U.S. Federal Reserve Vice Chair of Supervision (Former) Randal Quarles recently urged market participants to “act now to accelerate their transition away from LIBOR.” This is driven by the UK Financial Conduct Authority’s announcement in March stating clear end-dates for LIBOR and the U.S. regulator’s guidance that banks should cease entering new contracts that use USD LIBOR as soon as practicable or by December 31 at the latest. This guidance is further supported by an announcement yesterday (October 14) by the American Reference Rates Committee (ARRC), recommending that “all market participants act now to slow their use of US dollar (USD) LIBOR and leverage the next six weeks as a key window to reduce such activity to promote a smooth end to new LIBOR contracts by the end of the year.”
Alternate reference rates (ARR) need to be chosen now if they have not already been determined. For capital markets and derivatives markets, the direction is clear – products that use LIBOR should transition to Secured Overnight Financing Rate (SOFR), calculated by the Federal Reserve and endorsed ARRC.
The Federal Reserve and other banking regulators have not provided such a clear directive for loans, and other non-SOFR alternatives may be used. However, there is growing concern over certain ARRs like the Bloomberg Short-Term Bank Yield Index due to their similar flaws to LIBOR.
What is LIBOR?
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another for short-term loans in the international interbank market. Following the discovery by investigators in the U.S., UK, and EU that banks had been manipulating LIBOR rates to generate profit dating back to at least 2003, the Financial Conduct Authority (FCA) shifted the regulation from the “self-policing” British Bankers’ Association (BBA) to the International Exchange Benchmark Administration (IBA) to create oversight and enforcement.
In 2017, the FCA announced that banks would not be compelled to submit to LIBOR after 2021. At that point, LIBOR may cease to exist – either from immediate cessation or reduced participation of Panel Banks, making the rate unrepresentative. As if moving some $370+ trillion off the LIBOR market weren’t difficult enough, the onset (and continuation) of the COVID-19 pandemic and the stress caused to global markets has made the move off LIBOR even more challenging.
The end of LIBOR timeline was crystallized on 5 March when the FCA announced the cessation or loss of representativeness of the 35 LIBOR benchmark settings currently published by ICE Benchmark Administration (IBA), an authorized administrator, regulated and supervised by the FCA. Notably, this announcement made clear that there will be no USD LIBOR tenors after 30 June 2023.
In an October 5th speech to the Structured Finance Association, Federal Reserve Vice Chair of Supervision Randal Quarles told banks they needed to “pick up the pace” to leave LIBOR. Quarles stressed that “To be ready for year-end, lenders will have to pick up the pace [of transition], and our examiners expect to see supervised institutions accelerate their use of alternative rates.”
Why do U.S. Financial Institutions Need to Act Now?
If, as Quarles said, “the year of magical thinking is over,” banks need to look at two routes to make the transition as quickly as possible.
First, banks need to cease new LIBOR issuance, which is the primary step in ensuring the situation does not worsen. To facilitate this, global regulators issued guidance with recommended milestones for when market players should cease new LIBOR issuance for respective LIBOR products and rates. For the US, that date is December 31st – except for prudent risk management exceptions.
Second, with an estimate that a global systemically important bank (G-SIB) may have more than 250,000 contracts with references to LIBORs that are likely to mature post-2021 and thousand more with indirect exposure, banks need to fix the existing issue by remediating existing contracts.
While just as complicated as every other aspect of the transition, remediation options can be categorized into four large buckets.
First, proactive transition before LIBOR cessation to ARRs (e.g., unwinding and rebooking the trade). This option has been widely endorsed by global regulators, particularly the Bank of England Prudential Regulatory Authority.
Second, banks can insert robust fallback provisions, such as the IBOR Fallbacks Protocol for ISDA governed derivatives products, designed to take effect at the LIBOR cessation to ensure the smooth and effective transition of the contracts ARR equivalents.
Thirdly, specific contracts that genuinely have no alternative or realistic ability to be negotiated or amended can be remediated with legislative solutions such as the “Financial Services Bill” that provides FCA with powers to produce “synthetic LIBOR” based on a changed methodology. On 29 September, the FCA confirmed that to avoid disruption to legacy contracts that reference the 1-, 3- and 6-month sterling and Japanese yen LIBOR settings, it will require the LIBOR benchmark administrator to publish these settings under a ‘synthetic’ methodology, based on term risk-free rates, for 2022. These six LIBOR settings will be available only in some legacy contracts and not for new business use. In this announcement, the FCA reiterated that “users of LIBOR should continue to focus on active transition rather than relying on synthetic LIBOR. Synthetic LIBOR will not be published indefinitely.”
Finally, market players can rely on existing fallback language within products. The ability to withstand taking no action to amend existing contractual fallback provisions will depend on the nature of the fallback terms and the commercial importance of LIBOR dependency within the contract.
Key Considerations for U.S. Institutions
U.S. institutions, in particular those which have large USD LIBOR exposure, need to ensure they don’t lose focus – the UK, Japan, Switzerland, and the EU have a 31 December deadline; however, U.S. Regulators have continuously advised banks to stay diligent on the U.S. remediation despite the elongated timeframe to June 2023 for the majority of tenors.
Banks need to instill a sense of urgency with their clients. Certain market segments have been slow to act; however, all market participants need to transition in the same timeframe.
There are broad conduct risk implications for the transition which need to be considered. In addition to the existing inherent market risks associated with new or less liquid products, pricing considerations are also based on the difference in curve options across products (e.g., forward versus backward-looking curves). As always, banks need to be presenting all remediation options to their clients in a fair and transparent manner.
Finally, market players should continue to closely monitor IBOR transition developments, particularly outstanding regulatory solutions for un-remediated products (e.g., JPY, CHF, USD ICE Swap Rate Fallback).