Are You Ready for the Cessation of USD LIBOR?
Ready or not, businesses must transition financial contracts away from the benchmark rate. Here’s an update on what to expect.
Recent announcements by regulators in the United States and United Kingdom provided strongly worded reminders to banks and other entities they supervise that the London interbank offered rate for the U.S. dollar (USD LIBOR) will soon be discontinued or declared unrepresentative. One-week and two-month USD LIBOR—as well as all non-USD LIBOR tenors—will cease publication immediately after December 31, 2021. Three-month, six-month, and one-year USD LIBOR will cease publication after June 30, 2023.
In anticipation of the benchmark’s cessation, regulators warned entities to avoid taking on new LIBOR exposure except in very limited circumstances.1 These announcements make it abundantly clear that entities and other market participants that have engaged in (or continue to engage in) loans, floating-rate notes, securitizations, supplier contracts, and/or other financial instruments that reference USD LIBOR should already be well on their way away from the benchmark. Actions recently taken by other regulators, regulator-sponsored groups such as the Alternative Reference Rates Committee (ARRC), and trade associations emphasize this imperative.
Companies that have not adequately prepared for the transition away from LIBOR risk potentially adverse impacts to themselves, their borrowers, investors, customers, and counterparties.2
Stop Using LIBOR—Now!
On November 30, 2020, U.S. federal prudential regulators, including the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC), issued supervisory guidance encouraging banks to stop new USD LIBOR issuances by the end of 2021.3,4 On October 20, 2021, the U.S. prudential regulators issued a supplementary joint statement reiterating their December 31, 2021, cutoff date for new USD LIBOR issuances. They further stated that entering into new USD LIBOR contracts, including derivatives, after that date would create safety and soundness risks.5
The most recent joint statement clarified that the prudential regulators do not consider contracts which draw on an existing agreement that is legally enforceable—such as a committed credit facility—to be new issuances, even if those contracts create additional LIBOR exposure or extend the term of an existing LIBOR contract. The joint statement also provided considerations for entities assessing the appropriateness of alternative reference rates used in lieu of LIBOR, along with the prudential regulators’ expectation that new or updated LIBOR contracts should include strong and clearly defined fallbacks.
On November 16, 2021, the United Kingdom Financial Conduct Authority (UK FCA) released a series of documents confirming that:
- Starting January 1, 2022, institutions supervised by the UK FCA will be prohibited from using certain LIBORs, including sterling and USD LIBORs,6 and
- The UK FCA will allow the temporary use of “synthetic” sterling and yen LIBOR rates in all legacy contracts based on such rates, other than cleared derivatives, that have not been changed by December 31, 2022.7,8
With respect to USD LIBOR, it is possible that the UK FCA may consider allowing similar legacy use of a synthetic version of USD LIBOR after June 30, 2023, assuming that a large number of contracts referencing USD LIBOR in the one-month, three-month, and six-month tenors are still outstanding at that time—but this has yet to be determined.
The UK FCA’s and the U.S. prudential regulators’ prohibition on the use of LIBOR after December 31, 2021, is subject to some exceptions. One of these is around market-making in support of client activity related to USD LIBOR transactions executed before January 1, 2022. Another is for transactions that reduce or hedge USD LIBOR exposure on contracts entered into before January 1, 2022.
With December 31st Right Around the Corner: What’s Next?
The LIBOR fallbacks9 generally preferred by regulators are “risk-free rates” based on historical data averaged over a period of time. For the U.S. dollar, this is the Secured Overnight Financing Rate (SOFR). These risk-free rates seek to remove the risk of rate manipulation that LIBOR experienced, which culminated in bank criminal settlements in 2012.10 They also better reflect true market rates, given the decrease in the interbank lending that has formed the basis of LIBOR since the financial crisis.
However, no specific alternative rate is not mandatory, so myriad options have been developed to serve as benchmarks for unsecured bank lending. These include the American Financial Exchange’s American Interbank Offer Rate (AMERIBOR), Bloomberg’s Short-term Bank Yield Index (BSBY), and the ICE Benchmark Administration’s ICE Bank Yield Index (BYI), in addition to existing unsecured lending rates such as the prime rate.
That said, regulators have a strong preference for SOFR, particularly as the fallback rate used for outstanding LIBOR positions, known as “legacy contracts.”11 And regulators have set milestones for the entities within their jurisdictions to complete the transition in advance of the end of this month. They have indicated that failure to engage appropriately in the transition process may lead to regulatory enforcement.12
SOFR First. In light of the proliferation of alternatives to LIBOR and the slower-than-expected transition away from LIBOR, the Commodity Futures Trading Commission (CFTC)—through its Market Rate Advisory Committee (MRAC)— has taken action to move the markets to transition from LIBOR to SOFR.
On July 13, 2021, the MRAC adopted a market best practice known as “SOFR First.” SOFR First is designed to help market participants decrease their reliance on USD LIBOR.
SOFR First recommends that entities complete a four-phase process by December 31. The first and second phases—related to brokers’ replacement of interdealer trading in linear swaps and currency swaps that reference LIBOR with swaps that reference SOFR—were completed on July 26, 2021, and September 21, 2021, respectively. The third phase, related to the replacement of certain non-linear derivatives—e.g., caps, collars, floors—was completed November 8, 2021. The timing for the final phase of SOFR First, related to exchange-traded derivatives that refer to LIBOR (e.g., futures) has yet to be determined.13
ISDA. According to the ARRC, 95 percent of the multi-trillion–dollar outstanding exposure to LIBOR has been in derivatives transactions, a substantial volume of which are over-the-counter transactions documented under International Swaps and Derivatives Association (ISDA) agreements.14
On January 25, 2021, ISDA produced:
- A protocol to amend existing over-the-counter (OTC) derivatives transactions under its master agreements and other listed forms of agreements, and
- Amended definitions to be used in transactions going forward as mechanisms to apply new fallbacks designating an adjusted SOFR-based rate to in-scope derivatives transactions that reference USD LIBOR.15
To date 14,870 organizations have adhered to the ISDA protocol.16
Clearinghouses. LCH and CME have announced similar plans to convert all outstanding USD LIBOR cleared swaps to SOFR-referencing OIS standard swaps just prior to June 30, 2023.17,18 LCH has confirmed that it will run a process converting LIBOR cleared swaps to swaps using a market-standard risk-free rate, including SOFR for USD LIBOR swaps, and that it will do so shortly before the cessation date of June 30, 2023.19 A spread adjustment will be incorporated as a non-compounded spread on the risk-free rate leg of the affected contract.20
CME term rate. In light of the successful implementation of the first phase of SOFR First, the ARRC formally announced that a forward-looking term rate based on SOFR and published by the CME Group (“CME Term SOFR”21) is an appropriate fallback to USD LIBOR, and may be used for certain types of transactions. The CME Group is currently publishing one-month, three-month, and six-month tenors of CME Term SOFR.
The successful implementation of SOFR First and the ARRC’s support of CME Term SOFR are expected to increase the volume of new transactions quoted at SOFR and the adoption of fallback language for legacy contracts, supporting the transition away from LIBOR. The ARRC continues to recommend overnight SOFR and SOFR averages for replacement of LIBOR in all cases, including in cases for which the ARRC has not recommended CME Term SOFR or for which an appropriate tenor of Term SOFR is not available.
Supports for the Transition
Industry groups, including the ARRC, ISDA, and the Loan Syndications and Trading Association (LSTA), have echoed the concerns of regulators and have provided timelines and tools to facilitate an orderly LIBOR transition in order to avoid market disruptions.22
Typically, financial instruments are moving away from the legacy benchmark through negotiated amendments to the agreements. Alternatively—as has been the case for OTC derivatives using ISDA master agreements—the move may utilize industry-developed form amendments agreed to among adherents to a protocol, or it may use industry-developed standard amendments that the parties agree to bilaterally.23
On April 6, 2021, the New York governor signed into law the Senate Bill 297B / Assembly Bill 164B (the “New York LIBOR Legislation”).24 This legislation generally provides that references to a USD LIBOR–based benchmark, by operation of law, will be replaced by a “recommended benchmark replacement” (as defined in the New York LIBOR Legislation) based on SOFR. Or, if one of the parties has discretion to determine a LIBOR replacement, the legislation encourages replacement of the USD LIBOR rate with the “recommended benchmark replacement” by providing a safe harbor from certain legal challenges under New York law.
At present, there is no federal law akin to the New York LIBOR Legislation. The U.S. Congress began working on a draft version of federal legislation in October 2020 that would be based on the New York LIBOR Legislation. The current version of the legislation, the Adjustable Interest Rate (LIBOR) Act of 2021, was formally introduced in the House of Representatives on July 22, 2021. The bill was then assigned to the House Financial Services, Ways and Means, and Education and Labor Committees. On July 29, 2021, the House Financial Services Committee voted to positively report the bill out of committee and send it to the full House. Yesterday, the House approved the bill by a vote of 415-9, but what will happen in the Senate is anyone’s guess.
See also:
- How to Prepare for the End of LIBOR
- Derivatives Have a LIBOR Solution
- Fed Dials up Pressure to Ditch LIBOR
- LIBOR Chicken and Egg
- LIBOR Replacement Contenders
The Senate Committee on Banking, Housing, and Urban Affairs held a hearing on November 2, 2021, on its version of the legislation. While similar to the New York LIBOR Legislation, there are differences in the current draft of the federal legislation, including—perhaps most significantly—that the draft bill specifically provides for the preemption of state law, which would include the New York LIBOR Legislation, and addresses conflicting provisions in other federal laws, including the Trust Indenture Act.
At this time, it is uncertain as to whether, when, and in what form any federal legislation will be adopted. Regardless, although these state and federal legislative actions are intended to help address challenges with revising legacy contracts, they are not currently expected to address all potential issues of transitioning agreements. For example, the change in New York law would benefit only financial instruments and contracts governed by New York law. In addition, it could be subject to federal Constitutional or statutory challenges, as well as challenges to New York governing law in other jurisdictions.
In the absence of a federal law akin to the New York LIBOR Legislation, parties should consider avoiding taking on additional LIBOR exposure under new instruments or contracts. They should also verify that their existing LIBOR exposures have appropriate fallbacks or can be amended to include such fallbacks to a rate that is not based on LIBOR.
In light of the unambiguous regulator actions to date—as well as the recommendations and measures taken by the ARRC, ISDA, LSTA, and others—market participants have both the incentives and the tools to transition their current LIBOR exposures away from the benchmark.
Some may take comfort in knowing that when LIBOR tenors are no longer published or are deemed unrepresentative (January 1st for some tenors), their exposures will be covered by the “tough legacy” safety measures that New York and other jurisdictions are putting in place. However, reliance on such measures may be challenged, or it may be determined that they do not apply to particular exposures.
Parties that fail to catalogue their LIBOR exposures within the next two weeks, to select appropriate market and regulator-approved solutions, and to implement those solutions before LIBOR ceases to be published or is deemed unrepresentative run a real risk of uncertainty, regulator action, and litigation.
Notes:
1. This article focuses on the discontinuation of USD LIBOR.
2. The transition process that market participants have been using typically involves three stages: (i) identification of financial instruments and contracts with LIBOR exposures, (ii) development of solutions (e.g., negotiated amendments with appropriate fallbacks or negotiated termination), and (iii) implementation of the solutions (e.g., negotiation of amendments or terminations, sale of positions, customer and investor outreach) that will be in place at the time USD LIBOR is no longer available.
3. //www.federalreserve.gov/newsevents/pressreleases/files/bcreg20201130a1.pdf. The Federal Housing Finance Authority (FHFA), the regulator of federal home loan banks Fannie Mae and Freddie Mac, issued a similar letter. See //www.fhfa.gov/Media/PublicAffairs/PublicAffairsDocuments/Supervisory-Letter_Planning-for-LIBOR-Phase-Out.pdf. On December 18, 2020, the Farm Credit Administration (FCA) also issued a response and guidance noting its agreement with the November 30, 2020, statement from the U.S. prudential regulators and emphasized that the IBA’s timeline is not in any way intended to slow down the transition. The FCA letter is available at: //ww3.fca.gov/readingrm/infomemo/Lists/InformationMemorandums/Attachments/274/LIBORTransitionInfoMemo.pdf.
4. For information on other regulators’ statements (including the FCA), please see our firm’s legal alerts “FCA announcement triggers LIBOR endgame”and “The heat is on—Regulators step up pressure to implement LIBOR transition plans.”
5. See Remarks by Acting Comptroller of the Currency Michael J. Hsu at the ARRC Symposium, //www.occ.gov/news-issuances/speeches/2021/pub-speech-2021-110.pdf. In addition, members of the FSOC, including from the U.S. prudential regulators and the SEC and CFTC, the ARRC, and the IBA, also made statements and have taken action to move the markets to transition away from LIBOR using SOFR.
6. In the case of USD LIBOR, that includes the tenors of USD LIBOR that will be discontinued as of December 31, 2021, as well as—except in very limited circumstances—those tenors of USD LIBOR that will continue to be published until June of 2023.
7. The UK FCA release, with links to the various documents referred to therein and below, is available at: https://www.fca.org.uk/news/press-releases/fca-confirms-rules-legacy-use-synthetic-libor-no-new-use-us-dollar-libor. Note the UK FCA’s proposed rules on legacy use apply to U.K. “supervised entities” under the on-shored U.K. Benchmarks Regulation, by contrast to the U.S. and EU measures (outlined below), which apply to contracts governed by the laws of the relevant jurisdictions. This divergence in approach leads to a potential mismatch in the measures that apply in cross-border scenarios.
8. The UK FCA stated that there is now adequate confidence and liquidity in alternative benchmark rates, such as SOFR, and restricting the use of the prohibited USD LIBOR versions is not likely to result in material or widespread adverse impacts. The UK FCA also believes that market participants have had sufficient notice of the transition away from USD LIBOR by the end of 2021 and a prohibition of these versions is in line with U.S. supervisory guidance. The UK FCA, in its notice, provided a litany of reasons why continuing to enter into USD LIBOR–based contracts would be imprudent, even if such contracts included fallbacks to risk-free rates such as SOFR that would apply when the remaining LIBOR tenors are no longer published. See paragraphs 4.5-20 of the UK FCA’s Notice of Prohibition on New Use of a Critical Benchmark, available at Article 21A Benchmarks Regulation—Notice of prohibition on new use of a critical benchmark (fca.org.uk).
9. A fallback is a contractual mechanism that provides for an alternate reference/benchmark rate to apply at the point of cessation (or, in some instances, at an agreed-upon point prior to cessation) of the relevant LIBOR rate.
10. The LIBOR scandal resulted in significant regulatory reforms and a review of alternatives to LIBOR. On September 28, 2012, Wheatley Review published a final report which included a 10-point plan for comprehensive reform of LIBOR. The press release and full report are available at https://www.gov.uk/government/news/independent-review-into-libor-published.
11. According to some regulators, certain of these reference rate alternatives to LIBOR have a credit component based on the underlying cost of bank borrowing in wholesale term unsecured markets that suffer from the same sort of shortcomings as LIBOR. See ARRC Welcomes and Highlights Messages from Recent FSOC Principals Meeting (held 6/11/21) //www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/20210615-arrc-release-fsoc-meeting-final, and ARRC Welcomes FHFA Supervisory Letter on Transition Away from LIBOR (dated 7/1/21) https://www.fhfa.gov/SupervisionRegulation/LIBORTransition/Documents/Alternative-Reference-Rate-Selection-Risk-Management-712021.pdf. Attributes that potentially undermine the reliability of these rates include the alternative rates (i) being based on a relatively small number of actual transactions, (ii) using a wide spectrum of types and tenors of transactions, and (iii) in the event of failing to gather sufficient underlying transaction data, allowing the ability to increase the number of observation days or, in some cases, using indicative quotes. (Interestingly, the FHFA in its letter noted with respect to a rate indicating it is IOSCO compliant—which at least one of the current non-SOFR alternatives represents—that there is no IOSCO certification of such compliance granted by IOSCO itself. Instead, rate producers typically produce documentation explaining how they believe their rate to be IOSCO compliant. It is incumbent upon users of those rates to assess the level of support backing claims of IOSCO compliance.)
12. See, e.g., //www.federalreserve.gov/newsevents/pressreleases/files/bcreg20201130a1.pdf.
13. At the time SOFR First was adopted, the CFTC’s Acting Chair Rostin Behnam stated that in anticipation of the end of LIBOR and its replacement with SOFR, he planned to have his staff present the CFTC with a rule proposal addressing mandatory clearing of SOFR swaps, expected to be finalized in 2022. On November 17, 2021, the CFTC issued a notice requesting comments and information related to how it could amend its swap clearing requirements to address the transition away from LIBOR and other IBORs and the market adoption of alternative risk-free rates, such as SOFR. Comments to the CFTC’s request must be received on or before January 24, 2022, and may be submitted through the CFTC Comment Portal, by mail, or hand delivery/courier. The Federal Register notice, published on November 23, 2021, is available at: 2021-25450a.pdf (cftc.gov). The CFTC’s Press Release regarding its request is available at: //www.cftc.gov/PressRoom/PressReleases/8459-21. The CFTC’s request for comments follows European Union regulators’ recommendation to the European Commission, in the form of draft final regulations, to amend the European clearing mandate to remove certain EONIA- and LIBOR-based swaps from mandatory clearing. (While a “recommendation,” the European rules have been finalized, and approval by the European Commission is expected.) The draft regulations are available at https://www.esma.europa.eu/sites/default/files/library/esma70-156-4953_final_report_on_the_co_and_dto_re_benchmark_transition.pdf.
14. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report
15. The ISDA protocol and related FAQs are available at ISDA 2020 IBOR Fallbacks Protocol—International Swaps and Derivatives Association.
16. Current as of December 6, 2021.
17. LCH’s summary of its announcement regarding its consultation is here, https://www.lch.com/membership/ltd-membership/ltd-member-updates/summary-lchs-consultation-its-solution-outstanding-0, and its next steps can be found here, https://www.lch.com/membership/ltd-membership/ltd-member-updates/supplementary-statement-lchs-solution-outstanding.
18. The link to the consultation is //www.cmegroup.com/trading/interest-rates/files/cleared-swaps-considerations-for-ibor-fallbacks-and-conversion-plan.pdf.
19. See supra note 23.
20. Id.
21. The CME requires a Category 1 Use License for use of Term SOFR as a reference rate—primary or fallback—in cash market financial products (e.g., loans, notes, money market instruments). A Category 2 Use License may also be required; it allows use only as a reference rate in an OTC derivative product that is tied or linked to a licensee and “end user” hedging against exposure from one or more cash market financial products that references CME Term SOFR.
22. See e.g., Fallback Contract Language—Alternative Reference Rates Committee (newyorkfed.org); ISDA Launches IBOR Fallbacks Supplement and Protocol—International Swaps and Derivatives Association; and LSTA Library for the LIBOR Transition—LSTA.
23. See our firm’s legal alert “Lighting the Way Forward.”
24. For a detailed overview of the provisions in the New York LIBOR Legislation, please see our firm’s legal alert “Legislating for LIBOR’s cessation.”