With the industry expected to stop using USD LIBOR as a reference in the vast majority of new derivatives and cash products by the end of this year, the race is now on for market participants to accelerate their LIBOR transition programmes in order to ensure the ongoing and efficient functioning of financial markets.
The LIBOR transition is more than just ensuring that new instruments adopt alternative risk-free reference rates such as the secured overnight financing rate (SOFR); existing contracts must be prepared for when USD LIBOR will no longer be available.
According to the Alternative Reference Rates Committee’s (ARRC’s) March 2021 Progress Report, as of Q4 2020 there were more than $220 trillion of USD LIBOR referencing contracts outstanding. To put this number into context, the GDP of the US in 2020 was $21 trillion, meaning that the aggregate USD LIBOR exposure is approximately 10 times that of the US’s GDP.
While the current USD LIBOR exposure is almost unimaginably large, there are some important factors to take into account when thinking about the size of the risk this poses to the continued functioning of markets. First, much of this exposure relates to derivatives that will follow a clear path to migrate away from LIBOR to rates based on compound SOFR, with a credit-spread adjustment through a combination of a voluntary International Swaps and Derivatives (ISDA) protocol (in the case of uncleared derivatives) and rulebook changes (for cleared derivatives). Second, many of these exposures are either short term or will have matured by 30 June 2023, when the main representative USD LIBOR tenors will stop being published.
However, even putting derivatives and short-term instruments aside, the ARRC’s estimates suggest there will be a sizeable exposure that will reference USD LIBOR after 30 June 2023. The remaining business loans, consumer loans, bonds and securitisation exposures referencing USD LIBOR after June 2023 is estimated at approximately $5 trillion. Although, a fraction of overall USD LIBOR exposure today, this is still sizable.
Of that $5 trillion worth of loans, bonds and securitisation exposures that will reference USD LIBOR after June 2023, the ARRC estimates that “$1.9 trillion in exposures will remain in bonds and securitisations, many of which may have no effective means to transition away from LIBOR upon its cessation”.
The authors of those contracts will never have seriously contemplated a scenario where USD LIBOR wouldn’t be published for any material length of time. This has led to many contracts using clauses that have unintended consequences. For example, some agreements specify in the event USD LIBOR isn’t available to use the most recently published LIBOR rate.
While this might seem like an adequate assumption if USD LIBOR isn’t published for a day or two during periods of extreme volatility, in the event of permanent USD LIBOR cessation, such a clause turns the contract from a floating rate into a fixed-rate product. Clearly, this was never the intention of the original contract.
In theory, one could leave it up to the individuals to sort out this problem themselves. They may be able to get together and renegotiate the terms of the agreement in order to specify more suitable fallback language in the event of a USD LIBOR cessation. However, in practice this would be almost impossible. Some instruments are held by a large number of market participants and may require unanimous agreement to change the terms. Just think of the challenge to hunt down all the parties and then get them to agree on more suitable fallback language.
I can imagine a scenario where some parties might benefit from different fallback language, so coming to a consensus could be very difficult. Just in case it wasn’t challenging enough to do this once, now imagine repeating it many times for the large number of agreements that are outstanding. In addition to the operational burden, this could create a series of legal issues trying to resolve all the disputes.
The ARRC in conjunction with policymakers has not left this to individuals to sort out and has intervened to provide a suitable legal framework to address these issues. New LIBOR legislation recently signed into State of New York law reduces the adverse economic outcomes of legacy LIBOR fallback language. Where the contract has no fallback or the fallback is based upon LIBOR, the law strikes out any existing language and replaces it with the ARRC’s recommended fallback language. If the legacy language gives a party the right to exercise discretion or judgement regarding the fallback, that party can decide whether to use the ARRC’s fallback language and benefit from the statutory safe-harbour provision.
The ARRC has issued recommended fallback language specifying that contracts with that language would fall back to forms of the SOFR plus a fixed spread adjustment at the point of transition for legacy contracts. SOFR is the ARRC’s preferred alternative to USD LIBOR. For USD LIBOR, the purpose of a spread adjustment from the ARRC’s perspective is to reflect and adjust for the historical differences between LIBOR and SOFR in order to make the spread-adjusted rate comparable to LIBOR in a fair and reasonable way, thereby minimising the impact. Different markets adopt different conventions, so rather than having a single fallback rate, there is a family of rates, each of which is suitable in different markets.
For consumer cash products, the ARRC fallback rates will be based on compound SOFR in advance plus a fixed spread adjustment. Initially, the spread will be the difference between USD LIBOR and SOFR as of the LIBOR cessation announcement date (5 March 2021) and over the one-year transition period it will be a linear interpolation ending at a fixed value that measures the five-year median difference between USD LIBOR and compound SOFR in arrears immediately preceding the cessation announcement on 5 March 2021. Following the end of the transition period, the spread will remain fixed.
For commercial cash products, there are a range of different versions of the ARRC’s fallbacks reflecting different conventions in different markets. The risk-free rate will be captured through compound SOFR in arrears, compound SOFR in advance and a simple arithmetic average of SOFR (Daily Simple SOFR). The fixed spread adjustment is the same as that of consumer cash products, but without the one-year transition period.
Once a forward-looking Term SOFR rate, for example, based on suitable SOFR derivatives, is available and recommended by the ARRC, this may also be incorporated into the family of cash fallbacks.
On 17 March 2021, the ARRC announced Refinitiv as the publisher of its spread adjustment rates for cash products. Refinitiv will be leveraging its experience as a benchmark administrator of rates such as WM/Reuters, Canadian dollar offered rate (CDOR) and Term SONIA to publish the ARRC’s fallback rates. We’re looking forward to providing further details of the methodology and how to access the rates. The fallback rates will be available to the public later in the year.
Jacob Rank-Broadley is head of LIBOR transition, B&I, at Refinitiv, an LSEG business
Find out more about Refinitiv’s LIBOR Transition and Replacement Rate Solutions and Services here.
Further ACT resources on the LIBOR transition can be found here: treasurers.org/hub/technical/libor.
