For many affected currencies,1 the official2 choice for a replacement reference rate for LIBOR3 has been made.4 Without derogating from the generally thoughtful work done to make such choices, that was the easy part. The much more difficult part comes when market participants have (1) to determine if the chosen replacement reference rate is appropriate5 for a particular product or market (that is, a “fit for use” determination) and then, if it is, (2) to implement that rate across affected business lines for that product or market and ensure that such implementation is managed efficiently with minimal reputational or other litigation risk.
While there are a little over 500 days before LIBOR’s likely permanent cessation on December 31, 2021, that is not a lot of time for the extensive work that will be required to “operationalize” the chosen replacement reference rates (including programing payments and related systems to properly calculate such rates and back-test such systems and calculations to ensure reliability); manage communications with customers and, for financial institutions, their regulators regarding implementation of the rate change and status thereof; and, for certain legacy contracts that have to be amended to provide for the replacement rate(s), negotiate with related counterparties regarding such amendments.
For some legacy contracts (such as some bond indentures and similar agreements governing securitized products), successful negotiation of required amendments will not be possible or commercially practical and resort may have to be had to proposed legislative or regulatory “solutions” such as that prepared by the ARRC for the New York legislature,6 being developed by the UK Parliament7 or as proposed by the EU Commission for revisions to the Benchmark Regulation (and similar national legislation encouraged by the EU Commission to reach market participants not subject to EU jurisdiction).
However, it is the “fit for use” determination that has recently received a good deal of media and other attention,8 especially among regional and other non-money-center banks. These banks note that they do not hold significant US Treasury portfolios and only infrequently use overnight repo markets for funding. In such cases, the Secured Overnight Funding Rate (SOFR), a rate based on US Treasury markets that is preferred by the ARRC as the replacement rate for US Dollar LIBOR, is not appropriate for these banks in their corporate and commercial lending business since it is substantially unrelated to their costs of funding the same. They also note that SOFR, being a secured overnight rate, will behave differently as compared to LIBOR, a term unsecured rate, in distressed markets. In fact, this difference was clearly demonstrated during the recent COVID-19 pandemic. Lastly, they note that the static benchmark replacement adjustment will not cause adjusted SOFR to perform like LIBOR when distress exists, and they generally seek a more “credit sensitive” adjustment—e.g., a dynamic spread adjustment. These banks note that there are better “fit for use” alternatives to SOFR, including AMERIBOR, the ICE Bank Yield Index and a proposed credit-sensitive spread index from IHS Markit that is understood to be based on bank credit default swap data, which potentially behave more like LIBOR than SOFR.
A group of 10 regional banks wrote of their concerns to the US banking regulators this past September, prompting the establishment of a Credit Sensitivity Group9 this past February. Unfortunately, the first meeting of the group could not be held until June 4, 2020, due to the COVID-19 pandemic. Presentations10 made at this meeting noted the risk to bank capital posed by a replacement rate that was not sufficiently correlated to a bank’s funding costs.
Of course, for other corporate and commercial lending markets—for example, direct lending and private credit by private investment funds—it is even less clear what is or could be an appropriate proxy for the lender’s cost of funds. Moreover, the choice of a “fit for use” determination will affect related amendments, not the least of which are cost of funds/yield maintenance provisions.11 Hopefully, market consensus can be formed regarding the appropriate replacement for US Dollar LIBOR for corporate and commercial lending soon in order to avoid further regulatory concerns regarding the timing of the related implementation of such rate.
1 Including Australian Dollars (Reserve Bank of Australia Interbank Overnight Cash Rate (AONIA)), Canadian Dollars (Canadian Overnight Repo Rate Average (CORRA)), Swiss Francs (Swiss Average Rate Overnight (SARON)), Euros (Euro Short-term Rate (€STR)), Pounds Sterling (Sterling Overnight Index Average (SONIA)), Hong Kong Dollars (Hong Kong Dollar Overnight Index Average (HONIA)), Yen (Tokyo Overnight Average Rate (TONAR)) and US Dollars (Secured Overnight Financing Rate (SOFR)).
2 Including the semi-official “preferred” choice or “recommendation” by the Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Bank of New York and whose members are from the private sector.
4 See “Understanding IBOR Benchmark Fallbacks” published by ISDA and available at: https://www.isda.org/a/YZQTE/Understanding-Benchmarks-Factsheet.pdf. While the applicable “risk-free rate” forming the basis of the selected alternative reference rates has been determined, work usually remains in “adjusting” such rate to make it “comparable” to the LIBOR that it will replace. For US Dollars, that work includes using the “approved” methodologies to obtain a “benchmark replacement adjustment” (i.e., a five-year mean of the difference between SOFR and LIBOR) for particular tenors prior to and upon permanent cessation. At permanent cessation, the benchmark replacement adjustment becomes fixed. See the related discussion in ARRC’s most recent hardwired fallback for syndicated loans, available at: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/Updated-Final-Recommended-Language-June-30-2020.pdf.
6 See our earlier Legal Update “US ARRC Proposes a New York State Legislative ‘Solution’ for Legacy LIBOR Contracts Without Adequate Fallbacks—But What Does It Actually ‘Solve’?” available at: https://www.mayerbrown.com/en/perspectives-events/publications/2020/03/us-arrc-proposes-a-new-york-state-legislative-solution-for-legacy-libor-contracts-without-adequate-fallbacks-but-what-does-it-actually-solve?.
7 See our related Legal Updates: “Sunak’s Solution to LIBOR Transition in ‘Tough Legacy’ Contracts” available at: https://www.mayerbrown.com/en/perspectives-events/publications/2020/07/sunaks-solution-to-libor-transition-in-tough-legacy-contracts and “UK Parliamentary Statement Affirms Urgent Need to Transition From LIBOR and Previews Proposed Legislation to Extend Regulatory Powers of the FCA to Manage Transition” available at: https://www.mayerbrown.com/en/perspectives-events/publications/2020/06/uk-parliamentary-statement-affirms-urgent-need-to-transition-from-libor-and-previews-proposed-legislation-to-extend-regulatory-powers-of-the-fca-to-manage-transition.
8 The first overt expression of concern over SOFR for corporate and commercial lending was a letter dated September 23, 2019, to the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. A subsequent letter dated February 26, 2020, was sent by another 10 banks to the same regulators.
9 Although outside of the ARRC, the Credit Sensitivity Group’s work is supportive of the ARRC’s mission to ensure a successful transition from US Dollar LIBOR to a more robust reference rate, its recommended alternative, SOFR. Whether this limits the determination of an appropriate alternative to US Dollar LIBOR for corporate and commercial lending to SOFR as adjusted by a credit-sensitive spread remains to be seen.
11 Significantly, these (and similar) provisions may fall outside of the ARRC’s proposed fallbacks (see: https://www.newyorkfed.org/arrc/fallbacks-contract-language) regarding “Benchmark Replacement Conforming Changes” other than breakage.