The pending transition away from using LIBOR in various currencies, including the U.S. dollar (“USD”), as the floating rate in a large set of financial transactions is a topic of increasing interest, concern, and activity as the deadlines approach. The global notional amount of transactions in all currencies and structures that will be effected by the various LIBOR transitions is roughly equivalent to $400 trillion. Half of this entire amount, or $200 trillion worth, are based on USD LIBOR alone.
In the past few weeks, there have been several developments that everyone concerned with the pending LIBOR transition should be aware of and take into consideration.
Amended New York state LIBOR law enacted
The vast majority of major financings are governed by New York state law, making this a key element in the transition away from the use of LIBOR as a floating rate index. The New York state legislature measure that will help prevent hundreds of billions, if not trillions, of dollars of financial contracts from plunging into chaos when certain LIBOR rates start to phase out at the end of this year, others by the end of June 2023, was passed by the state’s Senate and Assembly. While most of the LIBOR indices that will be retired at year-end will be foreign currency denominated ones, the majority of USD LIBOR rates were provided a reprieve from its phase-out until mid-2023, in part to allow existing contracts that lack a clear replacement rate to expire naturally.
The law passed by the legislature is very similar to what New York Governor Andrew Cuomo included in his state budget proposal released in January of this year. Governor Cuomo signed this final legislation and officially placed it into effect on April 6th. This legislation is critical, particularly when it comes to diffusing litigation, as the most challenging USD LIBOR floating-rate transactions – such as certain forms of debt, securitizations, mortgages, and student loans – will remain in place after the USD benchmark is no longer published in 2023.
The approved measures will allow existing LIBOR-based contracts to use replacement indices recommended by regulators, led by the Alternative Reference Rates Committee (“ARRC”) and its key members, such as the Federal Reserve and the International Swaps and Derivatives Association (“ISDA”).
The case for national federal LIBOR transition legislation
This past Thursday, the Financial Services subcommittee on the LIBOR transition in the House of Representatives met virtually to conduct an informational and Q&A session on the need for federal LIBOR transition law that would stand alone and above any state laws, including the newly enacted New York state law.
The primary need for a national legislation would be to preempt any outstanding state laws on legacy
LIBOR-based financial contracts in order to avoid “conflict of competing laws problems”. Specifically, even though a financial transaction is overall governed by New York state law and thus its newly adopted LIBOR transition rules, there are still many potential conflicts with the jurisdiction of the other 49 states and Washington, D.C. when it comes to certain financings such as mortgages, credit cards, and certain student loans, to name a few examples.
The request for federal LIBOR transition legislation is strongly supported by President Joe Biden’s administration, Federal Reserve Chairman Jerome Powell, and Treasury Secretary Janet Yellen, all of whom are in favor of avoiding any systematic financial risks from the transition. And although this would appear as a bipartisan concern in need of consistent and transparent universal governance, there are some conservative Republicans that have issues of any federal mandate that overrides states’ rights.
At the House Financial Services subcommittee meeting, Brian Smith, the Deputy Assistant Secretary for federal finance at the Department of the Treasury, said that federal legislation would ensure that Treasury has sufficient authority to address the tax consequences of the LIBOR transition. Mark Van Der Weide, the general counsel for the Federal Reserve’s Board of Governors, said federal legislation would establish a “clear and uniform framework, on a nationwide basis” to avoid the volatility and price discrepancies in very similar legacy financial contracts that do not provide for an appropriate fallback rate.
In fact, a number of transactions have no fallback provisions and require an impractical 100% investor approval by the Trust Indenture Act that was put in place in 1939 primarily to protect bond investors. These are the types of financial transactions that will most certainly end in litigation if there are 51 potential different applicable LIBOR fallback laws.
The slow global adoption data
On April 14th, the ISDA-Clarus RFR Adoption Indicator for March was released, and it showed a deceleration of the already meek adoption of the identified risk-free rates (“RFR”) in the six major LIBOR currencies to be transitioned (such as the Secured Overnight Financing Rate, or “SOFR”, as the identified replacement rate for USD LIBOR).
This indicator tracks how much global trading activity is conducted in cleared over-the-counter (“OTC”) and exchange-traded interest rate derivatives that reference the RFRs based on various measures. On a traded notional basis, the percentage of RFR-linked interest rate derivatives decreased to 9.3% of total global interest rate derivatives traded in March, compared to 11.0% in April.
Specific to certain key currencies, the percentage of trading activity in SOFR was 4.7% of total USD interest rate derivatives transacted in March, down from 5.1% the prior month. All SOFR based derivatives continue to be executed by government and financial institutions, not by corporate entities. In regard to the British pound sterling (“GBP”), the leader of the global LIBOR transition effort, it saw the largest percentage of RFR-linked interest rate derivative trading activity, totaling 44.9%. However, this is still less than half of all GBP transactions from the nation leading the way with the global LIBOR transition effort through the United Kingdom’s Financial Conduct Authority (“FCA”) and whose GBP LIBOR will retire at year end, just nine months away.
Given these low levels of adoption with the clock ticking, global regulatory and oversight authorities are very dismayed with the transition away from LIBOR and the adoption of the various LIBOR alternative fallback reference rates in all forms of financial transactions.
The alternative USD fallback reference rate debate
At Thursday’s House subcommittee meeting, counselor Der Weide also said any federal legislation should not affect legacy contracts with fallbacks to another floating rate, nor should it dictate that market participants “must use any particular benchmark rate in future contracts.” This comment is consistent with a joint statement from U.S. regulators late last year that stated “a bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs.” This joint statement went on to say that “the agencies recognize that banks’ funding models differ and that in structuring their lending activities it is appropriate for banks to select suitable replacement rates for LIBOR that are most appropriate given their specific circumstances.”
These statements do not mean that the transition from the regulators’ preferred USD LIBOR replacement, SOFR, will stop. Rather, they came after multiple small and midsize banks heavily lobbied the Federal Reserve, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency that SOFR was ill-suited for them to employ as a replacement to USD LIBOR. They argued SOFR was more appropriate for larger banks that participate in the Treasury repurchase agreement (“repo”) market. Some banks have also expressed concern that SOFR could result in a mismatch between bank assets and liabilities in the event of economic stress.
Many small and midsize banks prefer AMERIBOR as the USD LIBOR alternative, as SOFR is seen by these banks as being too complicated for their clients and too difficult and costly to administer. AMERIBOR is a funding rate calculated from the actual borrowing costs between the banks that are members of the American Financial Exchange. Thus, AMERIBOR includes a credit component like those implied in LIBOR rates but not in SOFR rates and better represents these banks’ actual funding costs.
AMERIBOR futures are already trading on the Cboe Futures Exchange, which addresses another concern over the use of SOFR, not only by these smaller banks but also by corporate borrowers, both large and small. AMERIBOR, like LIBOR, is a “term” rate, meaning it is set at the beginning of an interest rate calculation period (known as being “set up front”) and is thus known ahead of time and can be accounted and appropriated for, used to forecast, and can be paid on the very last day of the interest period (known as being “in arrears”) given that all the calculation factors are known. SOFR, on the other hand, is a floating rate that resets daily with a one-day lag and does not allow for the upfront certainty of its interest period calculation.
Floating interest amounts based on SOFR must be calculated in arrears on a lookback basis. The method of calculating the applicable SOFR rate for any interest period has many methods, such as an average SOFR rate over the past period versus an alternative daily compounded SOFR rate over the period. Furthermore, the task of compounding itself has multiple methods, such as using or not using weekends and holidays in the calculation and whether to compound using the daily SOFR rates alone, or the SOFR rates plus its applicable spread to LIBOR as prescribed in the updated ISDA Definitions.
To overcome all these different methods of calculating SOFR, several parties, particularly corporates, are demanding a term SOFR rate that would be set up front, like LIBOR. But due to the lack of a sufficient amount of SOFR transactions to date, particularly medium and longer-term transactions, there is no liquid forward SOFR rate market to readily depend upon to establish a term SOFR rate that can be set up front. The ARRC has recently stated it cannot guaranty the market development of reliable, liquid term SOFR rates prior to the USD LIBOR cessation in mid-2023.
In addition to AMERIBOR, there are also a few other alternative LIBOR replacement rates that are gaining some traction, including the U.S. Dollar ICE Bank Yield Index introduced in 2019 by LIBOR’s administrator, The Intercontinental Exchange, and the Bloomberg Short Term Bank Yield Index (“BSBY”) that began publication on an indicative basis on October 15, 2020. But both these two possible alternatives lag well behind the adoption of AMERIBOR, which has been used as the floating rate leg in several middle-market financings and at least one interest rate derivative, executed in December of last year.
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