LIBOR transition update — Q2 2021 review

The LIBOR transition has continued to evolve rapidly, with U.S. authorities officially recommending forward-looking CME Term SOFR, including for use by commercial borrowers to hedge term SOFR-indexed loans. While there has been increasing discussion around credit-sensitive rates, the term SOFR recommendation may prove to be a watershed moment in establishing SOFR as the predominant replacement for USD LIBOR, although there are other rates in contention. As the year-end deadline for new LIBOR-based originations approaches, the next few months should prove significant in terms of the market’s adoption of replacement rates. In the interim, LIBOR remains a powerful market presence, with Freddie Mac recently encouraging its floating-rate multifamily real estate borrowers to consider extending certain LIBOR-based interest rate caps on loans that will require cap extension after the end of this year. And meanwhile, LIBOR transition-related federal legislation continues to work its way through Congress.

We address these and other updates below, along with some things to keep in mind as we approach the end of the summer.

Latest quarterly highlights in LIBOR-SOFR transition

Term SOFR

On July 29, the Alternative Reference Rates Committee (ARRC) formally recommended the CME Group’s forward-looking SOFR term rates (Term SOFR) to further support the transition from LIBOR. This long-awaited announcement has been in the works since 2017, when the ARRC published the first iteration of its Paced Transition Plan for Developing SOFR Markets, stating an expectation of an eventual adoption of SOFR term rates, and included such rates as the first recommended fallback rate in the ARRC’s form loan fallback documentation. As laid out in the Paced Transition Plan, the ARRC initially expected to recommend a forward-looking SOFR term rate by the middle of 2021 but announced in March 2021 that derivatives market had not developed sufficiently for it to do so. Then in April, the ARRC announced a set of key principles to be used as guidance while considering the necessary conditions for a SOFR term rate, including that such rate have a limited scope of use and be rooted in a robust set of derivatives transactions.

To further facilitate adoption of SOFR-traded products in the financial markets, on July 13, the Market Risk Advisory Committee of the Commodity Futures Trading Commission (CFTC) adopted the “SOFR First” initiative, whereby interdealer brokers would change linear swap trading conventions from USD LIBOR to SOFR, which adoption the ARRC commended as a market best practice that would lead to increased activity in SOFR derivatives markets. The initial phase of SOFR First took effect during the week of July 26, with the ARRC formally recommending Term SOFR mere days later.

While the SOFR First initiative may be a bellwether, borrowing and hedging entities will still need to voluntarily adopt Term SOFR in their contracts for the market to fully move away from LIBOR. There are outstanding questions for borrowers while LIBOR is still the status quo, such as the impact of loan margin/spreads under the new regime, the treatment of floors, and the approaches to refinancing versus originating new contracts.

In the derivatives markets, CME has yet to formally license Term SOFR for use in derivatives; assuming it eventually does, the ARRC's Term SOFR scope recommendations provide that Term SOFR’s use in derivatives markets is "limited to end-user facing derivatives intended to hedge cash products that reference the SOFR Term Rate." The derivatives market seeks clarity around this language and what scenarios are supported and which are not across the different segments of derivatives users.

Credit-sensitive rates/market liquidity

While the advent of Term SOFR addresses some challenge in operationalizing SOFR, SOFR’s lack of credit sensitivity remains an issue for many in the market. Many banks do not find SOFR to be representative of their borrowing costs, citing the outset of COVID as a concrete example of the disconnect between risk-free and credit-sensitive rates. This perceived lack of representativeness in part led a number of private market participants to develop and promote proprietary credit-sensitive benchmark rates, including AMERIBOR and BSBY.

In June, the ARRC highlighted several points made in a recent meeting of the Financial Stability Oversight Counsel (FSOC), in support of SOFR, as compared with credit-sensitive rates. While the SOFR First initiative inevitably will deepen SOFR derivatives market liquidity, the question of adoption of SOFR-based debt versus other credit-sensitive alternatives remains to be resolved. While the momentum for credit-sensitive rates may have slowed, it has by no means been halted. Indeed, as the end of the year approaches, borrowers may find a market of alternative benchmark rates rather than a single rate, depending on their own preferences or those of their lenders.

Freddie Mac encourages LIBOR cap extensions

In late July, Freddie Mac encouraged parties to certain LIBOR-indexed adjustable-rate mortgages (ARMs) on multifamily commercial real estate loans, to extend their LIBOR interest rate caps before the end of this year. Per previous guidance from bank regulators, banks may not offer LIBOR-indexed loans or derivatives after the end of this year.

In recognition of this possibility, Freddie is encouraging borrowers to extend their caps through earlier of loan maturity or LIBOR’s end date (June 30, 2023). Freddie has framed this as a request and not a mandate and says that borrowers are free to decide whether to extend their LIBOR caps now or buy a SOFR cap in the future. Here, we articulate some of the considerations our clients are weighing in evaluating this request from Freddie.

Federal LIBOR transition legislation

As we noted in our last quarterly update, in April 2021, 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. However, many market participants sought a federal equivalent as a more effective solution, given questions around the applicability of the New York law in certain instances, as well as the potential for differences in legislative treatment (if any) at the state level. In July, the House Financial Services Committee adopted the Adjustable Interest Rate (LIBOR) Act of 2021 (H.R. 4616), specifying SOFR as the LIBOR replacement without “disfavor[ing]” alternative rates, though the litigation safe harbor would only apply in fallbacks to SOFR.

SOFR and SONIA market activity

• While SOFR transaction volume rose through Q2 2021, it did not increase materially (see Figures 1 and 2 below)
• The SOFR First initiative drove a significant spike in SOFR derivatives volume during the first week of the initiative. That said, the market is still clearly in the early stages of functional transition, as SOFR derivatives volume is still roughly 8% of LIBOR derivatives volume. That ratio presumably will increase through October 2021, when the first phase of the SOFR First initiative finishes rolling out, and likely will increase more generally following the ARRC’s recommendation of Term SOFR.
• In the U.K., GBP LIBOR activity has continued to slow, given U.K. lenders’ no longer offering new GBP LIBOR-indexed loan facilities, along with non-linear derivatives market participants’ moving to SONIA in Q2.

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
  • With limited exceptions, banks likely to stop offering new USD 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
  • SOFR First extends to cross-currency swaps (expected September 2021), non-linear derivatives (timing tbd), and exchange-traded derivatives (timing tbd)
• 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