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Regulation

Time is almost up for LIBOR, less than one month to go

In general the run up to 30 June for USD seems to be going smoothly (see ARRC’s latest readout), very much a replay of the events leading up to GBP cessation back on 1 January 2022. The main focus in the press has been on use of Term SOFR2, particularly on the limitations around hedging following the recent announcement from ARRC3, and some concerns on how SOFR – as a secured overnight funding rate that has no bank credit component – will perform in times of financial stress (potentially remaining aligned to federal funding rates as bank funding costs rise). 

In terms of the status of USD cessation, three main areas come to mind:

Transition readiness

With the 30 June cessation date almost upon us, most counterparties have either completed active transition to alternative rates, or are depending upon fallbacks in existing contracts to apply from cessation. The second tranche of conversion of cleared swaps from USD LIBOR to SOFR completed successfully over the weekend of 20-21 May (with a continued clearing capability via LCH per the Legacy Solution [sect 16] to cope with physical settlement of swaptions). The vast majority of bilateral swaps are subject to the ISDA4 Fallback Protocol given widespread uptake prior to GBP cessation, meaning they will apply compounded SOFR in arrears plus the Credit Adjustment Spread (as published by Bloomberg here) from the first fixing following cessation. Note the difference between derivatives referencing LIBOR directly (covered by 2020 Fallbacks Protocol) and those such as CMS5 or cash settled swaptions that reference USD LIBOR Swap Rate, and need to adhere to the June 2022 Module of the Fallbacks Protocol.  There will of course be a tail of contracts without fallbacks, mainly across some loans and bonds, which will depend in the short term upon the tough legacy rate (more on that below).

Term SOFR

Term SOFR as published by CME has emerged as the de facto standard for loans that used to be linked to USD LIBOR. This differs from the UK market, where Term SONIA6 is only permitted in some very narrow use cases. That said, the ARRC Best Practice Recommendations are quite restrictive in terms of permitted hedging activities around Term SOFR. Previously banks were only allowed to offer hedges to end users to directly hedge their underlying Term SOFR exposure. This has led to a risk premium for Term SOFR hedges over SOFR OIS7, and concern amongst banks on the levels of Term SOFR risk that they will eventually be expected to warehouse. In response to this on 21 April 2023 ARRC made a limited concession with a ‘refinement’ to the guidelines, now permitting dealer banks to trade Term SOFR-SOFR basis swaps with non-dealer counterparties (e.g. Hedge Funds, Real Money or Corporates) on a standalone basis. This may mitigate to some extent the situation; however it is yet to become clear whether such non-dealer counterparties will provide much liquidity.

Synthetic USD LIBOR

At the start of April the FCA announced that they would require ICE8 to continue publishing 1-, 3- and 6-month USD LIBOR until 30 Sep 2024 using a ‘synthetic’ methodology. This is only permitted for use in referencing tough legacy contracts that have not yet transitioned (and do not have fallbacks in place), and is prohibited for any new use. The synthetic rate is constructed from CME Term SOFR + the ISDA credit adjustment spread. This was very much expected as a temporary bridge to avoid market disruption for any tail trades, and follows the pattern set by GBP previously. It does however provide some welcome respite for those who, for whatever reason, have not yet been able to transition their exposure or put in place fallbacks. Looking beyond September 2024, it is worth noting that any tough legacy contracts under US-governed law still referencing USD LIBOR would benefit from the legal safe harbour under the LIBOR Act allowing counterparties to apply fallbacks as recommended by ARRC. Non-US contracts still left on LIBOR by then would be in uncertain territory once synthetic LIBOR stops being published.

It’s been a long journey from the speech by Andrew Bailey, governor of the Bank of England, in July 2017 that fired the starting gun on the transition planning in earnest, but one that both the industry and regulators can be proud of. The end-2021 deadline set in that speech was hit for 4 out of 5 LIBORs, with the USD piece of the puzzle now falling into place later this month. Whether there will be a third act in the form of EURIBOR­­­­­9­ is something we pondered in our last piece, but that is perhaps a topic for another day.

In the meantime, please do get in touch through your usual bank contact if you have any questions on the upcoming transition steps for USD LIBOR, or indeed on other topics around regulation and market structure.  

Glossary

1 - LIBOR: London Interbank Offered Rate

2 - SOFR: Secured Overnight Financing Rate

3 - ARRC: Alternative Reference Rates Committee

4 - ISDA: International Swaps and Derivatives Association

5 - CMS: Constant-maturity swap

6 - SONIA: Sterling Overnight Index Average rate

7 - OIS: Overnight Index Swap

8 - ICE: Intercontinental Exchange, Inc.

9 - EURIBOR: Euro Interbank Offered Rate

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