LIBOR market update for financial institutions

Is LIBOR still being used in new loan and swap agreements?

LIBOR continues to be the dominant floating rate index used for commercial loans and swaps. While there has been a shift away from using LIBOR in balance sheet hedges, there has not yet been a similar movement with back-to-back (or borrower) swaps. Borrowers seem to prefer the familiarity of LIBOR-based loans and swaps, and many banks are still building the infrastructure to offer other rate alternatives. With the joint regulator announcement in late November and Federal Reserve examiner guidance in early March both stating that (with certain defined carve-outs) banks may no longer offer new LIBOR-based contracts after December 2021, we expect many financial institutions will begin offering other floating rate indices in the coming months.

How will LIBOR get replaced in existing loan and swap agreements?

The first step is to determine the type of LIBOR replacement language used in existing contracts. From a loan perspective, most financial institutions have reviewed their agreements and categorized them based upon fallback determination. If the loan agreements do not contain language that contemplate a transition away from LIBOR or result in a mutually agreeable outcome, then financial institutions and their borrowers need to amend the contracts.

From a derivative standpoint, International Swaps and Derivatives Association (ISDA) 2006 Definitions, which are referenced in most swap contracts, did not adequately allow for the replacement of LIBOR. Hence, ISDA recently amended the 2006 Definitions and established the IBOR Fallbacks Protocol to allow legacy derivative contracts to incorporate modified definitions and triggers for the appropriate LIBOR transition.

Excluding centrally cleared transactions, both counterparties to a derivatives contract must adhere to the ISDA IBOR Fallbacks Protocol or bilaterally agree to similar terms for proper fallback definitions to include in any existing agreements. Any new LIBOR derivative trades executed after January 25, 2021, which reference the 2006 ISDA Definitions automatically include these fallback definitions unless the counterparties agree otherwise. Note the IBOR Fallbacks Protocol language differs from more generic loan fallback language proposed by the Alternative Reference Rates Committee (ARRC).

From a cleared derivatives standpoint, both the LCH and CME’s rulebooks reference the amended 2006 ISDA Definitions and therefore all new and existing trades have fallback definitions included. Changes to their rulebooks become effective immediately and are not subject to bilateral acceptance to be incorporated into the applicable transactions. Although both LCH and CME have published their proposed plans on how transactions will transition to replacement indices, their plans are not yet final.

When will LIBOR “officially” sunset?

In early March 2021, the ICE Benchmark Administration (IBA), the administrator of LIBOR, released the results of its consultation on the cessation timeline for certain LIBOR tenors. In coordination with the IBA, the United Kingdom’s Financial Conduct Authority (FCA), LIBOR’s regulator, also confirmed when certain tenors of LIBOR will cease to exist. Pursuant to these announcements, the 1-week and 2-month LIBOR settings will end on December 31, 2021. Whereas, the more popular tenors including overnight, 1-month, 3-month, 6-month and 12-month USD LIBOR tenors will end on June 30, 2023. Extending certain LIBOR tenors to mid-2023 allows more legacy contracts that cannot be easily amended to mature on their current terms.

Is the IBA announcement considered a LIBOR “cessation event”?

According to ISDA, which also released a statement along with IBA and FCA, the announcement by IBA constitutes an Index Cessation Event for purposes of the ISDA IBOR Fallbacks Supplement and the ISDA 2020 Fallbacks Protocol. Hence, the Index Cessation Effective Date(s) and the 5-year historical median spread between LIBOR and Secured Overnight Financing Rate (SOFR) are now known. ISDA selected Bloomberg to calculate these spreads which were also released.

For contracts that have successfully incorporated the ISDA IBOR Fallbacks Supplement through one of the scenarios listed below, these LIBOR-based transactions will reference Fallback Rate (SOFR) upon an Index Cessation Event Date:

• Adhering to the ISDA IBOR Fallbacks Protocol
• Executing a new LIBOR transaction after January 25, 2021
• Bilaterally amending contracts to incorporate the fallback terms
• Being a counterparty to either the CME or LCH on cleared LIBOR transactions

Is SOFR being used in new loan and swap agreements?

SOFR has not yet been widely supported by the broader market given some of its structural and operational limitations. Federal Home Loan Banks (FHLBs) offer SOFR advances and other Government-Sponsored Enterprises (GSEs) have been active in the market to help build more liquidity. At this time, there are only a few community and regional banks currently offering SOFR-based loans. The index has become more commonly used as a rate alternative for subordinated debt offerings. However, the SOFR index referenced in many of these agreements does not yet exist (i.e. forward looking 3-month term SOFR) and includes fallback language to daily SOFR. Most of the swap dealers that work with financial institutions are now offering SOFR-based derivatives. Daily weighted average SOFR along with SOFR daily compounded in arrears are both conventions that are being structured in the market.

What other LIBOR alternatives are being used?

Some financial institutions are offering the Fed H.15 Prime Rate as a LIBOR replacement index for loans and swaps. The rate is well recognized by many market participants, but it may be a challenge to use with more sophisticated borrowers. There are also other limitations to consider. For example, the Prime rate used for loans and swaps is based on a daily weighted average with calculations and payments being completed at the end of each period, which limits timing for operational support. Additionally, Prime swaps often trade wider than LIBOR swaps, and not all swap dealers make a market in Prime. Lastly, Prime option products such as interest rate caps and floors are more difficult to execute in the derivatives market.

AMERIBOR is a benchmark interest rate that is gaining popularity. The American Financial Exchange developed it to reflect the borrowing costs of community and regional banks operating in the U.S. and help them better match their asset and liability mix. The index contains a credit spread based on unsecured loans and is being used by some banks for loan pricing purposes. In the hedging markets, the first AMERIBOR swap was recently executed and other banks are considering similar strategies.

Fed Funds Effective is another rate index being used as a LIBOR alternative primarily in the derivatives market for balance sheet hedging purposes. With more flexible accounting rules and growing liquidity positions, many financial institutions moved from hedging liabilities to assets over the last few years. This change provided an opportunity to use Fed Funds as a rate index. The market has deepened to provide similar pricing execution as LIBOR swaps. However, liquidity in Fed Funds options remains limited.

Are there more announcements expected from regulators and key market participants?

Regarding centrally cleared derivative trades, the CME and LCH have each announced a proposal and discussion document on how they intend to transition from LIBOR. Although both the CME and LCH rulebooks currently reference the 2006 ISDA Definitions, and any new or legacy transaction now incorporates the ISDA IBOR Fallbacks Supplement, both central counterparties (CCPs) are investigating whether they will have LIBOR transactions transition in the exact manner as outlined in the ISDA IBOR Fallbacks Protocol. Chatham has provided direct feedback to both CCPs on behalf of our clients with our concerns about their proposals.

In conclusion

As year-end approaches, we expect the frequency of statements from the various regulators and key market participants will increase. They will likely provide more clarity where needed and stress the defined timeline. We will continue to provide our clients, partners, and other stakeholders with timely updates to help them prepare their organizations for this critical market event. For more LIBOR transition information, please visit Chatham’s LIBOR transition insights page.