In July 2017, the United Kingdom’s Financial Conduct Authority announced that it would no longer compel banks to submit pricing data for the calculation of LIBOR, one of the most widely-used financial benchmarks, after December 31, 2021. Effectively, this means that the trillions of dollars of already-executed derivatives and lending transactions that reference LIBOR should be reviewed to determine whether they need to be amended, and new LIBOR transactions should include specific fallback terms that account for the phase-out of, or other disruptions to, LIBOR.
Several initiatives are underway to streamline the process for market participants to amend existing and new contracts that reference LIBOR. The International Swaps and Derivatives Association (ISDA), is working to amend the 2006 ISDA Definitions and create a protocol that derivatives market participants can adopt. When finalized, these efforts will allow parties to efficiently amend both new and legacy derivatives contracts that reference LIBOR, without the need for bilateral amendments to each contract. The Alternative Reference Rate Committee (ARRC) is also drafting LIBOR fallback terms to be used in different types of credit facilities. Unfortunately, the ISDA and ARRC initiatives are not coordinated, and market participants that wish to hedge floating rate loans will need to closely examine fallback terms in loan documents to ensure that their derivatives and loan documentation properly align.
Replacement rates have been announced for the most popular LIBOR currency types. For USD-LIBOR, the ARRC chose the Secured Overnight Financing Rate (SOFR), which is based on the market for repurchase agreements – meaning that it is a secured, overnight, ostensibly risk-free rate, unlike USD-LIBOR, which is an unsecured term rate which theoretically reflects the credit risk of interbank lending transactions. As a result, market participants should understand and consider that SOFR will not be a perfect substitute for LIBOR transactions.
The New York Federal Reserve Bank began publishing SOFR in mid-2018, and shortly thereafter CME Group began offering SOFR futures. So far, SOFR-based trading is fairly thin but growing. At various points over the past decade, the spread between three-month USD-LIBOR and overnight repo rates averaged around 30-40 basis points, which creates the potential for basis risk. ISDA plans to seek input from market participants about the appropriate methodology for pricing credit and term risk into SOFR (and the other replacement rates), as part of its LIBOR transition initiative.