FAQ: USD LIBOR Transition to SOFR
- July 14, 2020
Private Equity | Kennett Square, PA
Real Estate | Kennett Square, PA
Hedging and Capital Markets
Real Estate | Kennett Square, PA
Real Estate | Kennett Square, PA
USD LIBOR will transition to SOFR, likely the end of 2021. Chatham's experts answer the most pressing questions by our clients about how the transition will affect them.
The transition from the London InterBank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) looms over the capital markets as 2021 approaches, when LIBOR may no longer function as a benchmark rate. Chatham’s experts on financial risk, hedge accounting, and regulatory matters answered some of the questions our clients have asked to prepare themselves for the upcoming changes. As this transition is constantly evolving, we will continue to update this document to reflect these changes. Please note the publish date for reference.
- When is the transition from USD LIBOR to SOFR happening?
- What do we need to do to prepare for the transition? When will I need to act and how?
- What strategies are we seeing clients use to hedge through the IBOR transition?
- How will SOFR be calculated, and what are the benefits and challenges of the transition?
- What is the current status of the replacement rate? Is SOFR going to be the replacement rate? Is SOFR an alternative or a replacement?
- What are the key challenges of moving to SOFR?
- How will SOFR be calculated, and what are the benefits and challenges of the transition?
- How does Fed involvement in the Treasury repo markets affect SOFR?
- What fallback language does Chatham recommend be included in loan documents and ISDAs?
- What are the common changes in documentation (i.e. ISDA) for clients to consider in relation to SOFR for existing trades? Is there a Chatham-standard language?
- Will the cash and derivatives markets match up?
- How will the derivatives market (specifically caps) be treated?
- How will the spread be determined and implemented when LIBOR goes away and SOFR comes into place?
- What happens to existing trades when LIBOR goes away?
- What will regions outside of the U.S. use as the replacement rate? What’s the latest with other currencies and jurisdictions?
- Will there be a term structure for SOFR?
- Does Chatham recommend waiting until term rates are available before transitioning cash and derivative contracts from LIBOR to SOFR?
There is no concrete date on which the transition must occur. However, the FCA (UK Financial Conduct Authority), which is the overseer of LIBOR, that LIBOR is at risk of discontinuation after 2021. The current COVID-19 situation has not changed the timeline for the LIBOR transition. As recently as June, 2020, the current head of the FCA, Edwin Schooling Latter indicated that it is possible that the announcement of the eventual cessation of LIBOR could come as early as year-end 2020. (Back to top)
Organizations should continue to follow the status of the USD LIBOR transition, incorporate more robust fallbacks into their debt and derivatives and take stock of fallbacks or lack thereof in their “legacy” contracts. Continued monitoring of developments of the NY Fed’s ARRC, ISDA, and Official Sector remains warranted. Of note, in May 2020, the ARRC released its Recommended Best Practices for Completing the Transition from LIBOR.
Organizations should continue to monitor cash market issuance of non-LIBOR indexed debt, specifically those issuances unrelated to Government Sponsored Entities (GSEs), for signs of preparedness on the part of lenders and increased appetite from lenders and investors for exposures to benchmarks other than LIBOR.
In the derivatives market, the forthcoming amendments to ISDA’s 2006 Definitions and the associated ISDA Fallbacks Protocol should be carefully considered by organizations with derivatives exposure. The amended Definitions and Protocol are tentatively scheduled for release in late July 2020. Organizations should evaluate whether adherence to ISDA’s Protocol, which is elective, will be optimal for their pre-existing derivatives transactions, or whether individually negotiating bilateral amendments with counterparty banks will be available to them and potentially more favorable.
Also, in the derivatives market, both major U.S. clearinghouses (CME & LCH) plan to switch their discounting and price alignment interest for USD Cleared USD Interest Rate Swaps in October of 2020. Organizations with direct exposure to this switch should monitor developments and assess the impact. There is also widespread thought that this switch will increase liquidity in SOFR derivatives thereafter and organizations should monitor how this liquidity is impacted. Futures exchanges also continue to build out their SOFR product offering, including options on SOFR Futures. Organizations should continue to monitor liquidity in these markets.
Regulatory bodies, including accounting and tax bodies, continue to address regulatory considerations in the transition away from LIBOR. Organizations should familiarize themselves with transition guidance and any relief afforded. Lastly, as global regulators increase their focus on transition preparedness, organizations should assess whether any of their entities might be subject to regulatory scrutiny and what action may be required of them. (Back to top)
LIBOR borrowing/hedging is by far the most prevalent among real estate, private equity, and corporate client bases. LIBOR swaps, caps, and swaptions are being used to hedge floating rate loans and future refinances of fixed-rate debt. Most clients are focusing on ensuring flexibility for LIBOR fallbacks and cessation events in loan documentation. Some clients have included trigger-event and cessation-event language in trade confirmations for longer-dated trades (again focused on flexibility and commercial reasonableness). As for financial institutions, we’ve seen many of our clients move away from LIBOR-based balance sheet hedging programs to Fed-funds based programs. (Back to top)
In June 2017, the ARRC identified SOFR as its preferred alternative replacement rate to USD LIBOR. SOFR is calculated by taking the volume-weighted median of transaction-level data from three sources: 1) tri-party repo data, 2) GCF Repo (General Collateral Finance repurchase agreements) transaction data and 3) bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).
The primary benefit of SOFR is that it is fully transaction based. There are approximately $800 billion of underlying transactions supporting the daily calculation of SOFR. Whereas, USD LIBOR relies primarily on expert judgment of the panel submissions to calculate this rate. The most active tenor of USD LIBOR is 3 months, and less than $1 billion of transactions support the calculation of this rate. There is a much more robust market supporting the calculation of SOFR.
For end users, one of the biggest challenges associated with SOFR in its current form is the lack of a term structure for SOFR. SOFR currently is published daily but does not have the term structure (e.g., tenors of 1 month, 3 months, 6 months, etc.) that many end users have become accustomed to borrowing under. (Back to top)
The ARRC identified SOFR as the recommended replacement to LIBOR in the U.S. It is not certain that all market participants will use SOFR across all floating-rate indexed products. There are other indices contending to replace LIBOR, such as ICE Bank Yield and AMERIBOR. No other index has the broad-based support from the ARRC (cash markets) and ISDA (derivative markets) that SOFR does, which is why SOFR is viewed as the likely replacement to USD LIBOR. (Back to top)
The key challenges facing SOFR adoption are 1) the lack of a forward-looking term structure for SOFR, and 2) the fact that SOFR does not reflect a typical bank’s borrowing or funding cost nearly as accurately as LIBOR. These challenges are a function of SOFR being an overnight, secured, risk-free rate, whereas LIBOR is an unsecured, forward-looking term rate.
Because SOFR is backward-looking, it presents challenges from an operational perspective, as the SOFR rate in effect for a given interest period isn’t known until the day after the interest period ends (when the final SOFR setting is known). This operational challenge also impacts cash management as payments may have to be delayed for several days and there is less time to provide notices and process payments, which could lead to more late or missed interest payments.
A growing concern being raised by some market participants is whether SOFR is the best fit for all segments of the market. Some banks have argued that, because SOFR is a risk-free rate (RFR), the lack of credit sensitivity makes SOFR less reflective of a lender’s borrowing costs and could reduce the availability of credit under market stress.
Challenges in the areas of accounting, tax, and legal still remain and continue to be deliberated and addressed by standard setters and regulators. (Back to top)
In June 2017, the ARRC identified SOFR as its preferred alternative replacement rate for USD LIBOR. SOFR is calculated by taking the volume-weighted median of transaction-level data from three sources: 1) tri-party repo data, 2) GCF Repo (General Collateral Finance repurchase agreements) transaction data and 3) bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corporation’s Delivery vs. Payment Service).
A primary attraction for regulators is that SOFR is fully transaction based and therefore nearly impossible for market participants to manipulate. There are approximately $900 billion of underlying transactions supporting the daily calculation of SOFR. Conversely, USD LIBOR relies primarily on expert judgment of the panel’s 18-20 submissions to calculate this rate. The most actively traded USD LIBOR tenor is 3 months, and less than $1 billion of transactions typically support the calculation of this rate each business day. There is a much more robust market supporting the calculation of SOFR.
One of the biggest challenges associated with SOFR in its current form is the lack of a term structure. SOFR, monthly-compounded SOFR, and quarterly-compounded SOFR are all published daily, but they are all backward-looking rates. No forward-looking term structure for SOFR currently exists. (Back to top)
SOFR is a measure of the overnight cost of financing U.S. Treasury securities in the repurchase agreement (repo) market. It includes market data from bilateral trading (trimmed to exclude certain transactions using high-demand “on special” collateral) and the tri-party repo market. The dynamics driving pricing, volatility and risk in the U.S. Treasury repo market are therefore closely aligned with those driving SOFR levels.
The Fed’s Federal Open Market Committee is responsible for periodically setting targets for several key interest rates, enforced through open market operations. The NY Fed conducts both repo transactions and reverse repo transactions in the tri-party repo market to manage the level of reserves in the banking system in an effort to further support the transmission of monetary policy to the economy. In a repo transaction the NY Fed is a lender, providing reserves to Primary Dealers in what equates to a collateralized loan. In a reverse repo the NY Fed reduces reserves by effectively borrowing funds from the market. The Fed’s involvement in the repo markets, meant to ensure an orderly and liquid market, influences the SOFR rate by effectively setting both a floor and a ceiling on repo rates. When the Fed lends funds via repo they are implicitly providing an avenue for primary dealers to convert their Treasury and MBS holdings to reserves. This lending can act as a backstop, encouraging those dealers to lend out reserves to other market participants and thereby helping to ensure that repo rates don’t rise above the Fed’s targets. When the Fed borrows funds via reverse repo transactions they provide an alternative means for market participants to earn interest on their excess cash, which by design, keeps the Fed Funds rate from falling below the lower bound of the Federal Reserve’s target.
As a result of recent Fed actions the SOFR rate has averaged around 5 basis points since April 2020.Market uncertainty with respect to future Fed actions may introduce additional volatility to Treasury repo rates and SOFR. (Back to top)
Chatham does not currently make universally applicable recommendations for specific fallback language. While there have recently been several important steps toward the market achieving consensus on a standard substitute rate definition, there are still several unknowns. Up to this point, Chatham has not yet seen many clients incorporating fallback language into derivatives documentation. This may soon change once ISDA releases their amended Definitions and IBOR Fallbacks Protocol (tentatively scheduled for release in late July 2020).
However, we have seen some movement in loan documentation, with clients preferring a couple of different approaches, and some counterparties who have adopted the various approaches recommended by the ARRC. Some clients have preferred to take a hardwired approach to fallback language in their loans by including a specific rate, index, or the determination (or future determination) of a substitute rate by a specific committee or organization (such as the Fed, the ARRC, or ISDA). The ARRC recommended SOFR as its preferred substitute rate and released its “hardwired approach” to fallback language for syndicated loans (updated June 2020). This fallback language uses a decision waterfall based on SOFR to determine the substitute rate, and supports the ARRC’s recommendation that syndicated loans begin using hardwired fallback language by September 30, 2020.
Other clients, however, have preferred to retain flexibility in their loans and have included language incorporating whatever fallback rates are ultimately adopted by the marketplace. In April 2019, the ARRC released its “amendment approach” to fallback language for syndicated loans, which allows flexibility for loan parties to agree on the selection of a substitute rate and amend their existing documentation accordingly.
Whichever approach a client prefers, Chatham recommends that clients and their advisors take a close look at the trigger and fallback language (or lack thereof) in their loans and their derivatives used to hedge those loans. If the trigger and/or fallback language in a derivative and the underlying loan agreement do not match, the client should carefully consider the potential risks that a mismatch of such terms could have for them, and may want to reach out to their lender and derivative counterparty to proactively amend the agreements as soon as their lender is able to administer a SOFR loan.
In addition, since LIBOR, SOFR, and other proposed replacement rates are not directly comparable, to avoid or reduce any value transfer arising solely from the transition from LIBOR to a substitute rate, Chatham recommends that clients try to negotiate a reasonable spread adjustment in their loans and derivatives. Some loan documents include a spot-spread adjustment methodology; however, Chatham would advise clients to carefully consider the potential results before agreeing to this methodology since variations in SOFR create the potential for significant value transfer as a result of the selection of an arbitrary calibration date. Other loan documents and derivatives have begun using a spread adjustment methodology that compares the basis between SOFR and the applicable IBOR over a longer period of time to smooth out some of the day to day variations between the two rates. Still other loans call for the “amendment approach” in which lender and borrower agree to amend the loan to incorporate SOFR or another replacement index if certain triggers occur impacting LIBOR. (Back to top)
We have not yet seen clients adjust documentation for existing trades to reflect the change to SOFR since there is not, at this time, a definitive market consensus regarding a standard substitute rate definition. Prior to the release of the forthcoming ISDA IBOR Fallbacks Protocol, such a change would require the parties to amend their individual relevant trade confirmations to define and reference SOFR. (Back to top)
There remain differences between the cash and derivatives markets at this stage, but there have been several recent steps towards harmonization of approaches. For example, in June 2020, the ARRC announced that it would recommend alignment with ISDA on the value of the spread adjustment to USD LIBOR as well as the timing of when the spread adjustment will be determined.
If any differences between cash and derivatives markets persist through implementation, this mismatch could drive market participants to negotiate bilateral adjustments to their derivative transactions (to match their hedged items) rather than adhering to the new ISDA protocol as a standardized practice. This concern about the need for consistency has been echoed by other stakeholders responding to ISDA’s consultations regarding fallback methodology and pre-cessation triggers. End users need to be aware of the potential for mismatch and what that could mean from a risk perspective, advocating and pushing for change where necessary to minimize the gap. (Back to top)
Chatham expects the market to use SOFR compounded in arrears (with a lookback to the SOFR from X days earlier) for the derivatives fallback rate. Unfortunately, it’s too early to tell how the volatility markets will develop; data necessary to calculate volatility and convexity isn’t readily available given how new SOFR is. Nearly all the regulators’ focus at this stage has been on determining rates and calculating payments with seemingly little concern for related issues like volatility markets. This presents problems not only for caps but also for calculating XVA (Credit Valuation Adjustments, Debit Value Adjustments, Funding Value Adjustments, etc.) on other products like swaps. CME began offering SOFR options on 3-month SOFR futures earlier this year. The availability of option products will allow for volatility markets to develop. (Back to top)
ISDA has been soliciting feedback on how to amend derivative contracts in the event of a permanent discontinuation of IBORs. ISDA’s consultations have shown a growing market consensus that the IBORs should be replaced by an RFR that is adjusted by using a compounded setting in arrears rate plus a five-year median historical spread in the event of a permanent discontinuation or a declaration that LIBOR is no longer representative.
ISDA released the results of the Final Parameters Consultation on November 15, 2019. A majority of respondents preferred a five-year historical median spread approach that is:
- Applicable immediately after the discontinuation date
- Uses all data in the five-year historical data period
- Calculates interest over a period that is shifted by two banking days relative to the IBOR period (Back to top)
End users have significant concerns about how existing trades will be treated if LIBOR is permanently discontinued. If LIBOR is unavailable, the current fallback methodology included in the 2006 ISDA Definitions requires the calculation agent to request quotes from other banks and then to take the average of those quotes depending upon how many banks provide quotes. However, it is likely that many (if not all) banks would be unwilling to provide a quote on a permanently discontinued rate.
This methodology is not sustainable in the event of a permanent cessation of LIBOR, which is why ISDA is undergoing a process to revise its Definitions to include more robust fallback language. To the extent that the updated fallback methodology is incorporated into the terms of the existing trade, once one of the conditions mandating fallback to the replacement rate is triggered, the derivative will be updated to begin referencing the new fallback rate. If an entity does not incorporate the revised ISDA Definitions into the terms of its derivative, it remains to be seen how this will play out in practice. It is unclear what will happen if an entity does not, or refuses, to incorporate the updated fallback methodology into the terms of its transaction. (Back to top)
Eventually, we expect there to be a term structure for SOFR. Currently, the SOFR swaps and futures markets are not liquid or deep enough to reliably generate a SOFR term rate. Amongst risk-free rate markets, the SONIA (Sterling Overnight Index Average rate) market is a couple of years ahead of SOFR and is much more liquid/deep. It is just approaching a point where term rates may be possible.
The ARRC expects there to be a term structure for SOFR by the end of 2021, but this could easily slip. There is hope in the market that the move to SOFR for cleared swap discounting in 2020 could be a step-change catalyst for the necessary liquidity.
Additionally, the Fed is expected to publish compounded in arrears SOFR rates for 30, 60, and 90 days in the first half of 2020 to help with bank system constraints around independently calculating compounded in arrears rates. (Back to top)
No, Chatham recommends being as proactive as possible with respect to the LIBOR transition. Many organizations are just beginning their LIBOR transition plans. However, 2021 (when LIBOR could no longer be a benchmark rate) doesn’t leave much time for this massive transition, especially with key details yet to be determined. At this point, Chatham recommends that clients assess/inventory their risk to LIBOR/fallbacks. Clients should staff teams as necessary to monitor and facilitate the transition. The market has not yet developed to offer SOFR-based loans and liquidity for SOFR hedges, but this will change over time.
The transition may accelerate but, for now, it appears that a term structure may not become available until after the end of 2021. If the markets develop sufficiently to borrow and hedge at SOFR compounded in arrears prior to term structure availability, it would be safest not to wait for a term structure. (Back to top)
GAAP requires extensive analysis of contract modifications, the results of which can lead to current P&L impacts and loss of hedge accounting. Revenue, leasing, debt, loans and derivatives are all impacted by these analyses. FASB recently issued Topic 848 which disregards these analyses as long as the modifications relate solely to reference rate reform. Additionally, hedged accounting is allowed to continue while there is still uncertainty about how the contracts will ultimately transition to an alternative reference rate. Without this guidance hedge accounting for interest rate exposures would be lost by all market participants. (Back to top)
FASB and IASB are working on projects to reduce the amount of analysis that needs to be performed when legacy contracts are modified to support reference rate reform. FASB released an exposure draft of Topic 848, Reference Rate Reform on September 5, 2019. Topic 848 is a set of exceptions and practical expedients to current GAAP for contracts that are affected by reference rate reform. These exceptions and practical expedients treat the amendment of these contracts as a modification or continuation of the contract, as opposed to a termination. Additionally, Topic 848 extends practical expedients to allow hedging relationships to continue and to temporarily ease certain of the effectiveness assessment requirements.
For derivatives designated in hedge accounting relationships, a modification to the critical terms of a derivative requires that the hedge accounting relationship be discontinued. A new hedge accounting relationship can be established for the modified derivative if new accounting documentation is put in place. However, this revised hedge accounting relationship is more complex to account for and typically requires a more sophisticated approach. Optional expedients are available to overcome the requirement to redesignate the hedging relationship.
Fundamental to cash flow hedging relationships is the expectation that the future hedged transactions are probable to occur. Given the current definitions of hedged transactions, amended contracts that reference a new index would not qualify and hedge accounting would need to cease. Topic 848 allows an entity to assume that the derivative and exposure will transition to the replacement rate at the same time.
For fair value hedges, the value assigned to the hedged debt will need to be updated for the change in the reference rate, though no specific approach is mandated in Topic 848.
Effectiveness assessments are also impacted. There are several simplified approaches that would become invalid upon amendment of the derivative or hedged exposure. Topic 848 provides a range of optional expedients that will allow an entity to change assessment methods or ignore certain elements in the assessment. Quantitative effectiveness assessments may require market data that is not available and reasonable proxy data may be appropriate.
Debt and loans
When a debt contract is modified it must be analyzed to determine whether the change in cash flows indicates that the modification is in substance an extinguishment of the old contract. If deemed extinguished, any unamortized debt issuance costs must be recognized in current period earnings. Topic 848 provides relief in this area and waives the requirement to assess modified debt if the only modification is to make reference rate reform related changes.
All contracts – embedded derivative review
Upon issuance and modification, all contracts must be analyzed for embedded derivatives. Both qualitative and quantitative factors are considered to determine whether the embedded derivative should be accounted for separate from the host contract.
Topic 848 grants relief so that amendments related to reference rate reform will not trigger analysis of embedded derivatives.
New contracts will pass through the existing requirement to analyze embedded derivatives, though the market data for a new reference rate may not be robust enough initially to complete the analysis. In this case, a reasonable proxy may be appropriate.
Lessees carry most leases on the balance sheet as a liability with an associated right-of-use asset, while certain leases are off balance sheet. A modification in the contract requires a reassessment of this classification. Topic 848 grants relief for this reassessment.
Certain long-duration construction contracts are recognized in earnings based on a percentage of completion. Amendment of the contract requires a reassessment of the amount recognized in earnings and possibly a new pattern of recognition in the future. Topic 848 provides relief for this analysis if the modification is solely due to replacement of a reference rate.
Over the last two years, the Securities Exchange Commission (SEC) has encouraged entities to include additional disclosure in their filings to discuss the impact of reference rate reform. This disclosure should likely reside in the Management Discussion and Analysis section of financial statements. The SEC suggested the following disclosure:
- Population of contracts that extend past 2021 that reference LIBOR and the plan to convert those contracts
- The actions that are needed to mitigate the exposure to LIBOR cessation
- The expected impact on profitability
- The expected impact on the effectiveness of the company’s hedging strategy
- Disclosure that allows investors to see the issue through the eyes of management
- The impact on business, systems, processes, risk management, and clients
The SEC welcomes pre-filing consultation so companies can get the level of disclosure right.
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Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.19-0239