A quick refresher
As we’ve explained, LIBOR has been a key global reference point for calculating the value of swaps and other financial contracts for more than four decades. It’s based on a daily survey in which banks must state the rate at which they could borrow in reasonable size. One can see that because LIBOR isn’t based on actual transactions, it’s subject to manipulation, and a scandal along these lines arose in 2012. Global financial regulators, led by the United Kingdom’s Financial Conduct Authority (FCA), have embarked on a program to phase out LIBOR and related rates.
As we discussed in our earlier piece, the FCA took a major initial step in 2017, saying that at the end of 2021 it would no longer expect or request banks to submit LIBOR quotes. Because LIBOR has been called “the world’s most important number” and references, depending on who’s measuring and what’s being measured, somewhere in the gross hundreds of trillions of dollars (derivatives may overstate this amount),³ the task of rewriting contracts to replace LIBOR with reference rates based on observable transactions is a major global undertaking.
The New York Fed’s resolutions
Mr. Wuerffel’s primary resolution, “no new LIBOR,” calls for a cessation of any new LIBOR-based contracts by the end of 2021. This stands to reason, given the target set out by the FCA, and logically calls for the avoidance of new LIBOR-based transactions as soon as practicable. The Alternative Reference Rates Committee (ARRC), formed by the U.S. Federal Reserve in 2014, had requested no new U.S. dollar (USD) LIBOR floating-rate notes be issued after December 31, 2020, although it didn’t expect full compliance, and also asked for no new LIBOR-based business loans after June 30, 2021.⁴
His second resolution, “build SOFR into your diet,” refers to the Secured Overnight Financing Rate. As we discussed in our October 2020 piece, ARRC has chosen SOFR as its preferred replacement for USD LIBOR. SOFR is measurable with actual transactions, unlike LIBOR: It uses overnight loans collateralized by U.S. Treasuries. Mr. Wuerffel comments that issuance of SOFR-based cash floating-rate notes began to exceed comparable LIBOR-based notes during 2020 and that Fannie Mae and Freddie Mac say SOFR will be the basis for adjustable-rate mortgage products.⁵ The New York Federal Reserve began publishing SOFR in April 2018, so that trailing average rates started becoming available several months later.
LIBOR has generally exceeded lagged SOFR (%)
Source: Macrobond, March 3, 2021.
The final resolution, “work off those legacy LIBOR exposures,” emphasizes the importance of unwinding existing LIBOR-based contracts or modifying the “fallback language” that stipulates calculation procedures, usually based on an alternate rate such as SOFR, in the absence of an available LIBOR quote. It notes that, as we will explain shortly, market participants should have enough time to make the necessary adjustments.
A likely extension for USD LIBOR
On November 30, 2020, the ICE Benchmark Administration Limited, which is responsible for LIBOR quotes, announced it would explore extending the termination of requiring USD LIBOR quotes for most tenors (overnight, 1-month, 3-month, 6-month, and 12-month) until June 30, 2023.⁴ Publication of 1-week and 2-month tenors would still not be required after December 31, 2021. This would allow more LIBOR-based contracts to mature before the deadline while also giving the market significantly more time to unwind or amend the language of contracts extending past mid-2023.⁶
An acceleration of CDOR’s end
Canada went the other direction, accelerating the end of certain tenors of its LIBOR equivalent, the Canadian Dollar Offered Rate (CDOR). CDOR’s administrator, Refinitiv, announced on November 12, 2020, that the 6-month and 12-month tenors would no longer be published as of May 17, 2021. Shorter tenors would continue beyond that date.⁷ CDOR was originally developed as a reference rate for bankers’ acceptances (BAs), or drawdowns from established lines of credit.
But a Refinitiv study in the fall of 2020 found that less than 0.5% of all BA-related activity involved CDOR tenors of 6 or 12 months. The Canadian Alternative Reference Rate Working Group made recommendations on November 24 for substitute rates, including Canadian Overnight Repo Rate Average (CORRA), which like SOFR, is based on overnight transactions using Treasury securities.⁸
ISDA derivative fallback protocol taking effect
As of January 25, 2021, the International Swaps and Derivatives Association (ISDA) fallback language protocol covers all interest-rate derivatives overseen by ISDA. This protocol uses key alternative reference rates such as SOFR, CORRA, the Sterling Overnight Interbank Average Rate, and Swiss Average Rate Overnight, all designed to replace the LIBOR regime.
Much remains to be done
The likely extension of the USD LIBOR tenors to mid-2023 reflects the amount of work remaining. Nevertheless, the markets appear to be moving in the right direction. Financial institutions have set up substantial working groups for addressing relevant contract language, taking inventory of LIBOR-based exposures, and reducing LIBOR positioning as circumstances permit. It’s unlikely that we’ve seen the last timetable change, but a certain degree of flexibility is probably a good thing for an undertaking of this magnitude.
1 “A Resolution for 2021: No New LIBOR,” newyorkfed.org, December 10, 2020. 2 “Life after LIBOR,” Manulife Investment Management, October 20, 2020. 3 Second Report of the Alternative Reference Rates Committee, March 2018. 4 PwC Libor Transition Update, December 31, 2020. 5 “LIBOR Transition Playbook,” Fannie Mae and Freddie Mac, December 2020. 6 lexology.com, January 12, 2021. 7 mcmillan.ca, December 2020. 8 bankofcanada.ca, November 16, 2020.
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