No Rest For The Weary

Corporates and banks face a tight deadline to finalize migration from Libor.

Companies, institutional investors and lending institutions have fewer than six months to prepare for the day the universe changes. On June 30, the Intercontinental Exchange (ICE) will cease publishing the London interbank overnight rate (Libor) dollar-denominated tenors, the benchmark interest rate that has been used for pricing loans and other debt instruments since 1986.

According to Matthew Armstrong, a partner at the global law firm Dechert, much preparation remains: “We’ve seen some clients transition their entire loan portfolios, but they aren’t the majority. There are many lenders out there who haven’t started transitioning their portfolios yet, but they’ve been transitioning individual loans whenever they’ve been modified for other issues.”

The impact on trade and supply chain finance will be huge, as an estimated 80% of agreements used Libor’s dollar benchmark, estimated Kathleen Tyson, CEO of Pacemaker.Global, an analysis-software provider for central banks, in a 2021 blog post.

Organizations will need to adopt the new dollar-denominated Secured Overnight Financing Rate (SOFR)—the benchmark interest rate at which institutions can borrow US dollars while posting US Treasuries as collateral—in their new financial agreements. At the same time, they will need to swap out Libor references for SOFR references in existing contracts that remain in effect after the transition deadline.

The next several months represent the final phase of Libor’s retirement, which began in 2018—a year after the Federal Reserve Bank of New York–chaired Alternative Reference Rate Committee selected SOFR to replace dollar-denominated Libor rates. Throughout 2021, there was a push to adopt SOFR, including the US Commodity Futures Trading Commission’s “SOFR First” initiative in the derivatives market. The rest of the world was much the same, and the year ended with the ICE ceasing to publish Libor rates for the euro, Swiss franc, British pound and Japanese yen in the one-day, one-week, two-month, three-month, six-month, and 12-month tenors, as well as the one-week and two-month tenors for the dollar-denominated rates.

In their place, the respective regulators debuted the euro short-term rate (€STR or Ester), the Swiss average overnight  rate (Saron), the Sterling overnight index average (SONIA) and the Tokyo overnight average rate (Tonar), which calculate their rates differently.

Mileage May Vary

But adoption of SOFR and other new benchmark rates varies across financial markets and types of debt agreements. The monthly ISDA-Clarus RFR Adoption Indicator, which monitors trading across interest rate derivatives conducted using risk-free rates (RFR), reached 43.5% in the first three quarters of 2022, which was only 12.4% for the same nine months in 2021, according to data published in the latest ISDA-Clarus monthly adoption review.

Although the adoption percentages may seem low, they could acutally be higher if one considers the use of compression, the risk management pradctice of canceling trades that offset each other, note industry experts.

Meanwhile, J.P. Morgan’s research estimates that approximately 15% of loans in collateralized loan obligation (CLO) portfolios have adopted SOFR as of October 2022.

There remains much work to transition CLOs and their underlying loans to SOFR before the deadline, agrees Christopher Desmond, a partner at the global law firm Dechert.

To aid in the transition, various bodies established fallback protocols that provide instructions regarding the migration from Libor. In 2020 the International Swaps and Derivatives Association (ISDA) established its protocol to amend ISDA-based contracts, while the ARRC published its fallback protocol in early 2021.

The Consolidated Appropriations Act, signed into law by President Joseph Biden on March 15, 2022, also contains language for financial contracts based on US law that have not matured before the June 30 deadline and lack existing fallback protocols to choose SOFR as a successor rate.

Even with these protocols, there is more work to do, according to John Boyle, a partner at global consultancy EY. “In the first half of 2022, we have seen a little bit of a slower pickup in terms of product movement and the incorporation of fallback language in USD Libor contracts.”

A Choice of SOFRs

The ICE took over the administration of Libor in 2014, after it came to light that banks contributing interest rate quotes to calculate the benchmark had been manipulating the process for their benefit. The exchange operator changed the process, relying on 11 to 16 banks to contribute their rates for five currencies and their 35 tenors. It then sorts the quotes from highest to lowest, removing the top and bottom quartile quotes and taking an average of the remaining quotes to the fifth decimal point.

The New York Fed, which calculates SOFR, decided to omit the contribution model. Instead, it uses the volume-weighted median from transactions occurring on the triparty repo market, the General Collateral repurchase agreements and bilateral US Treasury repo transactions cleared by the Fixed Income Clearing Corp.

However, the market needs a backward-looking benchmark based on historical data, known as compounded SOFR, which is the compounded average of SOFR over rolling 30-, 90- and 180-day periods; and it also needs a forward-looking benchmark. Exchange operator CME Group calculates its CME Term SOFR benchmark using volume-weighted average price-trading data from 13 consecutive one-month SOFR futures contracts and five consecutive three-month SOFR futures contracts.

Each approach offers its own benefits. Compounded SOFR tends to move after the US Fed issues a rate hike. And since it is based on historical data, it does not run afoul of Shariah law’s prohibition on gambling and speculation. Term SOFR estimates where SOFR is heading using one-, three-, six- and 12-month tenors.

“Term SOFR has been a pretty seamless transition for those who have started putting it into place and using it,” says Dechert’s Desmond. “I think that was by design, because it was intended to perform like Libor and be as usable as Libor.”

Nevertheless, some see the choice between compounded and Term SOFR as a drag on adoption and implementation.

“I think the different permutations of SOFR, in terms of conventions as well as the potential emerging risk-free rates in the marketplace, has caused a little bit of a delay in the market’s transition,” says Boyle.

The Last Lap

Long projects are often compared to scorpions: The poison is always in the tail. The volume of US dollar Libor transactions is greater than the number of transactions that use Libor denominated in other currencies, which will make the transition more than a “rinse and repeat” exercise of earlier  Libor migrations, according to industry insiders.

“We don’t know what will happen if we get to June 30 and there is a large overhang of loans that have not transitioned with good transition language,” agrees Desmond. “Starting on July 1, agents will need to figure out how to calculate interest on these loans. Even if the language is self-executing, there will be a fair amount of legal administrative work, and other similar work, to put the language into effect.”

Yet, Armstrong notes that despite the available tools and protocols, there always will be tough legacy loans that will need added effort.

“We know how loans with ARRC language will transition, and we know how tough legacy loans will transition based on the federal legislation; but there’s going to be another group of loans that are three to 10 years old,” he says. “They could have different Libor transition language that transitions to other rates like the Treasury rate, prime rate or something else. That’ll be the batch of contracts that lenders and their counsel will need to go through to figure out what rate they’re supposed to transition to under the terms of the agreement.”

And the clock is ticking.