The financial industry and global regulators are transitioning from the London Interbank Offered Rate (LIBOR) to more robust alternative reference rates.
LIBOR is the most commonly used benchmark for short-term interest rates, often referenced globally in derivative, bond and loan documentation. It is estimated that $223 trillion of financial contracts and securities are tied to USD LIBOR and that matters to everyone – small businesses, corporations, banks, broker dealers, consumers, and investors. The transition from LIBOR to alternative interest rate benchmarks is well underway, but much work lies ahead.
LIBOR is referenced by approximately $223 trillion of financial products. Today’s LIBOR is informed primarily (and sometimes entirely) by “expert judgement” from estimates of transactions, not actual transactions. As a result, LIBOR doesn’t necessarily reflect the true cost of bank funding and is vulnerable to volatility and manipulation. Global regulators saw the problem with placing the foundation for global financial markets on such a construct nearly a decade ago, and they began to examine how more robust alternative reference rates could be identified or developed to replace LIBOR. As such, the regulatory community continues to believe that LIBOR is not a suitable rate and market participants must transition to alternative reference rates.
LIBOR Will End, Have No Doubt
LIBOR is ending, make no mistake about it. Most non-U.S. Dollar LIBOR tenors will cease on December 31, 2021. For U.S. Dollar denominated LIBOR, which includes the largest and most important tenors of LIBOR, cessation will occur on June 30, 2023. Federal banking regulators have issued guidance that regulated entities should cease executing new LIBOR transactions by the end of 2021 and expeditiously transition existing contracts to new reference rates, noting that “the agencies believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly” and have reiterated the “intense” supervisory focus on this issue. This regulatory posture has been echoed in the U.K and Europe and regulators are demanding in no uncertain terms that their regulated institutions move away from LIBOR this year. In October, the five federal financial institution regulatory agencies issued a joint statement to emphasize expectations that supervised institutions with LIBOR exposure continue to progress toward an orderly transition away from LIBOR. They noted, “failure to adequately prepare for LIBOR’s discontinuance could undermine financial stability and institutions’ safety and soundness and create litigation, operational, and consumer protection risks.”
The Uptake on SOFR
Through the Alternative Reference Rates Committee (ARRC), the Federal Reserve Board and New York Federal Reserve gather over 300 institutions, including SIFMA, to work on issues including legacy transactions, implementation of robust fallback provisions, and development of term rates in support of a successful transition to alternative reference rates. In 2017, the ARRC issued a recommendation that the Secured Overnight Financing Rate (SOFR) would be the preferred, robust alternative to LIBOR. SOFR is a fully transaction-based rate, referencing the previous day’s activity in the repurchase markets. SOFR is based on approximately $1 trillion of daily transactions from a wide range of market participants and is administered by the New York Fed. SOFR is, by intent and construction, a reliable and representative indicator of market interest rates; it is published on a daily basis by the New York Fed. The ARRC followed this milestone with the development and publication of numerous recommendations, guidance documents, and reference materials to promote a steady progression towards a successful transition away from LIBOR in line with its Paced Transition Plan, which lays out goals and
milestones for this important work. The market has broadly accepted this work, as shown by the usage of ARRCrecommended fallback language in new transactions, the issuance of significant amounts of debt referencing SOFR and the execution of trillions of dollars of SOFR-based swaps and futures contracts.
Federal Legislation for Tough Legacy Problems
SIFMA believes federal legislation is necessary to facilitate a smooth transition away from LIBOR for “tough legacy” contracts to an alternative reference rate. There are currently trillions of dollars of existing contracts and instruments that, as a practical matter, cannot be amended to utilize an alternative rate. SIFMA is supportive of federal legislation aligned with recommendations from the ARRC to address these situations where contracts cannot be easily transitioned from LIBOR due to legal or regulatory reasons. We believe such legislation would benefit all market participants including LIBOR’s end users, who range from investors to companies to consumers. The legislation would provide four key benefits: (1) certainty of outcomes; (2) fairness and equality of outcomes; (3) avoidance of years of paralyzing litigation; and (4) preservation of liquidity and market resilience.