LIBOR transition update — Q1 2021 review

The biggest news this quarter is that regulators have confirmed that all tenors of GBP LIBOR will be published through the end of this year and that one- and three-month USD LIBOR will continue to be published on a representative basis through June 30, 2023. In the case of USD LIBOR-based loans, these announcements could have the effect of eliminating 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, borrowers remain advised to take inventory of their specific fallback language and remain cognizant of the possibility that language containing “early opt-in" provisions could result in an earlier transition than the June 30, 2023 date. For transactions that extend beyond those dates, the market continues to consider how best to transition to (and use, more generally) a risk-free rate, given the pros and cons associated with different fallbacks.

We address these and other regulatory and legislative updates below, along with some things to keep in mind as we head into the middle of the year.

Q1 2021 Highlights in LIBOR-SOFR Transition

Revised ISDA definitions/Protocol take effect

• On January 25, ISDA’s IBOR Fallbacks Supplement and Protocol took effect.
• The Supplement and Protocol are designed to address derivatives fallbacks in connection with LIBOR replacement, which is 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 certainty 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, these 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 has applied automatically to any new cap or swap executed since January 25, the Protocol is used to incorporate the Supplement provisions to any pre-existing cap or swap.
• Chatham continues to recommend 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 extension of LIBOR’s publication through June 30, 2023 (see below), we believe that it still makes sense, in many cases, to wait on making these types of amendments to derivatives and other contracts.

IBA consultation, extension of USD LIBOR, and potential for “synthetic” LIBOR (March 2021)

• On March 5, a series of announcements and guidance (guidance for FIs) by the U.K. Financial Conduct Authority (FCA), the ICE Benchmark Administration (IBA), the International Swaps and Derivatives Association (ISDA), and Bloomberg, provided that:
  • IBA will continue to publish on a representative basis:
    • GBP LIBOR: all settings/tenors through December 31, 2021.
    • USD LIBOR: one- and three-month tenors through June 30, 2023.
  • Beyond those dates, the indices will no longer be representative; but the FCA will consider and/or consult on whether to compel IBA to publish “synthetic” USD and GBP LIBOR, consisting of a forward-looking term RFR plus the ISDA spread adjustment, for continued use with legacy contracts.
  • The ISDA five-year median lookback spread adjustments set as follows:
    • GBP LIBOR to SONIA: one-month (0.0326%); three-month (0.1193%)
    • USD LIBOR to SOFR: one-month (0.11448%); three-month (0.26161%)
    • These spread adjustments apply only to contracts that are subject to the Protocol, unless specifically amended.
  • The ARRC deemed the FCA announcement a “Benchmark transition event” under its recommended loan language.

• In the ensuing weeks, some issuers of commercial real estate collateralized loan obligation (CRE CLOs) came to interpret these events and announcements as triggering the beginning of LIBOR transition this year.
• On March 25, the ARRC released the latest version of its supplemental recommendations of hardwired fallback language for syndicated and bilateral business loans, specifically referencing the March 5 announcements, and endeavoring to synchronize its fallbacks with LIBOR’s presumptive end date of June 30 2023.
• As background, and as we’ve noted before, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued a statement in November 2020 that, notwithstanding the extension of certain LIBOR tenors to 2023 (and with some narrowly defined exceptions), banks may no longer offer new LIBOR-based contracts as soon as practicable, but no later than December 31, 2021. Further, all new contracts referencing LIBOR shall contain unequivocal fallback language to mitigate safety and soundness risks related to the transition.

The FCA curtails new GBP LIBOR issuance (March 2021)

• Since March 31, 2021, U.K. lenders have ceased offering new LIBOR-referencing loan facilities.
• This date applies to U.K.-based banks, but other banks are observing it as well.
• A consensus is emerging on areas where borrowers should focus to ensure an efficient transition on market-facing terms: fallback language, the timing of the transition (pre or at the cessation of LIBOR), the calculation of SONIA itself, differing methodologies for the calculation of credit adjustment spreads (CAS); and the interaction of SONIA loans with interest rate floors and associated derivative contracts.
• The ISDA IBOR Fallbacks Protocol establishes the mechanism by which SONIA credit adjustment spreads (CAS) will apply to contracts subject to the Protocol. The CAS for underlying loan facilities must still be amended.

Announcement of delay in SOFR term rate (March 2021)

• On March 23, the ARRC announced that it would not be in a position to recommend a forward-looking SOFR term rate by mid-2021, as they had previously hoped to be.
• The ARRC attributes this to the underdeveloped liquidity in SOFR derivatives markets.
• They also indicated that they’re continuing to evaluate the limited set of cases where they believe a term rate could be used.
• On April 20, the ARRC announced a set of key principles to be used as guidance while considering the necessary conditions for a SOFR term rate. The key principles to be followed include meeting the ARRC’s criteria for alternative reference rates, being rooted in a robust set of derivatives transactions, and having a limited scope of use.

New York state legislation (April 2021)

• On April 6, the state of New York enacted a law that provides for existing LIBOR-based “tough legacy” contracts to transition to SOFR after a “LIBOR Discontinuance Event,” also providing a litigation safe harbor.
• This legislation would not override contracting parties’ discretion to amend their legacy agreements to adopt SOFR or any other replacement rate, either on a bilateral basis or via an ISDA protocol.
• The ARRC endorsed this decision, noting that the provisions of the New York state law are consistent with the ARRC’s March 2020 proposal for New York state legislation.
• Many still await similar legislation at the federal level: officials from the U.S. Treasury Department, Federal Reserve, and the House Financial Services Committee are in favor of such legislation.

CME proposal for converting cleared LIBOR swaps (April 2021)

• On April 12, CME Group published a proposal to convert legacy cleared LIBOR swaps to SOFR OIS shortly before the LIBOR index cessation date.
• They propose doing so by (a) adjusting the floating leg by the ISDA spread to maintain duration, discounting risk, and accruals; and (b) processing a cash adjustment to account for any changes in valuation corresponding to the conversion.

Update to ISDA’s Interest Rate Derivatives Definitions (May 2021)

• ISDA’s Benchmark Reform Working Group is in the process of updating the 2006 ISDA Definitions to include a modular approach towards risk free rate compounding calculations.
  • Different conventions have developed in the cash markets to provide market participants with greater payment visibility prior to the end of the interest period. These conventions include observation shifts, lookback periods and lockout methods which are intended to provide market participants with additional time to make payments under cash instruments. ISDA’s standard compounding methodology is fixed at a two-day lookback period. However, ISDA in in the process of amending its compounding methodologies to reflect some of the conventions that have developed in the cash markets, including longer lookback periods, observations shifts, and lockout periods.
• Once finalized, ISDA’s modifications to their 2006 Definitions would allow market participants to better align their derivatives with the conventions employed in their cash products. The modifications are expected to be published in early May 2021.

Bloomberg Short-Term Bank Yield Index (BSBY)

• Bloomberg designed the Bloomberg Short-Term Bank Yield Index (BSBY) to provide a series of credit-sensitive reference rates that incorporate bank credit spreads, as well as to define a forward term structure.
• They intend to do this by measuring the average yields at which large global banks access USD senior unsecured marginal wholesale funding.
• Bloomberg calculates and publishes BSBY daily at 8 a.m. (EST) on each U.S. business day.
• On April 6, Bloomberg announced that an independent assurance review of BSBY confirmed that it adheres to the IOSCO Principles for Financial Benchmarks, which serves as a significant milestone along the path to its adoption.

SOFR and SONIA Market Activity

• SOFR volume has risen since CME and LCH, the leading US clearinghouses (CCPs or central counterparties), switched from discounting cleared trades using Fed Funds OIS to SOFR, for the purposes of valuing cleared USD-denominated interest rate swaps and interest due on collateral held against these positions.
• However, volume has stayed relatively flat for the last few months.
• Consistent with U.K. lenders’ no longer offering new LIBOR-referencing loan facilities, SONIA transaction volume has exceeded that of GBP LIBOR.
• The market expects SONIA volume to continue to rise, consistent with the FCA and Bank of England’s encouraging non-linear derivatives market participants to switch to SONIA from 11 May.

Recent and Upcoming Highlights in LIBOR Transition

There are a number of events we continue to await, some with specific dates associated with them:

• December 31, 2021
  • GBP LIBOR (all tenors) will no longer be published on a representative basis, subject to FCA consultation on “synthetic” GBP LIBOR
  • No new LIBOR-based loan or hedge products, per U.S. prudential regulators
• Sometime in 2021
  • FCA will consult on whether to allow publication of a new “synthetic” GBP LIBOR continuing beyond this date, for purposes of legacy contracts
  • U.S. lenders likely begin to move away from LIBOR-based lending
  • Federal legislation may advance
• June 30, 2023
  • One- and three-month USD LIBOR will no longer be published on a representative basis, subject to FCA consideration of a “synthetic” USD LIBOR