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LIBOR vs SOFR

The financial industry is trying to create a realistic alternative to LIBOR, but it will be challenging to switch seamlessly over to a newly created index by 2021.  Given the complexity of the existing infrastructure built around LIBOR, there is much incentive to retain it.

 

History

LIBOR is meant to represent the credit risk of one bank lending money to another bank on an unsecured basis.  In this way, it should reflect the credit worthiness of the banking industry.  Initially, the British Banking Association (BBA) surveyed the participating banks at 11am each day and asked them to submit their cost to borrow money; however, today ICE is responsible for the survey and publication of the rate.  Surveyed banks are asked, “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am London time?”

The banks respond with a cost of funds for each currency.  US borrowers are familiar with USD LIBOR, but that is just the cost of funds for a bank borrowing in USD.  These banks also provide quotes in euro, pound, yen, and francs.  Approximately $350 trillion in financial products, including $150 trillion in derivatives, are tied to LIBOR.

During the crisis, several banks reported artificially low cost of funds to avoid sending a signal of weakness to the market.  Post-crisis, it was determined these banks (and some individual traders) manipulated LIBOR and were fined a collective total of more than $9B.

This led the formation of the Alternative Reference Rates Committee (ARRC), headed by JPM’s Chief Regulatory Affairs Officer, Sandie O’Connor.  The ARRC is tasked with finding and implementing a replacement rate for LIBOR.

 

Why Now?

Although the ARRC selected a broad repo rate to replace LIBOR in June 2017, it wasn’t widely reported until July 27, 2017 when Andrew Bailey, head of the British Financial Conduct Authority (FCA), announced plans to phase out LIBOR by 2021.

The ARRC’s proposed rate will be based on a repo index.  Repos are short term funding mechanisms, usually where Treasurys are provided as collateral in exchange for cash.  In other words, repos are short term loans.

The ARRC announced the selected rate in late 2017, the Secured Overnight Financing Rate, or SOFR.  The NY Federal Reserve began publishing this index in April 2018 with the CME opening futures contracts in May 2018 to help facilitate derivative trading.

The goal is to run this index in parallel through 2021 to track correlation, encourage adoption, and gain trust.

 

Repo Rates

Repo rates tend to be more volatile than LIBOR (see chart below), which would need to be smoothed out, possibly through geometric averaging. Transaction volume will also need to grow, otherwise it could be plagued by the same lack-of-data problems as LIBOR. Finally, since the rate doesn’t yet exist, futures and derivatives markets will need to be built from scratch in order to develop a forward curve.

Treasurys also experience supply and demand issues that could artificially move the SOFR reset.  For example, at quarter and year end, banks tend to hoard Treasurys for balance sheet purposes.

In the graph below, the blue line represents LIBOR while the red line represents a repo index.  Note how the repo index experiences much greater volatility.

REPO INDEX VS 1-MONTH LIBOR

 

Some Initial Concerns

  • How will lenders account for loans and derivative contracts that extend beyond 2021?
  • How will lenders incorporate a potential new index into loans and derivative contracts that are made before the final transition?
  • The repo market is less liquid and more volatile than the LIBOR market, how will this be an improvement?
  • SOFR, because it is collateralized by Treasurys, is meant to reflect a risk-free rate. LIBOR, meanwhile, is meant to reflect a bank’s unsecured cost of funds.  Therefore, there should be a spread between these two indices to reflect the credit worthiness of the banking industry, but it remains to be seen what that spread looks like.
  • Is LIBOR really so broken that it is better to discard it entirely than make adjustments?
  • Repos are short term mechanisms, how will a forward curve be derived?
  • What impact will the Fed’s removal of accommodation have on a new index?

 

Could LIBOR Survive?

Yes.  Although there is a desire to find a replacement index, the adoption and implementation of that is easier said than done.  Currently, the Financial Conduct Authority (FCA) requires banks to contribute to the LIBOR survey and is authorized to criminally pursue any abuse of the LIBOR process.

As part of the transition to a replacement index, the FCA will remove this authority and enforcement feature of its role.  Afterwards, nothing would prevent a bank from voluntarily contributing to a LIBOR survey.  Given the complexity of the banking infrastructure built around LIBOR, this does not seem like an unreasonable outcome.

The largest and most sophisticated banks are heavily involved in the creation of the SOFR index, headlined by a well-respected JPM banker, Sandie O’Connor.  There is no doubting the intent to create a suitable market alternative, but given the size of the market dependent on LIBOR, there will likely be some growing pains.

 

What Do My Loan Documents Say Today?

Most existing loans, and certainly loans going forward, make reference to alternative rates in the event LIBOR is no longer available.  Unfortunately, this language is unique to each lender and intentionally ambiguous.  Some examples of current language found in loan documents:

  • if rate is not available at such time for any reason, then the rate will be determined by such alternate method as reasonably selected by the Bank.
  • if the rate referred to in the clause (i) above is not available at any such time for any reason, then the rate referred to in clause (i) shall instead be the interest rate per annum, as determined by Lender, to be the arithmetic average of the rates per annum, at which deposits in US Dollars in an amount equal to the amount of the Loan are offered by major banks in the London interbank market to Lender at approximately 11:00am (London time).
  • if the LIBOR Rate shall be discontinued or does not reflect the cost of funds of the Lender or for any other reason shall not be available for determining the LIBOR Rate, then the Loan shall bear interest based upon the Prime Rate
  • if any interest rate defined in this note ceases to be available from Bank for any reason, then said interest rate shall be replaced by the rate then offered by Bank, which, in sole discretion of Bank, most closely approximates the unavailable rate.

The language in the loan documents will have two primary effects:

  • calculating the floating interest rate payment if LIBOR is no longer available
  • if a hedge is in place on a portion or all of the debt, there could be a mismatch between the floating rate loan and the hedge. For example, if the floating rate index reverts to Prime, there will be a mismatch with a LIBOR-based swap.

 

What Should My Loan Documents Say?

Unfortunately, there is no universal answer.  Each lender has different issues and concerns.  In general, we have been focusing on themes rather than specific language.

  • Avoid references to an index like Prime, which is substantially higher than LIBOR and will not match any LIBOR-based hedge
  • The new rate should most closely approximate LIBOR, which should allow the Bank to use a replacement index like SOFR

Below is some language that we’ve seen incorporated on recent transactions.

  • “If the Index becomes unavailable during the term of this loan, and another independent index is generally accepted in the U.S. markets as a reference rate for loan obligations and interest rate swaps (the “ Replacement Reference Rate” ), then the independent index for this loan and the floating rate for any swap transaction related to the loan shall be amended to refer to the Replacement Reference Rate, it being the intention of Lender and Borrower that any such transition shall be as economically neutral to Lender and Borrower as possible as if the Index was still available. Lender understands that, in the unlikely event LIBOR is no longer available, the alternative independent index selected by Lender for this Note and the rate on the swaps tied to the ISDA between Lender and the Borrower needs to be the same.”

 

What Do My Derivative Documents Say Today?

The International Swaps and Derivatives Association (ISDA) have long incorporated an alternate rate in the event LIBOR is no longer available.  From the 2006 ISDA, here are the two definitions of LIBOR which are nearly identical, except one references Thomson Reuters while the other references Bloomberg.

  1. USD-LIBOR-BBA” means that the rate for a Reset Date will be the rate for deposits in US Dollars for a period of the Designated Maturity which appears on the Reuters Screen LIBOR01 Page as of 11:00AM, London time, on the day that is two London Banking Days preceding the Reset Date. If such rate does not appear on the Reuters Screen LIBOR01 Page, the rate for that Reset Date will be determined as if the parties had specified “USD-LIBOR-Reference Banks” as the applicable Floating Rate Option.
  2. USD-LIBOR-BBA-Bloomberg” means that the rate for a Reset Date will be the rate for deposits in US Dollars for a period of the Designated Maturity which appears on the Bloomberg Screen BTMM Page under the heading “LIBOR FIX BBAM<GO>” as of 11:00AM, London time, on the day that is two London Banking Days preceding the Reset Date. If such rate does not appear on the Bloomberg Screen BTMM Page, the rate for that Reset Date will be determined as if the parties had specified “USD-LIBOR-Reference Banks” as the applicable Floating Rate Option.

 

ISDA Alternate Rate: USD-LIBOR-Reference Banks

The ISDA LIBOR definitions from above each define the alternate rate as “USD-LIBOR-Reference Banks”.  Below is that definition from the 2006 ISDA.  In essence, it calls for each bank to survey the market to determine the appropriate rate.  The glaring issue with this definition is that it contains all the weaknesses associated with the current calculation of LIBOR.

“USD-LIBOR-Reference Banks” means that the rate for a Reset Date will be determined on the basis of the rates at which deposits in U.S. Dollars are offered by the Reference Banks at approximately 11:00 a.m., London time, on the day that is two London Banking Days preceding that Reset Date to prime banks in the London interbank market for a period of the Designated Maturity commencing on that Reset Date and in a Representative Amount. The Calculation Agent will request the principal London office of each of the Reference Banks to provide a quotation of its rate. If at least two such quotations are provided, the rate for that Reset Date will be the arithmetic mean of the quotations. If fewer than two quotations are provided as requested, the rate for that Reset Date will be the arithmetic mean of the rates quoted by major banks in New York City, selected by the Calculation Agent, at approximately 11:00 a.m., New York City time, on that Reset Date for loans in U.S. Dollars to leading European banks for a period of the Designated Maturity commencing on that Reset Date and in a Representative Amount. “Reference Banks” are four major banks in the London interbank market.

 

What Should My Derivative Documents Say?

As with the loan documents, there is no language universally acceptable to all derivative providers.  Banks are reluctant to incorporate language into Confirmations on new swaps and caps that allow for another index because that isn’t how they are hedging today.

Because ISDA oversees the derivative definitions, however, it should have the ability to incorporate changes more broadly and universally than what we expect to see in loan documents.  This also means there is less need to proactively address this issue in the derivative documents.

The primary objective should be to ensure the hedge index closely ties out with the index in the loan.

New Contracts

The most likely scenario is that ISDA will change the definition of USD-LIBOR to potentially capture, if needed, a new index like SOFR rather than simply relying on the LIBOR.  This change may not occur until an index like SOFR is more prevalent, however, and would only mitigate issues on new derivative contracts.

This also means SOFR would need to be defined.  Because SOFR involves Treasurys as collateral, this will likely be a nearly risk-free rate.  We would expect the definition of SOFR to include a spread to more closely approximate LIBOR.  For example, if the spread between SOFR and LIBOR is measured over a period of time to be approximately 0.10%, the definition of a floating interest rate trying to approximate LIBOR might read as:

SOFR + 0.10%

Existing Contracts

For existing contracts, ISDA will likely change the alternate rate definition to reference SOFR in addition to the current survey language.  The process may look like this:

LIBOR is no longer available -> USD-LIBOR-Reference Banks -> SOFR or Survey

The discontinuation of LIBOR without a designated replacement rate for legacy transactions could quickly overwhelm the market.  Banks would need to conduct their own surveys to determine the appropriate rate, which could easily result in different rates across the industry.

 

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