposed Path Outlines a Clear End Date for USD LIBOR; Would End New Issuances by End-2021, and Subject to Consultation Outcomes, Legacy Contracts Could Mature by Mid-2023
The Alternative Reference Rates Committee (ARRC) today applauded concurrent announcements by LIBOR’s administrator, its regulator, and U.S. regulators, regarding the proposed path forward for the transition away from U.S. Dollar (USD) LIBOR. The announcements include supervisory guidance encouraging banks to stop new USD LIBOR issuances by the end of 2021. They also cite plans to consult on specific timing for ceasing the publication of USD LIBOR, with proposed end dates immediately following the December 31, 2021 publication for the one week and two month USD LIBOR settings, and the June 30, 2023 publication for other USD LIBOR tenors.
TO SOFR OR NOT TO SOFR?
The OCC, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation issued an Interagency Statement on Reference Rates for Loans reiterating that they are not endorsing a specific replacement rate for LIBOR. Banks may use any reference rate for loans they determine to be appropriate for their funding models and customer needs. The agencies said banks should include language in lending contracts that provides for using a robust fallback rate if the initial reference rate is discontinued.
Capital & Liquidity Memo Published
The ARRC published a memo summarizing its preliminary findings and recommendations about potential regulatory considerations associated with applying current and anticipated capital and liquidity requirements to the LIBOR transition.
ISDA announced the launch of the IBOR Fallbacks Supplement and IBOR Fallbacks Protocol, providing a framework for transitioning USD LIBOR interest rate derivatives to SOFR. 257 derivatives market participants signed on to the Protocol during a two-week "escrow" period.
Following four Credit Sensitivity work shops,official-sector leaders released a letter stating they do not plan to recommend a credit sensitive supplement to SOFR or credit-sensitive rates. They plan to hold two additional working sessions to further discuss the subject and explore related commercial loan transition solutions.
Freddie Mac issued its first SOFR-linked credit risk transfer deal (STACR REMIC 2020-DNA5) that uses 30-day average SOFR, but Freddie Mac intends to transition the transaction to an IOSCO compliant one-month term SOFR if and when it becomes available.