LIBOR transition update — 2022

As we move into 2022, USD and GBP LIBOR-based originations have dropped substantially, in favor of various conventions of SOFR and SONIA, respectively. This update will address these markets, along with an update on federal LIBOR legislation recently passed in the United States. We address these and other updates below, also addressing considerations regarding the transition away from LIBOR vis-a-vis existing LIBOR-based agreements.

Latest quarterly highlights in LIBOR transition

SOFR hedging market update

With the increasing wind down of LIBOR as a primary benchmark, LIBOR usage has dropped. As of the start of 2022, all tenors of EUR and CHF LIBOR were discontinued, and most GBP and JPY LIBOR tenors were discontinued as well. Synthetic GBP and JPY 1-, 3- and 6-month tenors remain available for legacy contracts using a synthetic LIBOR calculation methodology.

The largely smooth transition away from these LIBOR rates suggests pathways for a successful transition away from USD LIBOR next year. Due in large part to the four-phased “SOFR First” Initiative, USD LIBOR trading has declined even though the commonly used overnight, 1-, 3-, 6- and 12-month USD LIBOR will continue to be published until the end of June 2023. Using data from reported trades, DTCC showed that LIBOR trade count has been on a decline since Q4 of 2021 and that increasingly, the majority of these trades will expire in the next year or two.

While USD LIBOR trading has declined, replacement rates have surged in usage. Leading that surge is SOFR. In the first quarter of 2022, SOFR established itself as a major part of the market. SOFR trading and hedging have become increasingly common and exceeded LIBOR by some metrics.

In the first quarter of 2022, SOFR trading on and off exchanges flourished and reached two important milestones. In late January, DTCC’s analysis of trades reported to its trade repository showed that SOFR trade count exceeded LIBOR trade count for the first time. Since then, SOFR has continued to grow. For the week ending March 18, there were a reported 12k SOFR trades as compared to about 6k LIBOR trades. These SOFR trades are increasingly well-distributed across different maturities. There is now ample liquidity across different tenors with more than 10% of SOFR trades expiring thirty or more years out. Associated SOFR traded notional has also grown significantly, with SOFR traded notional exceeding LIBOR traded notional for the first time in early March.

These graphs show that while more SOFR trades distributed across all tenors, LIBOR traded notional is still on par with SOFR traded notional. This is because the vast majority of LIBOR trades are now concentrated in short maturities expiring in the next two years and will only need fallbacks in place for a short period if at all.

LIBOR transition legislation

On March 15, 2022, President Joe Biden signed into law the Consolidated Appropriations Act, 2022 which includes the Adjustable Interest Rate (LIBOR) Act. This keenly anticipated legislation minimizes legal and operational risks associated with the discontinuation of USD LIBOR by providing contractual continuity to both borrowers and lenders in existing agreements that do not have a clear benchmark replacement framework. The legislation safeguards many products — including derivatives, student loans, leases, commercial and residential mortgages, and debt and equity securities that reference overnight or 1-, 3-, 6-, or 12-month USD LIBOR — from disruption caused by the transition. The Alternative Reference Rates Committee (ARRC) welcomed the news as providing much-needed clarity at a federal level. The ARRC stated that the legislation provides a targeted solution for financial contracts that mature after the cessation of LIBOR in mid-2023.

The LIBOR Act impacts approximately $15 trillion of “tough legacy” contracts in which there is inadequate or non-existent LIBOR replacement language. These contracts were at risk of litigation as they rely on a rate that would expire after June 30, 2023, potentially creating an unfavorable or inequitable economic outcome for one party and preventing both sides from meeting the original terms of their agreement. The LIBOR Act addresses this issue by allowing the Board of Governors of the Federal Reserve System (Federal Reserve Board) to select a benchmark based on SOFR plus a spread adjustment, as a replacement for LIBOR in these contracts by “operation of law.” Importantly, contracts that reference LIBOR but have a defined replacement rate, including prime rate, federal funds, or other credit sensitive rates, are outside the scope of this law. The Federal Reserve Board is required to complete this rule within six months of the bill’s enactment. The substitution of LIBOR with the SOFR-based replacement rate will occur on the first London business day after June 30, 2023. Commercial loan products will have applied the spread adjustment previously recommended by the ARRC. Consumer loans will convert to the spread adjustment over a period of one year.

Whereas certain contracts do not contain a replacement benchmark, there may be a defined party that is responsible for determining the fallback upon the discontinuation of LIBOR. In those cases, the federal legislation has created a “safe harbor” for those who select the Federal Reserve Board’s recommended replacement and exempts them from any legal liability arising solely from the selection of this SOFR based rate.

Many believe that the passage of LIBOR Act effectively supplants similar laws passed in New York and Alabama, except with regard to one-week and two-month LIBOR.

The legislation is intended to significantly reduce risks for market participants worldwide.

GBP LIBOR transition update

The majority of GBP LIBOR settings, including the benchmark 3-month LIBOR setting formerly the reference rate for most commercial debt and associated derivative instruments, ceased publication, as scheduled, on 31 December 2021. For those contracts which formerly referenced 3-month LIBOR, most transitioned to 3-month compound SONIA plus a credit adjustment spread of 11.93 bps / 0.1193% in accordance with the ISDA Fallback spreads as of 5 March 2021. Instruments that had not transitioned to a new reference rate (typically SONIA compounded in arrears) in advance of cessation, transitioned on the first Interest Payment Date (IPD) in 2022. Consequently, the transition process is largely complete as of the end of Q1 2022. Furthermore, given the scale of the transition, we are pleased to report that the process was remarkably smooth for our clients.

We are aware that not all LIBOR referencing contracts have transitioned. In the UK, the FCA had anticipated this outcome. In September 2021, the FCA announced that to avoid disruption to legacy contracts that reference the 3-month sterling LIBOR setting (amongst other rates), it will require ICE Benchmark Administration in its capacity as administrator of the LIBOR rate to publish this setting under a changed, ‘synthetic’, methodology. On 16 November 2021, the FCA confirmed it would allow the temporary use of ‘synthetic’ sterling LIBOR rates in all legacy LIBOR contracts, other than cleared derivatives.

Finally, on 15 December 2021, the Critical Benchmarks (References and Administrators’ Liability) Act 2021 became law in the UK. The Act seeks to support the wind-down of important financial services benchmarks and provide more certainty. The Act permits use of ”synthetic” LIBOR in certain contracts which have not been transitioned to an alternative rate and which do not incorporate suitable fallback mechanisms.

We have mostly seen the use of synthetic LIBOR in situations where consent is required from a wide group of financial stakeholders: for example, RMBS and CMBS vehicles. Where note holder consent has not been secured by the first IPD in 2022, the notes have reverted to synthetic LIBOR under the Critical Benchmarks legislation with the intention transition to SONIA (permanent replacement reference rate) from the second IPD in once the consent process is complete.

The key take-away is that ”synthetic” sterling LIBOR is intended for use only in relation to legacy contracts, and not for use in new contracts. The FCA’s current position is that synthetic LIBOR may be published for up to 10 years post cessation, but this will be reviewed annually – the first review by December 2022. Therefore, there are two key risks associated with its use: (i) it is no longer considered a representative rate; and (ii) its temporary nature provides no certainty for longer dated instruments. Synthetic LIBOR may secure additional time for market participants in specific circumstances; however, it should be regarded as temporary whilst parties to a LIBOR referencing contract continue to work on an active transition.

Looking ahead

With just over a year until USD LIBOR’s sunset date, companies are asking the question of what practical steps should they take in 2022 to prepare. Taking an inventory of all the company’s impacted LIBOR transactions is a crucial first step to assessing transition risk if this hasn’t been done already. Most companies have yet to proactively amend their debt and derivatives away from LIBOR. The steps are clearer for new debt originations given that new LIBOR-based originations are now prohibited. Companies who are expecting to refinance their debt or face a trigger event in 2022, however, should prepare themselves by becoming educated on the nuances of the current most common non-LIBOR alternatives.

If facing a trigger event, borrowers should also look at the impact to their derivatives. As noted above, SOFR liquidity is improving and as the market grows, we expect more companies to begin converting their debt and derivatives to SOFR-based instruments. In order to advocate for their own best interests in loans and derivatives, companies should understand the common rates observed as well as the events that would trigger the need to abandon their LIBOR-linked instruments.