LIBOR transition update — Q3 2021 review

As we approach the end of 2021, this update will address term SOFR, expectations around the continued use of USD LIBOR, as well as increases in SOFR derivatives transactions and continued headwinds in connection with the use of credit-sensitive alternatives. We address these and other updates below, along with some things to keep in mind as we approach the end of the year.

Latest quarterly highlights in LIBOR transition

Term SOFR

As we have noted previously, the ARRC has formally recommended the CME Group’s Term SOFR (Term SOFR) to further support the transition away from LIBOR. We have begun to see commercial real estate loans close over Term SOFR, and we have started to see hedges close over Term SOFR in the marketplace. One lingering question is how efficiently SOFR derivatives will price, given that regulators have articulated a limited use case for Term SOFR derivatives that does not include interdealer trades.

Expected waning use of USD LIBOR

U.S. prudential regulators have previously encouraged banks to cease entering into new LIBOR-based loans and derivatives (with limited exceptions) by the end of this year. On October 14, the ARRC recommended that all market participants act to slow their use of USD LIBOR as we approach the expected year-end cessation.

However, the prudential regulators have acknowledged certain “limited circumstances” where it may be appropriate for banks to continue to use USD LIBOR after the end of the year, including those that limit borrowers’ pre-existing LIBOR exposure. That said, regulators clarified their intent of LIBOR discontinuation for “new contracts” beginning in 2022, such that new contracts are those that “create additional LIBOR exposure for a supervised institution or extend the term of an existing contract.”

As such, we have received mixed feedback from hedge providers as to whether they will continue to offer LIBOR-based derivatives to hedge pre-existing risk, consistent with the limited circumstances that regulators have afforded them to continue to do so. Based on that feedback, we expect that LIBOR-based derivatives will remain available to some degree, though a number of banks still seem to be weighing the decision.

At the moment, use of USD LIBOR has slowed down although not materially. Trading in the last few weeks appears in line with the previous quarter. LIBOR trading did start to decrease before the October 22, 2021 date, when interdealer brokers' screens were supposed to go “dark” for LIBOR swaps. The decrease has not, however, extended and continued after the “dark” screen date. In fact, LIBOR trading has started to pick up again. Attributing recent changes in overall trading liquidity to regulatory action instead of regular market volatility and seasonality is still challenging. As we get closer to the end of the year, market participants will be closely monitoring LIBOR liquidity and pricing.

Increased SOFR volumes

As we have noted previously, the Market Risk Advisory Committee of the Commodity Futures Trading Commission (CFTC) has adopted the “SOFR First” initiative to change various swap trading conventions from USD LIBOR to SOFR. The initial phase of SOFR First (linear swaps) took effect during the week of July 26, and the second phase (cross currency swaps) took effect on September 21. The next phase of SOFR First (non-linear derivatives, i.e., swaptions, caps, and floors) takes effect on November 8. Since the start of the initiative, SOFR trading has grown at a rate of 12% per week. SOFR trading by number and volume is now about 20–25% of the LIBOR market and growing. Additionally, trading in other RFRs such as SONIA and ESTR has also significantly increased.

Most recent SOFR-based commercial real estate loan term sheets are indexed to 30-day average SOFR, daily simple SOFR, or Term SOFR. In early October, commercial real estate lender Walker & Dunlop became the first company to announce a leveraged loan sale that is indexed to SOFR. The seven-year loan with a notional of $600 million is the first of its kind and is yet another step towards market adoption of the new benchmark. Since SOFR First began to take effect, SOFR derivatives notional and transaction count have increased substantially. Freddie Mac and Fannie Mae have been lending based on 30-day average SOFR since Q4 2020, and anecdotally, Chatham warehouses nearly 50,000 loans in our industry-leading debt management platform and has begun to see commercial real estate borrowers close loans based on Term SOFR.

Regulators caution use of credit-sensitive rates

As SOFR transaction volumes increase, SOFR’s lack of credit sensitivity remains an issue for many in the market and, in part, has led a number of private market participants to develop and promote proprietary credit-sensitive benchmark rates, including AMERIBOR and BSBY. In recent weeks and months, regulators have continued to caution on the use of these rates.

On September 8, IOSCO released a statement expressing concern regarding the robustness and reliability of the available credit sensitive rates, specifically calling out the risk of the volume of trading becoming relatively large in relation to the underlying market. On a similar note, on October 20, U.S. prudential regulators issued a statement encouraging regulated entities (e.g., banks) to conduct due diligence around any alternative rate selection, including consideration of any fragilities associated with their chosen alternative reference rate and its underlying markets.

BSBY derivatives notional and transaction count remains significantly below that of SOFR and has not changed much since mid-October.

Recent and Upcoming Highlights in LIBOR Transition

We await a number of upcoming events:

• December 31, 2021
  • GBP LIBOR and JPY LIBOR (all tenors) will no longer be published on a representative basis, subject to FCA consultation on “synthetic” GBP and JPY LIBORs
  • With limited exceptions, banks are likely to stop offering new USD LIBOR-based loan or hedge products, per U.S. prudential regulators
• Q4 2021
  • U.S. lenders likely begin to move away from LIBOR-based lending
  • Federal legislation may advance
  • Final phase of SOFR First may be announced
• 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