LIBOR transition market brief — Q4 2020
- December 8, 2020
Real Estate | Kennett Square, PA
SummaryChatham's update on the LIBOR transition, summarizing upcoming deadlines, recent news, and resources to help you stay current as the market transitions away from LIBOR.
The biggest news this quarter is that regulators have signaled that they may extend LIBOR transition for certain USD LIBOR legacy contracts another 18 months from the end of 2021 to the middle of 2023. This could eliminate the need for LIBOR transition in any loans or derivatives that mature before then, which would relieve many borrowers, lenders, and hedge providers alike. However, the proposed extension is more nuanced than the headline, and we advise clients would not to ignore loans and derivatives maturing between December 31, 2021 (or even as soon as now) and June 30, 2023, as these loans may still be subject to transition, depending on how events play out and how the agreements are worded. We address this and other regulatory and legislative updates below, along with a summary of recommended LIBOR fallback language for derivatives, as well as what’s on deck going into the new year.
Q4 2020 Highlights in LIBOR-SOFR Transition
LIBOR extension and regulatory and legislative action (October-November 2020)
- On November 30, ICE Benchmark Administration (IBA), the administrator of LIBOR signaled a potential extension of USD LIBOR, announcing a December consultation on its intention to publish one-month and three-month USD LIBOR, along with three other tenors, through June 30, 2023. This announcement could effectively "solve" the USD LIBOR transition "problem" for parties to loans and derivatives that mature before then, as they would not need to transition from LIBOR.
- Global regulators, including the UK FCA, ARRC, and U.S. prudential regulators (Fed, FDIC, OCC) publicly supported the consultation and idea of an extension. Notably, the U.S. prudential regulators also encouraged banks to cease entering into new LIBOR-based contracts by or before the end of 2021. This has led to discussion of syndicated loans with the ARRC’s hardwired “early opt-in” language for syndicated loans, which could allow lenders to transition LIBOR-based contracts if a certain number of USD syndicated loans reference SOFR. This could lead to LIBOR-based loans transitioning between December 31, 2021 (or even sooner, depending on how rapidly the SOFR market develops) and June 23, 2023, which may be attractive to banks, depending on any other steps that regulators might take to encourage them to transition as much of their LIBOR-based portfolio as possible in the near term.
- The IBA extension aligns with a statement by Randy Quarles, the Fed’s vice-chair of supervision, at a Senate banking committee hearing on November 10, that the Fed was looking into a way for “tough legacy” contracts to remain indexed to LIBOR even after it has been discredited or discontinued. Quarles added that “[w]e need to consider a mechanism that would allow those so-called legacy contracts, the great bulk of them, to mature on their existing basis without having to be renegotiated and shifted to a new rate,” and said that the Fed would propose such a mechanism by December or January.
- Prior to that, on October 28, New York State Senator Kevin Thomas introduced a bill in the New York State Senate (Senate Bill S9070) to promote the adoption of robust LIBOR replacement conventions, particularly in “legacy” contracts that otherwise could not be updated to include adequate LIBOR transition language and help to protect end users of LIBOR loans and derivatives from undue costs caused by amendments to their contracts. The provisions of this bill are consistent with the ARRC’s March 2020 proposal for New York state legislation. Federal legislators are drafting a bill that would provide similar relief and create a safe harbor from litigation in certain instances where the interest rate associated with a financial contract is changed, upon LIBOR being unavailable, to SOFR. If passed, this federal bill would modify the fallback language in existing financial contracts to allow for SOFR adoption. Additionally, this anticipated federal legislation largely is consistent with the bill introduced in the New York State Senate. Borrowers should note the proposed safe harbor provisions: legislation that could limit our clients’ ability to pursue legal remedies concerns us greatly.
ISDA releases IBOR Fallbacks Supplement and Protocol (October 23, 2020)
- On October 23, prior to this recent legislative and regulatory activity, ISDA released its long-awaited IBOR Fallbacks Supplement and Protocol designed to address how derivatives will fall back to replacement rates in the event of cessation of a rate such as an IBOR. The Supplement and Protocol are necessary because the existing language for LIBOR unavailability in caps and swaps does not adequately address a permanent cessation of LIBOR.
- The Supplement is a series of updated provisions and definitions that provide a contractual framework for handling the transition of USD LIBOR to SOFR, as well as the transition of other “IBORs” to alternative risk-free rates. When incorporated into a derivative like a cap or a swap, they define the triggers causing a derivative to convert from LIBOR to SOFR, the precise SOFR rate that will serve as the replacement index for LIBOR, and the spread adjustment between LIBOR and SOFR.
- The Protocol is a contractual amendment mechanism that allows parties to incorporate the provisions of the Supplement into pre-existing derivatives. While the Supplement will apply automatically to any new cap or swap executed after the Supplement becomes effective on January 25, 2021, the Protocol is used to incorporate the Supplement provisions to any pre-existing cap or swap.
- The ISDA IBOR Fallbacks Supplement and Protocol will take effect on January 25, 2021. Until then, parties to derivatives can adhere to the 2020 IBOR Fallbacks Protocol for free, after which the cost will be $500/entity. Chatham recommends that parties to derivatives carefully evaluate their LIBOR transition risk under their loans and derivatives before deciding whether to adhere to the Protocol. Particularly given the probable extension of LIBOR’s discontinuation until June 30, 2023, we believe that it still makes sense, in many cases, to wait on making these types of amendments to derivatives and other contracts.
CCP Big Bang (Oct 16, 2020)
- CME and LCH, the leading U.S. clearinghouses (CCPs or central counterparties), switched from discounting cleared trades using Fed Funds OIS to SOFR, for valuing cleared USD-denominated interest rate swaps and interest due on collateral held against these positions.
- In connection with this conversion by CCPs, market participants have increased the amount of cleared SOFR swaps — measured both in notional and trade volume — leading up to this conversion, a trend that has sustained thus far since the conversion.
Agencies to stop purchasing LIBOR-based instruments after Q4 2020
In keeping with the timeline initially outlined in February 2020 by the FHFA (Federal Housing Finance Agency), Freddie Mac and Fannie Mae will stop purchasing LIBOR-based loans after Q4 2020, instead only purchasing SOFR-based products. As highlighted recently in our update on SOFR monthly transaction activity, Chatham has been increasingly hedging SOFR loans since the first one executed in September. While LIBOR-based agency loans are still closing in Q4, this only includes loan applications that were signed before September 30, 2020, making this the last quarter in which commercial real estate professionals will be able to close on LIBOR-based agency loans.
Recent and upcoming highlights in the LIBOR-SOFR transition
- Chatham Financial has prepared the following resources:
- The New York Fed publishes the following SOFR rates each business day at 8 a.m. EST:
- Some key players in LIBOR transition have published the following:
- ARRC: Recommended Best Practices for Completing the Transition from LIBOR (May 2020)
- Fannie Mae and Freddie Mac: LIBOR Transition Playbook (June 2020)
- ISDA: Benchmark Reform and Transition from LIBOR (first published May 2020)
- FASB: Reference Rate Reform
Speak to a Chatham expert
Please reach out to the Chatham team if you have questions about how the LIBOR transition could impact your loans and derivatives.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
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.20-0464
Our featured insights
SOFR: A comprehensive guide
How SOFR, the benchmark rate chosen by the ARRC to replace USD LIBOR, works and what drives its movements
USD LIBOR transition: credit-sensitive fallback rates
With more and more talk of various credit-sensitive alternatives to USD LIBOR, we’ve prepared an overview of some of the leading credit-sensitive alternative benchmarks (e.g., AMERIBOR, BSBY, et al.). We discuss what market events led to the current state, provide a comparison of the leading...
FAQ: GBP LIBOR transition to SONIA
GBP LIBOR will transition to SONIA, likely by the end of 2021. Chatham's experts answer the most pressing questions asked by our clients about how the transition will affect them.
FAQ: USD LIBOR transition to SOFR
USD markets started transitioning from LIBOR to SOFR in 2017 after the FCA announced that LIBOR was at risk of discontinuation at the end of 2021. Chatham’s experts answer the most pressing questions asked by our clients about how the transition will affect their port.
SONIA monthly transaction activity — October 2020
Each month, our team discusses the current state of GBP LIBOR and SONIA markets, exploring both the performance of the rates as well as the borrowing and hedging markets that surround them.
SOFR monthly transaction activity — October 2020
Each month, our team reviews and discusses the current state of USD LIBOR and SOFR markets, exploring the performance of the indexes as well as the borrowing and derivatives markets around them.
LIBOR: Update on industry initiatives and proposed legislation
LIBOR transition continues with the announcement of ISDA’s protocol release date, updated language from the ARRC for bilateral business loans, and possible amendments to the EU Benchmarks Regulation to help ease the transition.
SOFR forward curve update and the CCP "Big Bang"
In connection with the U.S. market’s transition from LIBOR to SOFR, Chatham has updated our SOFR forward curve by extending it from five years to 30 years. This piece explains the nature of that update, the reasons for it, and what may be in store for forward-looking term SOFR.