On August 5, 2020, FINRA issued a regulatory notice outlining steps for broker-dealers to prepare for the pending transition away from LIBOR. The notice reminds firms to “evaluate their exposure to LIBOR” and “review their preparedness to manage LIBOR’s phase-out.” While the notice expressly disclaims any agency view of “specific effective practices,” it provides questions for firms to consider and a general description of best practices, which derive from responses to a survey undertaken by FINRA of a cross-section of member firms.
As the 2021 deadline for the cessation of LIBOR approaches, two key milestones for the LIBOR transition in the derivatives space are set to occur in the second half of 2020. These are the SOFR discounting switch and publication of the ISDA Protocol and Supplement amending the 2006 ISDA Definitions. Market participants anticipate that these changes will continue to increase risk-free rate (RFR) trading volumes and address liquidity concerns.
SOFR discounting switch
In October 2020, major central counterparties will change price alignment interest and the discounting index for all cleared USD interest rate swaps from fed funds to SOFR. This migration was identified by working groups as being key to driving liquidity in SOFR-linked products, and market participants hope that this will lead to a ‘big bang’ in the trading of SOFR-linked swaps.
ISDA Protocol and Supplement amending the 2006 ISDA Definitions
ISDA intend to publish a supplement to the 2006 ISDA Definitions, after which all new transactions incorporating the 2006 ISDA Definitions will include fallbacks that will apply upon the permanent cessation of certain IBORs, and upon an announcement of LIBOR ceasing to be representative. ISDA will also publish a protocol to facilitate amendments to incorporate these updated 2006 ISDA Definitions into legacy derivative contracts. Though no definitive date has been provided for these publications, they are anticipated within the coming months.
Despite the positive trend of trading volumes in RFR-linked interest rate derivatives (IRD) shown in Q1 2020, there is still concern among market participants that significant progress needs to be made to meet the end-2021 deadline. Whilst SOFR-linked IRD traded notional rose 68.9% in Q1 2020 compared to Q4 2019, the traded notional only amounted to $280.4 billion, compared to $35.89 trillion in USD LIBOR-linked IRD. While the SONIA swaps market is much more liquid, the slow uptake of SOFR-linked swaps is a concern, and market participants are hopeful that trading volumes will accelerate in the second half of 2020. This concern was echoed by ISDA’s Chief Executive, Scott O’Malia at the ISDA/SIFMA AMG Benchmark Strategies Forum in February 2020, who noted the short-dated nature of many RFR-linked swaps in the market. For example, 96.5% of the SONIA-linked IRD traded in Q1 2020 had a tenor of up to one year. He went on to say that it is hoped that the implementation of the above changes will start addressing these concerns.
That being, whilst these are significant milestones for the LIBOR transition in the derivatives market, whether they will succeed in providing the desired liquidity for RFR-linked derivatives remains to be seen. An increase in liquidity will ultimately depend on completion by market participants of their internal and operational policies.
Please contact any of the authors of this briefing or your regular McGuireWoods contact if you have questions about, or would like assistance with, the LIBOR transition.
As the world continues to deal with the COVID-19 pandemic, the end of 2021 deadline for the LIBOR transition has remained unchanged. However, certain deadlines along the way have been extended in recognition of the difficulties that market participants face in these tumultuous times.
In what follows, we explore the current timelines on the path to the transition from LIBOR.
On June 30, the ARRC published a revised version of its hardwired fallback language for new US Dollar LIBOR-linked syndicated loans. Along with this updated language, the ARRC also updated its user’s guide, which contains guidance for market participants for the adoption of the refreshed fallback provisions.
Legaltech News, an American Lawyer Media publication, quoted Chicago partner Clayton Stallbaumer in a June 1, 2020, story about financial institutions leveraging legal and technology expertise to prepare for the coming replacement of the London Interbank Offered Rate (LIBOR) in 2022.
The LIBOR rate is found in hundreds of thousands of financial contracts worth an estimated $220 trillion, Legaltech News reported. That means technology will be vital in helping institutions prepare for the transition to LIBOR’s replacement rate, Stallbaumer said.
“We saw a real opportunity for technology to help our clients transition from LIBOR in an efficient way,” Stallbaumer explained. “The problem they have is it’s a volume and timing issue. We’re roughly 18 months from LIBOR going away, and a lot of our institutional clients have thousands of documents that reference LIBOR. As we were talking to clients about this, there seems to be a real opportunity to use certain types of technology.”
On Thursday, June 4, the Consumer Financial Protection Bureau (“CFPB”) issued guidance to address issues arising out of the pending discontinuation of LIBOR and the resulting need for creditors to transition to other benchmarks. As the CFPB has noted, at this time, the transition is expected after 2021, with the anticipated shift to the Secured Overnight Financing Rate (“SOFR”) index supported by the Alternative Reference Rates Committee (ARRC), a public-private working group organized to address the transition. Ahead of an inevitable, challenging transition, the CFPB issued an extensive rulemaking proposal with request for public comment, a revised consumer handbook, and updated compliance guidance.
In his speech in July 2019, Andrew Bailey called for public debate on potential outcomes for legacy contracts that prove unable to convert or be amended to include fallbacks to risk free rates before the discontinuance of LIBOR. In response to that speech, the Working Group on Sterling Risk-Free Reference Rates last week published a paper on how to catalyse the transition of such ‘tough legacy’ contracts away from LIBOR.
To address ‘tough legacy’ contracts, the Working Group has proposed that the UK Government consider introducing legislation. They note that in the U.S., the Alternative Reference Rates Committee (the ARRC) has proposed a similar approach and there would be benefits from the international consistency that would result from the UK mirroring this.
On April 17, the ARRC released a set of key objectives for 2020 that the ARRC has set for itself to support the voluntary use of SOFR as an alternative to USD LIBOR. The ARRC stated that its objectives were developed keeping in mind the current expectation that LIBOR can no longer be guaranteed beyond the end of 2021, noting that this timeline was recently reinforced by the UK FCA in a statement released in the context of dislocations surrounding the coronavirus.
On April 17, the ARRC released a webinar providing an in-depth overview of the ARRC’s proposed New York State legislation.
As previously noted on this blog, the ARRC has indicated that the proposed legislation is intended to minimize legal uncertainty and adverse economic impacts associated with LIBOR transition and would: (i) prohibit a contract party from refusing to perform its contractual obligations or declaring a breach of contract as a result of LIBOR discontinuance or the use of the legislation’s recommended benchmark replacement, (ii) establish that the recommended benchmark replacement is a commercially reasonable substitute for and a commercially substantial equivalent to LIBOR, and (iii) provide a safe harbor from litigation for the use of the recommended benchmark replacement.
The ARRC’s webinar relating to the proposed New York State legislation is available here.
On April 8, the ARRC announced that it had agreed on a recommended spread adjustment methodology for cash products referencing USD LIBOR.
The ARRC’s recommended methodology is intended for use in for USD LIBOR contracts that have incorporated the ARRC’s recommended hardwired fallback language or for legacy USD LIBOR contracts where a spread-adjusted SOFR can be selected as a fallback. According to the ARRC, the recommended methodology is intended to make the ARRC’s recommended spread-adjusted version of SOFR more comparable to USD LIBOR and consistent with ISDA’s fallbacks for derivatives markets. Except to the extent required by the terms of parties’ contracts, use of the ARRC’s recommended methodology is voluntary.
The ARRC has recommended a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR, consistent with the methodology recommended by ISDA for derivatives.
For consumer products only, the ARRC has recommended a 1-year transition period to this five-year median spread adjustment methodology.
The full text of the ARRC’s announcement is available here.