Publication
By Jim Rosenbloom[1]
Background - The Demise of LIBOR
"LIBOR" is the acronym for the London Interbank Offered Rate. LIBOR is based upon (and its rates are set on the basis of) the average (after dropping the top and lowest four submissions) of submissions made each London banking day by a group of "panel banks" (historically 11-20 major banks that loan and borrow in the London Interbank Market). Each submission would set forth the rate that the submitting bank would expect to pay for borrowing in the London Interbank Market. LIBOR is (a) a credit-sensitive rate, in that the underlying transactions which are theoretically the basis of the panel bank submissions are unsecured loans and the rate reflects the creditworthiness of the borrowing bank, and (b) a forward-looking term rate for the available tenors (e.g., 1, 3, and 6 months).
Although variable reference rates using LIBOR-like methodology have been around since 1969, formalized oversight of the data and administration of LIBOR by the British Bankers Association ("BBA") began in 1986. By the 1980s, the London Interbank Market had become a significant source of unsecured funding among banks. As a result, LIBOR was regarded as a benchmark for borrowing costs by banks, and became a dominant reference rate for lending and derivative transactions generally. It was used as the benchmark for financial transactions having aggregate cash or notional values of hundreds of trillions of US Dollar ("USD"), including cash products like syndicated and bilateral loans and notional products like derivative contracts. Besides representing rates for USD deposits, LIBOR was also published as a benchmark rate for transactions in other major currencies, which as of December 31, 2021, included the British Pound, the Euro, the Swiss Franc and the Japanese Yen. Although USD LIBOR was historically the most widely recognized benchmark, the other LIBOR rates used the same basic methodologies to determine the applicable benchmark rate.
Concerns about the methodology for determining LIBOR as a benchmark rate surfaced during the financial crisis of 2007-2009 when regulators and market observers noted that LIBOR failed to behave in line with expectations with respect to other benchmarks, such as US Treasury yields, the Fed Funds rate, repo rates and the Overnight Index Swap rate. Investigations by U.S. and British regulators and the financial press uncovered manipulation and misreporting by certain panel banks in order to improperly influence the setting of the LIBOR rates with the intent to project greater financial soundness on the part of the panel banks and protect their proprietary derivatives positions. Those investigations led to manipulation claims (including private lawsuits) against some of the panel banks, resulting in billions of USD claims settlements and fines, as well as prison terms for individuals engaged in the related fraud.
It was subsequently determined by the regulators that, due to the lack of a robust market (interbank borrowing on the London Interbank Market had declined in favor of other sources of bank funding, especially in the wake of the financial crisis), the setting of LIBOR had become overly dependent upon the "expert judgment" of the panel banks. In addition, the methodology of relying on market participant (panel bank) submissions was thought by some to create inherent conflicts of interest (no pun intended). Moreover, panel banks were becoming reluctant to make LIBOR submissions because of potential legal exposure.
Following the LIBOR scandal, various proposals were made for the repair and reform of LIBOR, most prominently the Wheatley Review of LIBOR Final Report, which was issued in 2012 by Martin Wheatley, a prominent "hardline" British regulator who was the chief executive of the UK Financial Conduct Authority ("FCA") until he was replaced in 2015. However, some analysts questioned whether LIBOR should continue.
The Federal Reserve Bank of New York, Staff Report No. 667, dated March 2014 and entitled "LIBOR: Origins, Economics, Crisis, Scandal and Reform," provides an extensive analysis of the LIBOR scandal, the methodology for determining LIBOR, and the need for reform or transition. The report noted that "A decline in unsecured term interbank activity following the financial crisis and a gradual shift toward reliance on secured funding begs the question of whether a LIBOR-like rate, even if equipped with ample governance, is appropriate going forward."
In 2014, British financial regulators called for the development of interest rate benchmark alternatives to LIBOR. On February 1, 2014, the BBA was replaced by the Intercontinental Exchange Benchmark Administration as administrator of LIBOR.
Among the efforts to identify and develop alternatives to LIBOR:
In July 2013, the International Organization of Securities Commissions ("IOSCO") issued its "Principals for Financial Benchmarks" (the "IOSCO Principles") establishing an overreaching framework of principles for establishing and maintaining benchmark/reference rates. The IOSCO Principles address governance (avoidance of conflicts of interest), design (data quality and reliability), quality of underlying methodology (a benchmark should be based upon "prices, rates, indices or values that have been formed by the competitive forces of supply and demand anchored by observable transactions entered into at arm's length between buyers and sellers in the market") and accountability (record keeping and cooperation with regulatory authorities).
In November 2014, the Federal Reserve and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee ("ARRC") to consider USD so-called “risk free” (i.e., not borrower credit-sensitive) reference rates as alternatives to LIBOR and to recommend "best practices" procedures to assure the orderly transition from LIBOR to such alternative rates. ARRC originally consisted of a diverse group of private sector entities having an important presence in markets affected by USD LIBOR, as well as a wide array of official-sector entities, including banking and financial sector regulators, as ex-officio members.
ARRC was reconstituted in 2018 to expand its membership and "serve as a forum to coordinate planning across cash and derivatives products." See, "Frequently Asked Questions" version dated August 27, 2021, issued by ARRC (the "August 2021, FAQs"). New members included regulators, trade associations, exchanges, and other intermediaries and buy- and sell-side market participants. ARRC has been the principal architect of procedures and documentation for orderly transition from LIBOR with respect to cash products, such as syndicated and bi-lateral loans. After the transition and the maturity of all Legacy Contracts (defined below), this spread should no longer be necessary.
By 2017, considerable doubt as to the continued viability of LIBOR as a benchmark emerged, notwithstanding improved governance and submission controls, primarily because activity in the market for unsecured wholesale bank borrowing market had become insufficient to support LIBOR as a benchmark. As a result, in July 2017 the FCA announced that the transition away from LIBOR as a benchmark and reference rate would occur by the end of 2021, although the cessation date with respect to the overnight, one-, three- and six-month tenors of LIBOR was subsequently extended to June 30, 2023. After that, the panel banks will no longer make submissions in support of LIBOR. Similarly, LIBOR will also be phased out for currencies other than USD. Alternative reference rates have been selected by public/private sector working groups for each of the British Pound (Reformed Sterling Overnight Index), the Swiss Franc (Swiss Average Rate Overnight), the Japanese Yen (Tokyo Overnight Average Rate) and the Euro (Euro Short-Term Rate).
The Transition From LIBOR
In various announcements after 2017, U.S. regulators directed that all supervised (i.e., regulated) financial institutions, which essentially includes all banks, should (a) prepare for the LIBOR transition by notifying customers and negotiating amendments to existing financial contracts contemplating such transition and (b) not enter into any new financial contracts, including derivatives using LIBOR as a reference rate, after December 31, 2021. According to regulatory guidance, "new" contract includes the creation of any additional LIBOR exposure and any extension of the term of an existing financial contract using LIBOR as a reference rate, unless such exposure or extension arises out of a commitment entered into prior to December 31, 2021. After December 31, 2021, new contracts using USD LIBOR as a reference rate essentially ceased, although some unregulated lenders continued to enter into contracts using one-, three- and six-month USD LIBOR as a reference rate with the intention of transitioning to an alternative reference rate on or before June 30, 2023. LIBOR is now completely phased out except for tenors of one, three and six months, which will be phased out on June 30, 2023.
In 2017, the ARRC identified SOFR as the "most suitable alternative reference rate for USD LIBOR" and it represents best practices for use as a reference rate in certain financial contracts, such as loans and derivatives. "SOFR" is the acronym for the Secured Overnight Finance Rate. In its iterations as Overnight SOFR or Average SOFR (which are rolling 30-, 90- and 180-day compounded averages of Overnight SOFR), it is a backward-looking rate. "SOFR is a fully transaction-based, nearly risk-free reference rate. It is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities….SOFR reflects an economic cost of lending and borrowing by the wide array of market participants active in the market." See, August 2021 FAQs. SOFR is based upon transactions (more than $1 trillion daily) in the three major overnight repo markets (i.e., markets involving borrowing transactions collateralized by U.S. Treasury repurchase agreements). It is compliant with the IOSCO Principles. SOFR is calculated and published each business day by the Federal Reserve Bank of New York. ARRC's recommendations are not binding on lenders or other financial market participants, but its influence is considerable.
Since 2017, the ARRC (for cash products) and the International Swaps and Derivatives Association ("ISDA") (for derivatives) have worked on and published several iterations of recommended "fallback language" for financial contracts using USD LIBOR as the reference rate, which will mature after the applicable LIBOR reference rate ceases ("Legacy Contracts"). The fallback language mandates the transition from LIBOR to alternatives rates and covers the situation of an alternative rate becoming unavailable. Although the ARRC initially introduced both a "hardwired" and "amendment" approach to amending business loan contracts to address the transition away from LIBOR, the hardwired approach has become the recommended approach after CME Term SOFR was accepted by the ARRC as a recommended alternative reference rate. A similar approach is taken in the 2022 ISDA Protocol with respect to derivatives (the "2022 ISDA Protocol"). More recently, banks and other institutional lenders have implemented the hardwire approach, especially in the case of syndicated loans. Both have recommended SOFR as the replacement reference rate for LIBOR, and Term SOFR (discussed below) will likely be the dominant rate for syndicated and large bi-lateral commercial loans, especially where hedging, by way of swaps or caps are required or desired. For Legacy Contracts, both ARRC and ISDA have adopted fixed credit spread adjustments based upon tenor to make SOFR (which, because it is a secured rate, is lower than LIBOR) more equivalent to LIBOR. See Appendix 1. See discussion below regarding use of Term SOFR in derivatives.
In late July 2021, ARRC announced that it had selected Term SOFR, which was developed and is administered the Chicago Mercantile Exchange ("CME") as its recommended Term SOFR rate. CME Term SOFR is (i) compliant with IOSCO Principles, (ii) based upon transaction data from trading of one month SOFR (SR1) and three month SOFR (SR3) CME futures contracts and (iii) a forward-looking rate that offers tenors of one, three, six and (more recently approved by ARRC) 12 months. A set of volume-weighted average prices are calculated using transaction prices observed during several observation intervals through the trading day. Those results are then used in a projection model to determine the CME Term SOFR rates for each tenor. Use of the rate will require a license from CME. While the ARRC has noted that the "Term SOFR Rate will be especially helpful for the business loan market ¾ particularly multi-lender facilities, middle market loans and trade finance loans ¾ where transitioning from LIBOR to an overnight rate has been difficult," ARRC has published principles related to the scope and use of Term SOFR, and stated that, due to lack of depth of transactions and underlying derivative transactions to date, Term SOFR is not yet recommended by ARRC for transactions where the use of overnight SOFR and SOFR averages is appropriate. In addition, the ARRC has stated that it does not recommend use of Term SOFR for derivatives except for end-user facing derivatives intended to hedge cash products that reference the Term SOFR rate. According to ARRC, the limitation "is intended to avoid use that is not in proportion to, or materially detracts from, the depth of transactions in the underlying derivatives markets that are essential to the construction of the SOFR Term Rate over time." See, August 2021 FAQs. In that regard, CME has stated that "Our policy is to limit the use of CME Term SOFR Reference Rates to avoid overly detracting from volumes in the underlying SOFR-linked derivatives that are relied upon to construct CME Term SOFR rates. Whilst independent, our policy aligns with ARRC guidance on the recommended scope of use of Term SOFR." See, CME Term SOFR Rates Frequently Asked Questions, published by CME on November 14, 2022. Presumably, the foregoing limitation on the use of derivatives will survive the maturity of the Legacy Contracts.
On July 11, 2022, the ARRC published its LIBOR Legacy Playbook, which offers, among other things, recommendations and relevant information to market participants party to financial contracts surviving the end of LIBOR reporting (the "Playbook"). As of the end of 2020, the ARRC estimates in the Playbook that approximately $223 trillion of legacy USD LIBOR exposures were outstanding, and $74 trillion of that amount was estimated to mature after June 30, 2023. Over 90 percent of the $74 trillion are in derivative products. Most of those will be covered by the 2022 ISDA Protocol. On November 23, 2022, the FCA released its consultation on "synthetic" USD LIBOR, which provides for the publication of one-, three- and six-month non-representative synthetic USD LIBOR settings for use in all U.S. and non-U.S. Legacy Contracts (except cleared derivatives) until September 30, 2024, and establishes a methodology for each setting based upon the relevant tenor of CME Term SOFR, plus the fixed spread adjustment.
On March 15, 2022, the federal Adjustable Interest Rate (LIBOR) Act ("LIBOR Act") became law. The LIBOR Act provides a uniform federal solution for financial contracts that do not otherwise adequately address the transition from LIBOR ("Problem Contracts"). This would not apply to Legacy Contracts with respect to which fallback language is negotiated. The Board of Governors of the Federal Reserve System issued the final rule for implementing the LIBOR Act on December 19, 2022 (the "Rule"). The LIBOR Act and the Rule essentially mandate the reference rates that will replace the corresponding LIBOR reference rate(s) contained in the applicable Problem Contract. The rule covers all types of financial contracts, including loan contracts, derivatives, consumer financial contracts and government regulated entity.
With the adoption of the LIBOR Act, transition from LIBOR will be addressed either contractually or by law for virtually all Legacy Contracts. See Appendix 2.
Reference Rates Other Than SOFR
Although SOFR is likely to be the dominant reference and benchmark rate in the loan and derivatives markets, examples of additional rates that have gained some traction in the market are set forth below. Except for Ameribor, each is a forward-looking (term) rate. Unlike SOFR, they are all based upon unsecured underlying transactions, and therefore are credit-sensitive rates, which may be more attractive than SOFR to lenders not engaged in the repo market. Each complies with the IOSCO Principals.
- BSBY: The Bloomberg Short Term Bank Yield Index ("BSBY") is based on rates for commercial paper, certificate of deposit and short term bank bond transactions. BSBY is available on a daily basis and in tenors of one, three, six and 12 months.
- Ameribor: Ameribor is a weighted average of daily transactions in the overnight unsecured loan market on the American Financial Exchange where banks lend to each other through mutual lines of credit. There is no built in floor or spread adjustment. It claims to reflect the actual borrowing costs of small, medium and regional banks. Ameribor does not have rates for tenors similar to Term SOFR.
- ICE Bank Yield Index: The ICE Bank Yield Index, published by the ICE Benchmark Association, is an index of short term, unsecured bank yields based on executed transaction data. It is reported for one-, six- and 12-month tenors.
- USD Credit Inclusive Term Rate ("CRITR") and USD Credit Inclusive Term Spread ("CRITS"). CRITR and CRITS are forward looking rates published by IHS Markit that measure the daily USD cost of funding in the international markets based on institutional certificate of deposit, commercial paper and short term corporate bond transactions. CRITR and CRITS are published for one-, three-, six- and 12-month tenors.
SOURCES
The sources used in the preparation of this article include:
- Various guidances and announcements published by the UK and U.S. regulatory authorities.
- Various guidances and announcements published by ARRC.
- Articles by Tess Virmani of the Loan Syndications and Trading Association, dated November 23, 2022, January 5, 2023, and January 11, 2023.
- Federal Reserve Bank of New York, Staff Report No. 667, dated March 2014 and entitled "LIBOR: Origins, Economics, Crisis, Scandal and Reform."
- LIBOR Reform Frequently Asked Questions, December 2022, published by JP Morgan Bank
Appendix 1
Appendix 2
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