In this podcast, Jill Kalish Levy and Joel Wattenbarger discuss the impending cessation of LIBOR at the end of 2021 and its proposed replacement, SOFR, and how they differ. Market participants are already taking different approaches to the replacement of LIBOR from the documentation and logistical perspectives. This podcast explains the pros and cons of the various approaches, including the advantages and challenges associated with the "amendment approach" and the "hardwired approach" in documentation, and what actions credit fund managers may want to consider taking in 2019 to begin the transition away from LIBOR.
Joel Wattenbarger: Hello, and welcome to our podcast. My name is Joel Wattenbarger, and I am a partner at Ropes & Gray in our asset management practice. Joining me today is Jill Kalish Levy, who is knowledge management counsel in our finance group. In this podcast, we will be discussing the impending cessation of LIBOR and what market participants should be thinking about with respect to this issue.
Jill, I know you've been spending a lot of time thinking about this issue and talking to managers. First, let's talk for a moment about the background and how we got to where we are today.
Jill Kalish Levy: Sure. As many people are aware, LIBOR has been under a great deal of scrutiny for several years. The fundamental issue with LIBOR stems from how it's derived; it is an average interest rate based on submissions by major banks of what those banks would expect to pay to borrow money, and it's therefore subject to judgment, which is less than ideal for such a widely-used benchmark. The banks whose quotes create the LIBOR benchmark are actually currently required to submit those quotes. And then in recent years, certain bankers were convicted of manipulating LIBOR, and that development made the requirement to submit LIBOR even more risky and unattractive for the banks. The vulnerability of LIBOR, combined with the fact that LIBOR supports trillions of dollars of debt, caused the Financial Conduct Authority (or the "FCA") to announce in July of 2017 that after 2021, they will no longer compel the banks to submit LIBOR quotes.
Joel Wattenbarger: So shortly after the FCA made its announcement, the Fed created the Alternative Reference Rates Committee (or the "ARRC"), a group of private sector entities that have a central presence in markets affected by LIBOR, to study the scope of LIBOR exposure and identify a workable replacement. The ARRC estimates that over $200 trillion of market debt uses LIBOR as a reference rate. Some people have pointed out that even though banks will no longer be required to submit LIBOR quotes, the reality is that LIBOR may very well continue to be available after 2021. However, given the pervasiveness of LIBOR, there is likely significant risk in continuing to rely on LIBOR beyond when it might be available. Jill, what are your thoughts about how managers should be approaching this risk?
Jill Kalish Levy: Yes, there certainly is a lot of exposure and that creates risk of both confusion and value loss. Because LIBOR is so widely-used, the ARRC is very focused on minimizing the logistical chaos that would ensue if all of those contracts in all those different asset classes had to be amended at once to reflect the new rate. In addition to those logistical challenges, that kind of scenario would also likely result in value transfers where parties aren't getting the amount of interest that they contracted to receive. That's why one of the ARRC's main goals is to make sure that all parties know what the replacement rate will be before LIBOR ceases to be available, and also that the legal documentation is set up to amend either quickly or automatically when LIBOR goes away so we don't have a situation with thousands of agreements requiring amendments at the same time.
Now, people initially wondered whether there would be a "one size fits all" type solution to the LIBOR problem for different asset classes, like leveraged loans, mortgages, cash products and derivatives. One piece of good news is that the ARRC has all but settled on a new rate to replace LIBOR, and it's called "SOFR," which is the Secured Overnight Financing Rate. SOFR would be used to replace LIBOR market-wide in the U.S. (in the UK, the likely replacement is the Sterling Overnight Interbank Average Rate, or "SONIA"). SOFR is actually a combination of three treasury repo rates and it's a rate compiled by the Fed. The ARRC and the Fed are hoping that SOFR's adopted in advance of LIBOR cessation so that the transition away from LIBOR is as seamless as possible.
Joel Wattenbarger: It is certainly good news that parties have identified a rate that will work for so many different financial products. Why is SOFR a good replacement for LIBOR?
Jill Kalish Levy: Well, SOFR seems like a good replacement for LIBOR because it doesn't have the characteristics of LIBOR that have made LIBOR so vulnerable. First, SOFR has a daily trading volume of over $900 trillion, which far exceeds the $500 million of daily trades of 3-month LIBOR. As a rate, SOFR is just far deeper and more liquid. The size and depth of SOFR, and the fact that it isn't a rate that is calculated using credit judgment all mean that SOFR can't be manipulated the way LIBOR has been manipulated, and that's very appealing.
Joel Wattenbarger: But are there other meaningful differences between LIBOR and SOFR and if so, how are managers approaching those differences?
Jill Kalish Levy: There are. One difference is that LIBOR is an unsecured rate and that it includes the cost of funds to banks, and SOFR is secured and risk-free. Another difference is that LIBOR is more stable, in large part because it's really an estimate of a rate, while SOFR can become very volatile at quarter-end and year-end. People have taken comfort in the fact that compounded or term SOFR isn't volatile at those times the way that overnight SOFR has shown itself to be. But the biggest and most important difference between the two rates is that LIBOR has a term structure and SOFR is an overnight rate. The reason this difference is so important is because contracts that are based on term LIBOR would likely need to transition off of LIBOR to another term rate. Borrowers, for example, will select a 3-month or 6-month LIBOR term for their loans that allows them to lock in their interest rate for that period of time. The overnight rate that SOFR offers may not be as attractive as an option.
Joel Wattenbarger: So it seems as that the market should aim to generate a version of SOFR that is available as a term rate – is that right?
Jill Kalish Levy: Well, that's the current goal, yes. LIBOR has a forward looking term curve, so counterparties know their rate in advance, and the rate incorporates interest rate expectations. In order for SOFR to be used as a term rate, a SOFR term curve would have to be developed from SOFR futures trading. My understanding is that plans are already underway to start that process and the ARRC has said it will launch a SOFR term curve at some point this year, but we can't close our eyes to the possibility that since a term SOFR reference rate is dependent on robust SOFR futures trading, there's just no guarantee that we will have a term SOFR benchmark before 2021 (or at all). Another option is to use a compounded retroactive rate that looks back over the course of a term and generates a term retroactively, but that will presumably be less attractive to borrowers who want to know ahead of time what their rate will be. The term issue is a big part of what is giving operations and back-office teams a great deal of aggravation right now.
The market has tentatively arrived at a solution to the LIBOR problem in SOFR, but it isn't clear whether the solution will actually be available. At the recent LSTA Ops Conference, there was a panel of four individuals representing banks and other financial institutions, all of whom are working closely on this problem, and they all disagreed vigorously with one another about whether a SOFR term curve is realistically achievable.
I should also note that in addition to the issue of identifying a suitable successor rate, we also have to solve the problem of the spread adjustment. Even if we can switch over to a new rate with relative ease, the new rate won't be an exact match for LIBOR, and so we will need a spread adjustment to maintain the economics of all LIBOR contracts. ISDA is developing a credit spread adjustment for legacy derivatives and the ARRC has said it will work on a credit spread as well.
Joel Wattenbarger: It seems like the LIBOR story is a lot more thorny than people might originally have thought. Let's talk about the problem through the lens of legal documentation. How are people addressing this uncertainty in LIBOR contracts? Do you think the market has settled on a particular approach in documents?
Jill Kalish Levy: There's still a great deal of inconsistency in how the issue is treated in documentation across asset classes. Many agreements have adopted what's been termed the "amendment approach," in which there is a market-based trigger that indicates that LIBOR is no longer a reliable or available rate, and then borrowers and agents select a new rate together based, again, on market-based factors, such as which rate's being used by similar debt in the market. The spread adjustment is also selected based on prevailing market convention. Lenders then have a five-day negative consent period in which they can object as a majority to the selected rate. Parties continue to negotiate the nuances of all of these pieces, the trigger, the authority to select the new rate, and the negative consent right. This has led to many differences in "LIBOR replacement" provisions across the market. The amendment approach is preferred by many people because it doesn't rely on a rate and spread adjustment that aren't yet known today, but it has a big disadvantage in that it would likely create a situation in which thousands of documents will need to be amended at once, which could obviously create a lot of problems.
Joel Wattenbarger: Thousands of agreements amending at the same time does sound less than ideal. An additional issue with that approach is that it saves the choice of a replacement rate for the last minute, making it hard to plan for the transition from an operational perspective. Are there alternatives we can consider?
Jill Kalish Levy: The other approach being promoted by the LSTA is called the "hardwired approach." In that approach, after a trigger, there is a waterfall of rates that would replace LIBOR, depending on what was available. The first rate would be term SOFR, followed by other, less desirable replacements. There is also a waterfall to select the margin adjustment. The significant benefit of the hardwired approach is that it precludes the need for actual amendments. But the biggest disadvantage of using the hardwired approach is that parties would basically be committing now to rates and spread adjustments before those rates and spread adjustments have been determined.
Joel Wattenbarger: It sounds like both approaches have pros and cons.
Jill Kalish Levy: Yes, absolutely. In terms of SOFR use to date, the LSTA tells us that more than $70 billion of SOFR notes have been issued since June of 2018. We still haven't seen bilateral or syndicated loans on SOFR, but parties are talking about those for 2019. The hope of everybody involved is that we will effectively replace LIBOR before it becomes unavailable – that would make for the smoothest transition. It's probably not realistic to think that there will be no more LIBOR contracts outstanding when LIBOR goes away, but we can certainly try.
Joel Wattenbarger: So to summarize: while there is a lot up in the air, there are a number of key steps that managers can start to take now to make sure that the transition goes as smoothly as possible for them. The first step is for managers to get organized by identifying all of their LIBOR exposures so that they know clearly which of their contracts are affected by the end of LIBOR. The next step is for managers to identify which rate those contracts will be moving to, which will very likely be compounded SOFR for hedges and related products but may be another form of SOFR for other products, like leveraged loans. They then need to work with their back office and operations staff to begin to think about how they will transition to the new rate or rates from a logistical perspective. Managers should be working with external legal counsel to ensure that they have solid, current, market-based fallback language for LIBOR replacement in all LIBOR-based contracts and begin amending documents as needed to add such language. Since the conversations around LIBOR are still evolving, managers will need to continue to monitor developments here as we approach the LIBOR transition date. What else can we expect?
Jill Kalish Levy: Well, as banks and borrowers and managers all take steps to prepare from a documentation and logistical perspective, the hope is that we see greater clarity from the market about what the rate will definitively be and how the spread adjustment will be determined. As that becomes clearer, market participants can start to include the new rate into documents. The ideal scenario would be for most of the market to have transitioned off LIBOR before LIBOR becomes unavailable at the end of 2021. Hopefully, the ARRC will continue to guide us through this process and we will all come out on the other end with a new rate and minimal value transfer. But, we have quite a bit of work to do before that can happen.
Joel Wattenbarger: Thank you, Jill, for sharing these insights. We will certainly come back and check in as the issues here develop. For more information on the topics that we discussed today or other topics of interest in the asset management and finance communities, please visit our website www.ropesgray.com. And of course, if we can help you navigate any of the topics we discussed today, please don't hesitate to get in touch. Stay tuned for future podcasts on the latest developments in this space, and thank you for listening.
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