U.S. Dollar LIBOR, the ubiquitous interest rate benchmark used in over $200 trillion of transactions worldwide, is going away. Regulators have issued stern warnings against its continued use in new transactions after this year. The publisherof LIBOR and its U.K.regulator have announced that LIBOR will no longer be published as a representative rate for new or legacy transactions afterDec. 31, 2021, for 1-week and 2-month tenors, and after June 30, 2023, for all other tenors. It is estimated that $90 trillion of legacy transactions will be outstanding at that time, including mortgages, consumer loans, syndicated business loans, swaps, bonds, securitizations, and other products. Through significant efforts by financial market participants, the vast majority of these legacy transactions are expected toinclude language that contemplates the end of LIBOR, or will mature before LIBOR ends.
This article describes legislative initiatives in the U.S.to avoid the uncertainty, disputes, litigation, and market disruption that could arise from the trillions of dollars of remaining legacy transactions. (In this article, "LIBOR" means USD LIBOR.)
How Did We Get Here?
LIBOR is published by an administrator based in London. Following investigations surrounding its manipulation, The Wheatley Review of LIBOR: Final Report was prepared at the request of British regulators. The report identified concerns about the suitability of LIBOR, given the large volume of contracts that used it and the declining volumesof transactions that the rate was based on. Subsequent reviewswere conducted by international and U.S. regulators, leading to reports issued by the Financial Stability Board and the Financial Stability Oversight Council. In 2014,the Federal Reserve Board and the New York Federal Reserve convened the Alternative Reference Rates Committee (ARRC), a group of private market participants, to help ensure a successful transition away from LIBOR to a more robust alternative reference rate. After nearly three years of analysis, including a detailed interim report and public input from a wide range of market participants, the ARRC identified the Secured Overnight Financing Rate (SOFR) in June 2017 as its recommended benchmark rate to replace LIBOR.
Less than one month later, a speech by LIBOR's regulator in the U.K. set off a tsunami across the global financial markets. In that speech, Andrew Bailey, then-CEO of the Financial Conduct Authority (FCA), announced that publication of LIBOR could not be expected tocontinue beyond December2021. To some, the four-year horizon and the magnitude of the challenge was a distant and nearly incomprehensible reality. But as the ARRC's plans progressed and announcements by Bailey and other globalregulators grew more frequent and urgent, more market participants started to prepare for the change.
In 2018, the ARRC began to publish recommended documentation foruse in new issuances of LIBOR-based cash market instruments, including loans, securities, and consumer products. This initiative was undertaken in coordination with a similar initiative for the derivatives market led by the International Swaps and Derivatives Association (ISDA).
The documentation established market standards for robust contract language to be added to new or amended contracts while the market continued to use LIBOR. The idea was to "stop digging the hole" of increased LIBOR exposure while the markets developed plans to transition toward SOFR. Specifically,the new language clearly provides that, when LIBOR ceases, the rate on the contract will "fall back" to a SOFR-based rate.
The ARRC then turned its sightson solving the problem of LIBOR contracts that will remain outstanding after LIBOR ends, so-called "legacy contracts." A critical component of the ARRC's strategy is legislation that addresses legacy contracts that never contemplated the permanent cessation of LIBOR, as described below.
LIBOR is an index determined by an administrator in London, the ICE Benchmark Authority IBA), on the basis of rates submitted by a panel of banks. The rates are supposed to reflect the interest rate at which each panel bank believes it could borrow on each day for a given maturity or "tenor" and in a given currency. However,the market for unsecured interbank lending, such as LIBOR, dropped steadily afterthe 2008-2009 credit crisis, resulting in an inverted pyramid and inherent fragility of LIBOR "where the pricing of hundreds of trillions of dollars of financial instruments rests on the expert judgment of relatively few individuals, informed by a very small base of unsecured interbank transactions," according to the Federal Reserve Bank of New York.
For the reasons described above, on March 5, 2021, IBA and its regulator announced that USD LIBOR will cease being published or cease being fit for purpose as soon as Dec. 31, 2021, for certain tenors and by June 30, 2023, for all other tenors. (More specifically, LIBOR will "no longer be representative" of the underlying market and economic reality that it is intended to measure. In this article, these events are all referred to generally as the "end" of LIBOR.) U.S. regulators have advised banks to stop entering into new LIBOR contracts "as soon as practicable" and that entering into new LIBOR contracts afterDec. 31, 2021, will create "safety and soundness risks."
SOFR is the rate derived from overnight lending transactions secured by U.S. treasury securities, i.e., the overnight repo market, which has approximately $1 trillion in daily volume. It is produced daily by the New York Fed. It is a transparent rate that is representative of the market across a broad range of market participants, which protects it against manipulation. As the repo market is fully collateralized by U.S. Treasury securities, it also maintains relatively consistent trading volumes through various market cycles, unlike the unsecured rates underpinning LIBOR.
Because SOFR is an overnight secured rate and LIBOR is a term unsecured rate, an adjustment is added to SOFR to make the rates comparable. The ARRC has recommended spread methodologies that are appropriate for various cash products and consistent with the spread adjustment for derivative contracts adopted by ISDA.
The Legacy Contracts
Inadequate or Ambiguous Legacy Provisions
LIBOR is embedded in over $200 trillion of outstanding legacy transactions, including mortgages, consumer loans, syndicated business loans, swaps, bonds, securitizations, and other products. Over time, each of these markets developed itsown conventions for using LIBOR in its legacy documents. Many of these contracts do not contemplate the permanent end of LIBOR. Some, for example,rely on a poll or survey of large dealer banks to request their input on where they would set LIBOR. When LIBOR ceases to be produced, it is unlikely these banks would respond to these polls. Other legacy contracts default to the last published value of LIBOR, in effect turning a floating rate instrument into a fixed rate instrument. Consumer contracts generally give the lender(or noteholder) discretion to choose the replacement for LIBOR.
Addressing LIBOR's End
It is certainly preferable for parties to a transaction to agree when possible on the replacement for LIBOR before its end date. Such an advance agreement can take the form of a specific replacement rate, a "fallback provision" where the replacement rate is determined according to an agreed method, or by authorizing one of the parties (usually the lender) to select the replacement.
Where none of those options exists in a legacy contract, market participants have been attempting toadd them through amendments. Often these amendments are modelled on the ARRC's recommended documentation fornew contracts. In the case of swap agreements, which are generally documented on standard forms, improved fallback language for new transactions and amendments forlegacy transactions were published by the International Swaps and Derivatives Association Inc.
Originally Published by Bloomberg Law
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