Regulation

USD LIBOR - the sequel

Just when you thought it was safe to go back in the water...

It is generally accepted that GBP LIBOR transition went pretty well. There are a few bits and pieces still to mop-up (more on that below), but all-in-all job done. Question is, will it be a similar success story with USD? Below we consider recent developments, what you need to think about now, and some of the possible dorsal fins circling the boat down the line. We wrap-up with some observations on GBP and EUR.

Recent history...LIBOR controls

A quick refresher on what’s happened recently with USD LIBOR. On 1 January 2022 the authorities implemented the no-new-LIBOR mandate for USD (with a few exceptions). So, no new $LIBOR loans or bonds permitted, and derivatives only allowed to hedge existing (pre-Jan) exposure – specific wording below:

* Reference Federal Reserve and FCA statements

... and the rise of SOFR

The market seems to have moved more decisively to SOFR [3] (see latest ARRC [4] minutes), though there are a few flavours to choose from. Derivatives are largely daily SOFR, compounded in arrears. Loans seem to be tending towards Term SOFR as their preference. And bonds present a more mixed picture but also tending towards SOFR compounded in arrears, usually with a 2-day shift, though conventions still vary. The credit sensitive rates like BSBY [5] are still lurking in the wings, though authorities have been quite keen to discourage their use.

 

So new controls are stopping the increase in use of USD LIBOR, and from a derivatives perspective at least due to the transition plans of central counterparties (see LCH consultation paper) and the resounding success of the ISDA 2020 IBOR Fallbacks Protocol, almost all legacy positions have baked-in fallbacks to compounded SOFR in arrears + fixed Credit Adjustment Spread (CAS) as published by Bloomberg back in March 2021:

Source: Bloomberg - full list of tenors

Bond and loan fallback arrangements vary – some have robust fallbacks, but many still need to be agreed bilaterally.

Legislative safe harbour to the rescue?

But behind all this there is the US legal safe harbour making its way through the legislative process. This would give air cover to counterparties to apply a market standard fallback to legacy positions that have not transitioned or had fallbacks put in place by the cessation deadline – this would come by way of a waterfall logic at the top of which would be CME Term SOFR + CAS [6] for loans, bonds & securitisations. Summary of ARRC’s fallback recommendations for New York law across various products and tenors, which are now being adopted across the US via the federal legislation.

 

That would be good for US governing law contracts, but may leave non-US law ones still in uncertain territory. There is some talk of the UK directing IBA [7] to publish a synthetic LIBOR rate for USD (comparable to the GBP solution), though whether that would then be the ICE Term SOFR rate rather than the CME one is not clear. And if it was different, how problematic would that be? CME & ICE have slightly different methodologies for their construction of Term SOFR, but the difference in actual rates may not be that material. 

So what is there to consider now?

It’s déjà vu all over again! 

 

We wrote a piece Act now or fall back? The LIBOR transition dilemma back in April last year about the transition for Sterling. You can open that up and search/replace SOFR for SONIA and it is pretty much the story for USD today. There are a few differences around the nuances of the conventions and legal options under tough legacy (which, at the time we wrote this, had not yet crystallised into the eventual much broader synthetic LIBOR solution), but essentially it is a fairly good summary of the options.

 

The question is whether to actively transition your LIBOR positions to RFR [8] now or leave them to fall-back to SOFR + CAS come cessation in June 2023. 

  • For derivatives assuming you are signed up to the ISDA [9] protocol (or they’re cleared), then leaving trades to fall back come cessation may be a reasonable approach. If no protocol, or if for example they are swaps linked to loans where you want to match the hedge against the underlying loan, then you may want to agree a bilat amendment to achieve that (be that to compounded SOFR with a 5d lag or Term SOFR*) 
  • For loans you can actively transition at today’s prices (i.e. spread adjustment calculated on current LIBOR/SOFR basis) or enter into an amendment agreement to apply fallback of SOFR + the fixed CAS come the first roll date after cessation
  • For bonds where you are the issuer you need to establish what fallback provisions may be allowed for in the documentation, and what consent mechanism is required if changes needed; if you are the bond holder then an awareness of the position and plans of the issuer is needed 

* Generally derivatives referencing Term SOFR are not encouraged, but one exception is when hedging directly a Term SOFR underlier. 

 

To transition or not to transition, that is the question...

There has been some focus recently on the perceived volatility of daily SOFR, and the difference between current LIBOR/SOFR basis and the published fixed CAS that will come into play after June 2023. We think some of that is a bit of a red herring. If you transition now, you will get the adjustment spread between LIBOR and SOFR as dictated by the forward swaps market today. 

 

If you wait for fallbacks, you will eventually get the fixed CAS. But in the intervening period the forward basis is going to converge with the fixed CAS as the market already knows that is the end point. You can see in the graph below of projected LIBOR and SOFR rates that the implied basis between the benchmarks is already quite close to the fixed spread and is expected to remain like that:


Source: NatWest

 

Ultimately as we said in conclusion in the earlier Sterling piece, there are a variety of factors to consider in the decision about when to move, but it will probably be driven more by broader portfolio management and ops considerations than particular pricing factors.

Any sharks circling?

So what is there to worry about? There is likely to still a lot of wood to chop in terms of renegotiating contracts, especially in the loan space, both bilateral and syndicated. As we saw with GBP, this takes time and if left too late it might mean no contractual provisions for fallbacks when USD ceases to be published on 30 June 2023. 

 

In the UK, the synthetic LIBOR solution rode to the rescue at the eleventh hour – we suspect deliberately left quite late by the authorities to encourage the laggards. Will it be the same story of a safety net in the US? Probably, but that is only a stay of execution as we are seeing in the UK now, and for longer-dated transactions you still have to get the job done.

 

The safety net in US does differ in nature slightly to what the UK did for GBP, in that it offers a safe harbour fallback permanently to Term SOFR, as opposed to the UK's time limited used of synthetic LIBOR (Term SONIA).

The swaptions story

A sideshow on the derivatives front is dealing with the contracts that reference the USD LIBOR ICE Swap Rate (ISR) rather than LIBOR directly, most commonly cash settled swaptions and CMS. Here the ISDA 2020 IBOR Fallbacks Protocol does not apply. In GBP you had to bilaterally agree to use the ISR Fallback Rate, for which ISDA provided a standard template.

 

For USD, ISDA has helpfully gone a step further. They are in consultation to add a module to the later ISDA 2021 Fallbacks Protocol to cover USD LIBOR ICE Swap Rate fallbacks which people can choose to adhere to. It will work in the same way as the original Fallback Protocol, where if both sides sign-up, then problem solved.

Term SOFR versus SOFR in Arrears

A year ago, the worry was whether there was sufficient SOFR liquidity to support transition – with the ‘SOFR first’ initiatives and the no-new-LIBOR mandates, that is perhaps a diminishing concern. But you still need to choose a flavour of SOFR – in arrears or term. Unlike the UK where regulators were very reluctant to condone use of Term SONIA (limited to some Trade Finance use cases and ultimately for synthetic LIBOR), in US Term SOFR seems to be becoming more of the standard in the loan market, and baked-in at the top of the waterfall for fallbacks in the legislative solution.

 

There is some concern whether this is a wise long-term solution. If the point was to move the market to rates based on high volume observable ‘real’ transactions, do you want to still be rooted in a system based on pricing positions of trading desks in the Futures market?

Still more Godfather II

All said and done though, USD transition is heading in the right direction. There will be a few bumps in the road, particularly in getting clients engaged and documents signed, but the sequel won’t be a turkey. And the legal safe harbour will be there to catch the few caught napping.

And GBP is done and dusted?

Not quite, although they are certainly scaling back oversight as evidenced by the revision to the Sterling RFR WG terms of reference in April. But there is still an albeit small legacy synthetic GBP LIBOR population out there. The loan amendment agreements that never got signed, the bonds with no fallbacks, the odd derivative that didn’t adhere to the protocol. 

 

The UK authorities are turning the screws on the hold-outs. First to go will be the 1m and 6m tenors – a consultation is planned in early Q3 2022, but expect to see them gone by year end (i.e. no longer published as synthetic rates by IBA). That will just leave the most popular 3m still published, and no doubt the writing is on the wall there as well 6 or 12 months down the line. 

 

So a contract left on 1m or 6m GBP LIBOR from start of next year (assuming consultation goes through as expected) will be in contract frustration, unable to settle. At that point you can imagine a counterparty just unilaterally applying the standard fallback rates, whether any formal commercial agreement to do so or not.

EURIBOR... the last guest at the party?

It will rather stick out come July 2023...EURIBOR will be the only IBOR left with GBP, JPY, CHF and USD LIBOR all retired. The last diner at the restaurant, waiters all standing around and chairs on the tables.

 

For EURIBOR, assuming you have adhered to 2020 ISDA Fallback protocol then derivatives are covered for fallbacks, to €STR + a credit adjustment spread, but the value of that CAS will only be known at some point in the future when (if) a cessation announcement is made. The graph below shows how the estimated CAS will rise over time as the 5-year historic median (5YHM) lookback window for EURIBOR / €STR basis shifts forwards (based on current projected rates):


Source: NatWest

 

One consequence of the GBP / USD moving to RFR but EUR staying on EURIBOR can be seen in the cross-currency market. The ‘RFR First’ initiative means the market has moved to SOFR / €STR10 and SONIA11 / €STR, but the funding and swaps market in EUR is still on EURIBOR. Without clear transition plans for EUR and a future fixed spread (CAS) on the horizon, this is presenting greater risk management challenges (especially with liquidity worsening and the ECB entering a rate-hiking cycle).

 

We are a long way from any transition plans – the EU has not so much as started to consult on EURIBOR’s demise, but with all the other jurisdictions having moved to replacement rates, will the EU really stick forever with the last IBOR standing? We give it five years... you heard it here first!

So to recap....
  • USD: full steam ahead for June 2023, keep an eye out on legal safe harbour and be prepared for a scramble to get legal docs signed in H1 2023
  • GBP: pretty much done, but watch out for the odd legacy transaction still on 1m or 6m LIBOR this year, and 3m next year
  • EUR: it’s only a matter of time, but who knows when? nothing to do now but watch this space 

 

We haven’t got a film analogy for EURIBOR.... Home Alone 3 maybe?



1 LIBOR - London Inter-Bank Offered Rate

2 EURIBOR - Euro Interbank Offered Rate

3 SOFR - Secured Overnight Financing Rate

4 BSBY - Bloomberg Short-Term Bank Yield Index rate

5 ARRC - Alternative Reference Rates Committee

6 CAS - Credit adjustment spread

7 IBA - ICE Benchmark Administration

8 RFR - Risk Free Reference Rates

9 ISDA - International Swaps and Derivatives Association

10 €STR - Euro short-term rate

11 SONIA - Sterling Overnight Index Average

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