Guide to the LIBOR Transition

CONTRIBUTORS

Patrick Greene
Managing Director

Rachel Fetrow
Analyst

TABLE OF CONTENTS

  1. What is LIBOR?

  2. Why is LIBOR Changing?

  3. What are regulators proposing is the solution?

  4. What is SOFR?

  5. Who does this transition affect?

  6. References

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Chapter 1
What is LIBOR?

The London Interbank Offered Rate (LIBOR) is a reference rate, and over time since the 1980s has become the dominant rate for most adjustable-rate financial products. A group of banks (panel banks) voluntarily report the estimated transaction cost for unsecured bank-to-bank borrowing terms ranging from overnight to one year for various currencies. The number of currencies and maturities has fluctuated over time, but LIBOR is currently produced across seven maturities: overnight/spot, one week, one month, two months, three months, six months and one year. LIBOR rates are produced for the American dollar, the British pound sterling, the European euro, Japanese yen, and the Swiss Franc, resulting in the current 35 rates.[1][2] The aggregated calculations behind the rates are supposed to reflect the average of what banks believe they would have to pay to borrow currency or the cost of funds for a specified period. However, because the contributions are voluntary, and the rates submitted are a subjective assessment of probable cost, LIBOR indices do not reflect actual transactions.

LIBOR rates became heavily used in trading in the 1980s, officially launched by the British Bankers Association (BBA) in 1986 and regulated by the Financial Conduct Authority (FCA), the independent UK body that regulates financial firms, since April 2013.[3] Until 2014, LIBOR was developed by a group of UK banks, under the BBA. The Intercontinental Exchange Benchmark Administration (ICE) took over administration of the rate in 2014 in an effort to give the rate credible internal governance and oversight – ICE created third-party oversight, which resolved the BBA’s inherent conflict of interest in generating a sound rate while also protecting its member institutions.

Chapter 2
Why is LIBOR changing?

International investigations into LIBOR began in 2012 and revealed widespread efforts to manipulate the rates for profit, with issues discovered as far back as 2003. The investigations resulted in billions of dollars in fines for involved banks globally and jail time for some traders. Most recently, in October 2018, a Deutsche Bank trading supervisor and derivatives trader were convicted of conspiracy and wire fraud in relation to LIBOR rigging.[4]

The scandal challenged the validity of LIBOR and deterred panel banks from continuing their involvement in LIBOR generation. Because LIBOR rates are collected by voluntary contribution, in recent years the number of banks contributing, and therefore also the number of underlying transactions, are waning. In July 2017, Andrew Bailey, Chief Executive of the FCA announced that LIBOR rates would only be formally sustained by the FCA through the end of 2021, due to limited market activity around LIBOR benchmarks and the waning contributions of panel banks. The FCA has negotiated with current panel banks for their agreement to continue contributing data towards LIBOR rate generation through the end of 2021.[5]

Even without the challenge of collecting contributions from panel banks, many regulators have expressed concerns with the representative scale of LIBOR, which creates concerns of instability. The market of products referencing LIBOR dwarfs the transactions that LIBOR is supposed to represent. The New York Fed approximated that underlying transaction volumes for USD LIBOR range from $250 million to $500 million, while exposure for USD LIBOR as of the end of 2016 was nearly $200 trillion.[6]

Chapter 3
What are regulators proposing is the solution?

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In 2014, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York (New York Fed) convened the Alternative Reference Rates Committee (ARRC) in order to identify best practices for alternative reference rates and contract robustness, develop an adoption plan, and create an implementation plan with metrics of success and a timeline. The Committee was created in the wake of the LIBOR scandals, with the intention of verifying some alternatives, though no formal change in LIBOR was announced until 2017. The Federal Reserve reconstituted this board to include a broader set of market participants in March 2018 with the updated objective of developing a transition plan away from LIBOR and providing guidance on how affected parties can address risks in legacy contracts language that reference LIBOR.

In June 2017, the ARRC announced the Secure Overnight Financing Rate (SOFR) as its recommended alternative rate, and the New York Fed began publishing the rate on April 3, 2018. In October 2017, the ARRC adopted a “Paced Transition Plan” with specific steps and timelines designed to encourage use of its recommended rate.[7]

Chapter 4
What is SOFR?

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. As such, it will reflect an economic cost of lending and borrowing relevant to the wide array of market participants active in the financial markets. However, SOFR is fundamentally different from LIBOR. SOFR is an overnight, secured, nearly risk-free rate, while LIBOR is an unsecured rate published at several different maturities. It is a fully transaction-based rate incorporating data from transactions across three segments of the U.S. Treasury Repo market (tri-party repo, General Collateral Finance (GCF) repo and bilateral repo cleared through the Fixed Income Clearing Corporation (FICC)).[8]

The ARRC noted the need for replacement rate spreads due to the differences between rates:

Because LIBOR is unsecured and therefore includes an element of bank credit risk, it is likely to be higher than SOFR and prone to widen when there is severe credit market stress. In contrast, because SOFR is secured and nearly risk-free, it is expected to be lower than LIBOR and may stay flat (or potentially even tighten) in periods of severe credit stress. Market participants are considering certain adjustments, referenced in the fallback proposal as the applicable ‘Replacement Benchmark Spread’, which would be intended to mitigate some of the differences between LIBOR and SOFR.[9]

While the ARRC selection of SOFR as the U.S. replacement rate of choice is final, their selection is only a recommendation that LIBOR be replaced with SOFR. This creates a precarious outlook for the transition: financial institutions have to choose to take the transition seriously, and if they choose to employ rates other than SOFR, the transition could be longer and more complicated than many expect. That said, the cost benefit of choosing a different alternative reference rate is increasingly difficult to justify. With the selection of SOFR as the recommended rate, the New York Fed established an industry standard and did so in a lengthy process that included market participants and a public comment period. They also began publishing SOFR regularly on April 3, 2018.[10]

Additional steps taken by government–sponsored enterprises (GSEs) have initiated the momentum in building out the SOFR market. In July 2018, Fannie Mae issued the first SOFR-denominated securities, leading the way for other institutions who have since followed suit.  In November 2018, the Federal Home Loan Banks (FHLBs) issued $4bn in debt tied to SOFR. The action was taken to support liquidity and help demonstrate SOFR demand to develop the SOFR market for the approximately 7,000 member institutions – banks, credit unions, and insurers – who are in the process of transitioning away from LIBOR.[11] CME Group, a derivatives and futures exchange company, launched 3-month and 1-month SOFR futures contracts in 2018.[12] All of these steps taken to build out the market create a strong start for a rate that is already more stable than LIBOR—the transaction volume underpinning SOFR rates is around $750 billon daily, compared to USD LIBOR’s estimated $500 million.[13]

The ARRC has begun publishing guidance for fallback language and in the fall of 2018 published consultations on recommended language for floating rate notes and syndicated business loans.[14][15]

These initial steps to build out the necessary SOFR market put the United States ahead of the ARRC transition plan schedule and position the market well to begin SOFR implementation. However, a successful transition will require extensive engagement from other institutions. Affected institutions need to begin their transition now in order to make the gradual transition in time for the 2021 deadline.

Chapter 5
Who does this transition affect?

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The transition affects any institutions that hold contracts, products, or tools that reference LIBOR and will not reach full maturity or phase out before the end of 2021. 

 

WHAT ACTIONS DO AFFECTED INSTITUTIONS NEED TO TAKE?

  1. Establish a Sponsor and Project Team:  Affected institutions need to take a phased approach to the transition away from LIBOR. Because of the need for continuous oversight, they should begin by identifying an executive sponsor and establishing a project team. The team should be responsible for all transition-related activities across the organization, including assessment of exposure and the applicability of alternative reference rates where necessary, planning the steps and timing of transition, and coordinating the implementation of transition away from LIBOR.
  2. Conduct an Impact Assessment:  The first task of the project team is to complete an impact assessment to determine the institution’s LIBOR exposure across all financial products and existing contracts that mature after 2021, as well as any related models and business processes (including third-party vendors and data providers). Regarding contracts, the team should identify and categorize all variants of legacy fallback language in existing contracts. Additionally, the assessment should analyze the risk of the LIBOR transition to the institution’s basis and operational risk and across financial holdings.
  3. Mitigate Risks:  Using results from the LIBOR exposure assessment, the project team should develop a plan running through 2021 to prioritize transition activities in a way that best mitigates risk on LIBOR exposure, and communicates the transition activities to employees and clients with ample time for them to learn about and buy into the transition objectives.  
  4. Prepare new products and tools linked to alternative reference rates: This mitigates risk by limiting the number of legacy exposures that will still be in effect in 2021 and creates a clear direction for transition activities. New references may include financial instruments and products, contract language, models, pricing, risk, operational and technological processes and applications to support the new rates.
  5. Develop and Implement Transition Contract Terms: In legacy contracts that will mature after 2021, the project team will need to amend contracts and fallback language. The ARRC has begun to provide guidance for amendments or transitions related to some financial products and will continue to publish legacy transition guidance as it fulfills its mandate. Where necessary, products must move to ARRs.
  6. Update Business Processes: Based on the impact assessment, various business processes surrounding the management of interest rate changes, including those built into models and systems will require updating to accommodate the switch away from LIBOR. For new products utilizing the new index rate, procedures, processes and policies will need to be established and tested before rollout to clients. 
  7. Manage Change and Communicate:  The project team will need to develop educational materials explaining specific changes and their impacts to stakeholders. The materials must be distributed as part of an outreach strategy to external stakeholders, including clients and investors, as well as rating agencies and regulatory bodies. The outreach strategy should help to ensure that the transition message is consistent and clear as it is communicated from executives and board members to operational personnel, other stakeholders and outer spheres of influence.  
  8. Test: Financial institutions will want to prepare for regulatory oversight by testing business processes in advance. Regulators may look for documentation of the processes used to identify and remediate LIBOR risks and any risk exposure that has not been completed.

Chapter 6
Resources

Alternative reference Rates Committee. “Frequently Asked Questions.” Federal Reserve Bank of New York. 20 September 2018. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Sept-20-2018-FAQ.pdf, Accessed November 2018.

Bloomberg. “SOFR’s growing use means it’s when, not if, it replaces LIBOR.” 15 October 2018. https://www.bloomberg.com/professional/blog/sofrs-growing-use-means-not-replaces-libor/, Accessed November 2018.

Bloomberg. “The long hunt of an incorruptible successor to LIBOR.” 17 October 2018. https://www.bloomberg.com/professional/blog/long-hunt-incorruptible-successor-libor-quicktake/, Accessed November 2018.

Bloomberg. “America’s LIBOR successor is racing to gain traction.” 11 October 2018. https://www.bloomberg.com/professional/blog/americas-libor-successor-racing-gain-traction/, Accessed November 2018.

Exchanges at Goldman Sachs. “Episode 107: LIBOR’s Long Goodbye.” 29 October 2018. https://www.goldmansachs.com/insights/podcasts/episodes/10-29-2018-granet-and-hammack.html, Accessed November 2018

LSTA. “LIBOR Replacement: Understanding the ARRC’s Loan Fallback Consultation.” 4 October 2018. https://event.webcasts.com/viewer/event.jsp?ei=1214424&tp_key=8e9f891c9a, Accessed November 2018.

McBride, James. “Understanding the LIBOR Scandal.” Council on Foreign Relations. 12 October 2016. https://www.cfr.org/backgrounder/understanding-libor-scandal, Accessed November 2018.

SIFMA Podcast. “The Transition from LIBOR.” 31 October 2018.

ENDNOTES

1 Kiff, John. “Back to Basics: What is LIBOR?” International Monetary Fund. Accessed November 2018. December 2012. https://www.imf.org/external/pubs/ft/fandd/2012/12/basics.htm, Accessed November 2018.

2 “LIBOR – current LIBOR interest rates.” Global Rates. https://www.global-rates.com/interest-rates/libor/libor.aspx, Accessed November 2018.

3 Bailey, Andrew. “The Future of LIBOR.” Financial Conduct Authority. 27 July 2017. https://www.fca.org.uk/news/speeches/the-future-of-libor, Accessed November 2018

4 “Two Former Deutsche Bank Traders Convicted for Role in Scheme to Manipulate a Critical Global Benchmark Interest Rate.” U.S. Department of Justice press release. 17 October 2018. https://www.justice.gov/opa/pr/two-former-deutsche-bank-traders-convicted-role-scheme-manipulate-critical-global-benchmark, Accessed November 2018.

5 Bailey, Andrew. “The Future of LIBOR.” Financial Conduct Authority. 27 July 2017. https://www.fca.org.uk/news/speeches/the-future-of-libor, Accessed November 2018.

6 Alternative Reference Rates Committee. “Second Report.” Federal Reserve Bank of New York. March 2018. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report, Accessed November 2018.

7 Alternative Reference Rates Committee. Federal Reserve Bank of New York. https://www.newyorkfed.org/arrc/index.html, Accessed November 2018.

8 Federal Reserve Bank of New York. “Secured Overnight Financing Rate Data.” https://apps.newyorkfed.org/markets/autorates/sofr, Accessed November 2018.

9 Federal Reserve Bank of New York. “ARRC Consultation: Regarding more robust LIBOR fallback contract language for new originations of LIBOR syndicated business loans,” 24 September 2018. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Syndicated-Business-Loans-Consultation.pdf, Accessed November 2018.

10 Federal Reserve Bank of New York. “Statement Introducing the Treasury Repo Reference Rates,” 3 April 2018. https://www.newyorkfed.org/markets/opolicy/operating_policy_180403, Accessed November 2018.

11Guida, Victoria. “Federal Home Loan Banks boost LIBOR replacement with $4B debt issuance,” Politico. 13 November 2018. https://www.politico.com/story/2018/11/13/federal-home-loan-banks-libor-replacement-939489, Accessed November 2018.

12 CME Group. “Secured Overnight Financing Rate (SOFR) Futures.” https://www.cmegroup.com/trading/interest-rates/secured-overnight-financing-rate-futures.html, Accessed November 2018.

13 Graph: LSTA. “LIBOR and the Loan Market.” 24 April 2018. https://www.lsta.org/uploads/DocumentModel/3523/file/libor-in-the-loan-market_042418.pdf, Accessed November 2018.

14 Federal Reserve Bank of New York. “ARRC Consultation: Regarding more robust LIBOR fallback contract language for new issuances of LIBOR floating rate notes,” 24 September 2018. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-FRN-Consultation.pdf, Accessed November 2018.

15 Federal Reserve Bank of New York. “ARRC Consultation: Regarding more robust LIBOR fallback contract language for new originations of LIBOR syndicated business loans,” 24 September 2018. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Syndicated-Business-Loans-Consultation.pdf, Accessed November 2018.

16 Federal Reserve Bank of New York. “Minutes,” Alternative Reference Rates Committee (ARRC). 31 October 2017. https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/October-31-2017-ARRC-minutes.pdf, Accessed November 2018.

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