Navigating The LIBOR Transition
Industry Updates / Questions & Answers
- ISDA Latest News Alert: Adoption of Risk-Free Rates: Major Developments in 2020 February 12, 2020
- ARRC Releases Consultation on Swaptions Impacted by Central Counterparty Clearing Houses’ Discounting Transition to SOFR: February 7, 2020
- ARRC Welcomes Federal Housing Finance Agency’s Announcement that Fannie Mae and Freddie Mac Will No Longer Accept Adjustable-Rate Mortgages Based on LIBOR by Year-End February 5, 2020
- Federal Housing Finance Agency’s (FHFA) specific to Fannie Mae and Freddie Mac no longer accepting adjustable rate mortgages (ARMs): February 5, 2020
- ARRC Releases Vendor Survey and Buy-Side Checklist on Transition to SOFR: January 30, 2020
- ARRC Releases Recommendations for Interdealer Cross-Currency Swap Market: Conventions January 24, 2020
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 regulator decided that it will not compel LIBOR panel banks to make LIBOR submissions after 2021. 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 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 U.S. 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.
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 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. It 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?
Use of a SOFR-based rate, by itself, likely will result in somewhat different economics from a transaction using a LIBOR-based rate (although the degree of difference will vary by transaction and be based on several factors). That is because LIBOR is based on short-term loans between banks that are unsecured, while SOFR is based on overnight repo transactions between banks or nonbanks secured by U.S. Treasury securities.
One of the consequences of moving from LIBOR to SOFR is that an unintended “value transfer” may occur. The ARRC has addressed the value transfer that is expected to occur by recommending a credit spread adjustment be added to SOFR (the credit spread adjustment).
The ARRC has indicated that it will consult with market participants and then recommend how a credit spread adjustment that will supplement the SOFR-only value should be calculated. Some market participants may be satisfied with the ARRC recommending a static, one-time credit spread adjustment to be added to SOFR when a SOFR-based financial transaction is created, while other market participants are interested in developing a credit sensitive or “dynamic” spread adjustment that would make a SOFR-based transaction perform more like its LIBOR-based predecessor and possibly reduce an unintended value transfer between the parties.
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.
Has the ARRC issued any consultation regarding the credit spread adjustment?
The ARRC issued on Jan. 21, 2020 a consultation on credit spread adjustment methodologies for cash products referencing U.S. dollar LIBOR. The consultation seeks input from market participants regarding the calculation of the credit spread adjustment to account for the differences between SOFR and LIBOR. The consultation is open for feedback through March 6.
The ARRC stated in the consultation that it is proposing a static credit spread adjustment that would be implemented at a specific time on or prior to LIBOR’s cessation and would make the spread-adjusted version of SOFR comparable to LIBOR. The credit spread adjustment is intended to minimize the expected change in the value of contracts as a result of shifting from LIBOR to SOFR. The ARRC further added that it has committed to making sure that its recommended credit spread adjustments and the resulting spread-adjusted rates are published and made publicly available.
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 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 . Including a fallback provision in new and existing financial contracts would simplify the transition from LIBOR to an alternative reference rate.
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 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 initiatives of the International Swaps and Derivatives Association for fallback language supporting LIBOR transition for derivatives (non-cash products)?
The International Swaps and Derivatives Association (ISDA) has proposed amendments to its 2006 Definitions for future derivative contracts to incorporate fallbacks to one or more reference rates (each a fallback rate) for certain key IBORs. ISDA will also publish a protocol to enable market participants to include fallback rates within legacy derivatives contracts. The protocol will cover ISDA master agreements, ISDA credit support documentation, confirmations, local law master agreements and collateral agreements that reference certain IBORs. ISDA is also expected to publish a template form of amendments that parties could negotiate and agree to bilaterally.
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. In February 2020, ISDA announced that it will re-launch a consultation on how to implement pre-cessation fallback triggers in derivatives documentation to address a regulatory announcement that an IBOR is no longer representative of the underlying market. An earlier consultation on pre-cessation fallback triggers failed to achieve market consensus. The new consultation is expected to be published at the end of February and will ask market participants to indicate whether the 2006 Definitions should be further amended to include fallbacks that would apply following the permanent cessation of an IBOR or a pre-cessation event, whichever occurs first. The publication of the amended 2006 Definitions and the protocol is subject to the results of the new consultation.
In terms of the spread adjustment, ISDA’s November 2019 consultation indicated that the majority of participants preferred a historical median approach over a five-year lookback period. ISDA has selected Bloomberg Index Services Limited to calculate and publish indicative spread adjustments related to fallback rates starting in the first half of 2020.
ISDA launched in December 2019 a new supplemental consultation on the spread and term adjustments that would apply to fallbacks in derivatives referencing euro LIBOR and EURIBOR. In the event the results are consistent with prior consultations, ISDA is expected to implement fallbacks for euro LIBOR and EURIBOR in 2020, in line with fallbacks for nine other IBORs covered by the earlier consultations.
How is the market reacting to SOFR?
Since the initial publication of SOFR in April 2018, the 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 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 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.