Replacing LIBOR in Derivatives Transactions: A Complex Undertaking

The London interbank offered rate (LIBOR), the submission of which will cease to be mandated by the U.K. Financial Conduct Authority in 2021 as a result of concerns over its reliability and robustness due to its lack of grounding in actual transaction data, is gradually being replaced in derivatives transactions. Since LIBOR is currently used in calculating floating or adjustable rates on more than $350 trillion of financial agreements in a number of currencies, its phaseout is a complex process that requires finding a clear successor for both existing and future financial instruments. The questions and uncertainties raised along the way therefore have the potential to create new areas of risk across a number of financial products.

Various groups were formed internationally to identify risk-free rates that may replace LIBOR. In the U.S., the Federal Reserve formed the Alternative Reference Rates Committee (ARRC), which includes financial institutions and regulators. In June 2017, the committee selected a new overnight rate, named the secured overnight financing rate, or SOFR, as the preferred successor to USD LIBOR.

In April 2018, the Federal Reserve Bank of New York began publishing SOFR. In order to create a threshold level of liquidity in derivatives markets, the ARRC has been promoting the development of products referencing SOFR. Various clearinghouses have since listed one- and three-month SOFR futures, and in late July 2018, Fannie Mae notably used the benchmark rate in a $6 billion offering of adjustable-rate securities. Finally, on July 30, Standard & Poor’s announced that floating-rate securities and notes linked to SOFR will be classified as an “anchor money market reference rate” and therefore no longer will be considered higher-risk investments for money market funds. This announcement represents a major milestone in the transition to SOFR and paves the way for the additional volume transaction data required to build the robustness of SOFR as an interest rate benchmark.

For existing transactions, transition to a successor rate presents a number of challenges. The current rules created by the International Swaps and Derivatives Association (ISDA) rely on an alternative rate derived from a bank polling process. One fundamental flaw in this fallback is that the process could yield different results across financial instruments, depending on who the calculation agent is and which banks participate in the poll. The procedure also does not specify what happens if agents are unable to procure quotes from banks. For these reasons, the current fallback provisions could be only a temporary solution for the derivatives market, if even a solution at all.

To address those issues, the ISDA announced it will:

• Amend the fallback provisions to include the risk-free rates and deal with related fallback issues, but only for derivatives created after the amendment.
• Develop a separate mechanism — via a so-called protocol — for existing financial instruments, enabling parties to amend all derivatives transactions in a streamlined fashion.

ISDA and other financial market associations conducted a worldwide survey of 150 banks, market infrastructure providers and law firms to gauge market readiness for the transition. It published the results in June, in a transition report that covered various issues raised by the participants:

• First, documentation risk — market participants pointed out that the lack of standardized documentation would make the protocol approach very challenging for cash market products. These products include mortgages, securitizations and bonds.
• Second, basis risk — predominantly arising from the lack of standardized amendment mechanisms between financial products. For example, if a variable interest rate commercial loan using LIBOR as the reference rate is hedged by an interest rate swap, the fallback to an alternative reference rate must be coordinated between the loan and the swap. If the fallback rate is not calculated in the same manner or if the fallback is triggered at different times, this could lead to unexpected costs and unintended exposure.
• Finally, market participants warned against the risk of a “zombie” or synthetic LIBOR. This is the risk that the fallback is not triggered if LIBOR is not permanently discontinued. Indeed, since the U.K.’s Financial Conduct Authority merely proposed to cease requiring dealers to make submissions and not to prohibit the use of LIBOR, the rate could potentially continue to exist past 2021.

To address some of these issues, the ISDA is launching another marketwide consultation, which runs until Oct. 12. The consultation is primarily designed to get market input on certain adjustments that are proposed to be made to SOFR and other fallback risk-free rates identified for other currencies in order to more closely align those rates with certain features of LIBOR. Since many issues remain unresolved at this time, market participants should closely monitor developments in this area and, more generally, assess the impact of LIBOR transition on their business.