LIBOR’s Final Chapter: Practical Considerations for Buy Side Market Participants

Uses of LIBOR in the Swaps and Derivatives Markets

LIBOR influences the derivatives markets in many ways, including the following:

• LIBOR is the benchmark interest rate for the financing leg of many swap transactions (for example, the payments made by the synthetic long party to an equity total return swap).
• In interest rate swap transactions, LIBOR-based payments may hedge a party’s exposure to LIBOR under another financial instrument such as a bond or loan.
• LIBOR can be used as a base rate for late payments.

LIBOR’s Designated Successor: The Secured Overnight Financing Rate

In the United States, the Federal Reserve Alternative Reference Rates Committee was tasked with identifying potential alternative reference rates to LIBOR.⁶ In June 2017, the Committee recommended the “Secured Overnight Financing Rate” (SOFR), or a benchmark based on SOFR, as its successor. SOFR is calculated primarily based on a variety of overnight repurchase agreement transactions on U.S. Treasuries. It was first published by the Federal Reserve in April 2018.⁷ 

The transition from LIBOR to SOFR is likely to be difficult. Adoption of SOFR or any other LIBOR replacement will be entirely voluntary, unless regulators require banks and swap dealers to amend their agreements to agree on successor rates. To date, many market participants have not embraced SOFR as LIBOR’s successor in part because SOFR is a secured overnight risk-free rate. In contrast, LIBOR is an unsecured rate that includes a credit component and a term element (typically determined in 30-day increments). The differences between a risk-free overnight rate (SOFR) and a credit based term rate (LIBOR) mean that a transition from LIBOR to SOFR will be complicated.

U.S. regulators and industry trade groups are working to develop a standardized methodology for calculating credit and term spreads to be added to SOFR to adjust for these differences and thus to make SOFR a viable LIBOR fallback.⁸  To date, they have not reached consensus about how to do this. Further complicating matters, since its initial publication, SOFR has been unexpectedly more volatile than LIBOR; it has been susceptible to price swings tied to Treasury issuances, as well as to month- and quarter-end supply variations. In addition, contrary to market expectations, SOFR has trended higher than overnight LIBOR.⁹ 

While it is unlikely that LIBOR will be discontinued without the designation of a successor rate (by one means or another), it is possible that any designated successor will not initially be treated consistently in the market. Moreover, it is also possible that Buy Side Participants will find it challenging to maintain the economics of outstanding derivatives transactions that reference LIBOR following its phase out, because doing so will require a clear market consensus about spread and other adjustments to address the fundamental differences between LIBOR and SOFR (or any other successor rate).

The ISDA Consultation

The ISDA Consultation indicates that standard ISDA documentation will be amended to implement fallbacks for certain key IBORs. ISDA will amend rate alternatives in the 2006 ISDA Definitions, which will apply to new swap contracts, and it expects to publish a protocol that will permit market participants to amend existing swap contracts to incorporate the new fallbacks. The fallbacks will be tied to alternative RFRs that are identified for the relevant IBORs.

The ISDA Consultation underscores the general risk associated with the LIBOR phase out. The ISDA Consultation does not directly address U.S. dollar LIBOR (or Euro equivalents), but its treatment of IBORs for other currencies highlights the complexities associated with the LIBOR phase out. The ISDA Consultation proposes four alternative options for adjusting replacement RFRs, which are overnight rates, to achieve fallbacks for term IBORs; and it proposes three alternative options for adjusting RFRs, which are risk free rates, for the credit spread component that inherent in all IBORs. The ISDA Consultation then sets forth the different combinations of alternatives—nine combinations in all (as some of the adjustments for terms and credit spreads are incompatible with one another)—and requests respondents to rank the combinations in order of preference. The ISDA Consultation requests market feedback by October 12, 2018.

Specific Transition Challenges

As suggested above, the LIBOR phase out will raise fundamental issues, because new interest rate alternatives cannot be made fungible with LIBOR, and the available alternatives will represent tradeoffs that are likely to be viewed differently by different market participants. Among the specific issues raised by the LIBOR transition will be the following:

• Existing Contractual Fallbacks Are Inadequate. Many financial contracts that reference LIBOR include provisions to address LIBOR’s unavailability. Those provisions were generally adopted to address a temporary unavailability of LIBOR, and they do not address a permanent discontinuation, as is currently contemplated. Thus, existing fallbacks are not likely to address the LIBOR phase out effectively. For example, the 2006 ISDA Definitions, which are incorporated by reference into most swaps contracts, require the Calculation Agent to take the arithmetic mean of rates obtained from a poll of banks in the London market if a swap transaction’s reference rate is not published. This may work temporarily, but not as a long-term solution. Such a bank poll would be cumbersome to conduct on a daily basis, and many London banks may be reluctant to participate (even if they are not otherwise prohibited from doing so by the European Union’s financial benchmark regulations. The ISDA Consultation is part of the industry response to these fallback issues.
• Basis Risk. LIBOR is used in many swaps contracts because it is intended to hedge exposure under another contract or transaction that also references LIBOR, making the matching of the LIBOR rates in the two transactions fundamental to the economics of the swap transaction. For example, consider a fixed-for-floating interest rate swap that hedges a Buy Side Participant’s exposure to LIBOR under an outstanding loan agreement. The LIBOR successor rate identified for the swap will need to match exactly the LIBOR successor rate determined for the hedged loan agreement in order for the Buy Side Participant’s hedge to remain effective. For a Buy Side Participant to avoid basis risk in outstanding derivatives transactions at the time of LIBOR’s phase out, it will need to ensure that a consistent approach is taken in all of its hedged financial instruments that reference LIBOR.
• ISDA Protocol Limitations. When a regulatory or market development requires modifications to a large number of derivative contracts, ISDA often implements these modifications by publishing a protocol. Such protocols provide a standardized approach for market participants to use to amend their swaps contracts. The ISDA Consultation indicates that, in addition to amending rate alternatives for use in future swap contracts, ISDA expects to publish a protocol to establish a LIBOR fallback for existing swaps contracts governed by ISDA master agreements. However, any protocol is unlikely to be a one-size-fits-all solution, given the large volume and wide range of commercial terms in existing derivatives transactions that reference LIBOR.
• Regulatory Concerns. Some market participants have expressed concern that amending an existing swap transaction to identify a LIBOR successor rate may result, for purposes of certain regulatory regimes, in a material amendment to an existing swap or a termination of the swap and the creation of a new swap. If such a swap had been grandfathered from recent regulatory requirements (for example, the clearing or variation margin requirements), such a material amendment or termination and re-execution might result in a loss of grandfathered status.¹⁰
• Tax and Accounting Considerations. At this time, it is not clear what impact a transition from LIBOR will have on the hedge accounting treatment of derivative instruments. As mentioned above, it is possible that amending the interest rate benchmark in an outstanding derivative could be viewed as a termination of the contract and the entry into a new contract referencing the new rate. This may have a negative impact on the tax and/or the accounting treatment of such derivative contracts.¹¹ Further, changes to the LIBOR rate used in swaps that hedge other transactions, where the other transactions fall back to a different rate than do the swaps (resulting in the creation of new basis risk), may affect the hedge accounting and tax treatment of the swaps.

Considerations and Proposed Steps for Buy Side Participants

Despite the risks associated with the adoption of a successor to LIBOR, Buy Side Participants are currently limited in the actions that they can take to prepare for the transition. Nonetheless, Buy Side Participants may wish to consider the following steps:

• Continue to monitor developments related to the LIBOR transition, especially those led by ISDA. The ISDA Consultation requests market feedback by October 12, 2018. The ISDA Consultation indicates that ISDA will publish further consultations as well. The various ISDA consultations, together with related feedback from market participants, are expected to result in a LIBOR protocol. That protocol will designate fallback rates that will specify related spread adjustments (to account for term and credit spread elements missing from RFRs) and related events that will trigger applicability of the fallbacks. Buy Side Participants will need to consider whether the ISDA fallbacks are suitable for existing trades. They will also need to consider the fact that a protocol will directly affect only transactions governed by ISDA master agreements. It is important that Buy Side Participants actively comment on the ISDA consultations to ensure that the resulting LIBOR protocol accommodates their needs in addition to the needs of dealers.
• Take inventory of existing derivatives and non-derivatives transactions that reference LIBOR and categorize those that are scheduled to mature, or may otherwise terminate, before and after LIBOR’s phase out at the end of 2021.
  • For existing transactions that mature before 2022, consider using SOFR or some other rate in any successor or renewal of the transactions.
  • For existing swap transactions that mature after 2021, consider amending ISDA master agreements and master confirmation agreements to address the consequences of a LIBOR phase out. As any master agreement will specify terms applicable to all open transactions governed by the agreement, such an amendment will ensure that all of a Buy Side Participant’s outstanding derivatives transactions will include acceptable fallback provisions when LIBOR is discontinued.
  • When identifying fallback rates for swap transactions that reference LIBOR and that hedge a Buy Side Participant’s exposure to LIBOR under another financial instrument, the Buy Side Participant will want to ensure that the fallback rate in the swap transaction matches any fallback identified in the hedged financial instrument. This may be challenging, especially where the respective swap dealer is not a party to the hedged financial instrument.
• When entering into a new transaction that will mature after 2021, if SOFR or an alternative reference rate is not viable, and LIBOR is thus still preferred, consider incorporating terms into the trade confirmation to address actions that the parties will take at the time of the LIBOR phase out. Given the uncertainty at this time, it may make sense to include in the applicable trade confirmation a covenant to negotiate in good faith to designate successor rates for individual transactions if no viable fallback exists.

¹ See, e.g., Fin. Stability Bd., Interest rate benchmark reform: overnight risk-free rates and term rates (July 12, 2018).

² Andrew Bailey, Chief Executive, Fin. Conduct Auth., The Future of LIBOR at Bloomberg London (July 27, 2017) (draft available at https://www.fca.org.uk/news/speeches/the-future-of-libor).

³ See ISDA, Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions: Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW (July 12, 2018).

⁴ Giancarlo, J. Christopher, Opening Statement of Chairman J. Christopher Giancarlo before the Market Risk Advisory Committee Meeting (July 12, 2018).

⁵ Int’l Swaps and Derivatives Ass’n, Inc. et al, IBOR Global Benchmark Transition Report (June 2018) [hereinafter IBOR Global Benchmark Report] (available at https://www.isda.org/a/OqrEE/IBOR-Transition-Report.pdf) On June 25, 2018, the International Swaps and Derivatives Association, Inc. (ISDA), the Association for Financial Markets in Europe (AFME), the International Capital Market Association (ICMA), the Securities Industry and Financial Markets Association (SIFMA) and SIFMA’s Asset Management Group (SIFMA AMG) participated in a survey of market participants conducted by Ernst & Young LLP. Market participants included commercial and investment banks, other banking and financial entities, financial end users, corporates, infrastructure providers and law firms.

⁶ Press Release, Alt. Reference Rates Comm., The AARC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (June 22, 2017).

⁷ While this Sidley Update is focused primarily on LIBOR, the interest rate for most USD denominated transactions, there are concurrent efforts under way to identify alternative RFRs for each of GBP, EUR, CHF and JPY. To date, an alternative RFR for each of these currencies except EUR has been identified. IBOR Global Benchmark Transition Report, supra note 5, at 10.

⁸ Emma Dunkley, ISDA eyes contingency plan as Libor Demise Looms, Fin. Times (May 21, 2018), https://www.ft.com/content/c7a04bdc-5cab-11e8-ad91-e01af256df68.

⁹ Alexandra Harris, Libor Refuses to Die, Setting up a $370 Trillion Benchmark Battle, Bloomberg (May 7, 2018, 9:26 AM), https://www.bloomberg.com/news/articles/2018-05-06/libor-refuses-to-die-setting-up-battle-for-benchmark-supremacy.

¹⁰ Fin. Stability Bd., Reforming Major Interest Rate Benchmarks: Progress Report on Implementation of July 2014 FSB Recommendations (October 10, 2017).

¹¹ IBOR Global Benchmark Transition Report, supra note 5, at 34