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LIBOR transition update — Q4 2021 review

Date:
January 10, 2022

Summary

Chatham’s update on the LIBOR transition, summarizing recent news, upcoming deadlines, and available resources to help you stay current as the market transitions away from LIBOR.

As we pass the end of 2021 and several significant deadlines, this update will address the status of SOFR hedging markets, expectations regarding the continued use of USD LIBOR, USD LIBOR transition legislation and litigation, and the GBP LIBOR transition. We address these and other updates below, along with some things to keep in mind as we begin the new year.

Latest quarterly highlights in LIBOR transition

SOFR hedging markets

As we have noted previously, the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission (CFTC) has adoptedSOFR First,” a four-phase initiative to prioritize trading in SOFR rather than USD LIBOR. The third phase of SOFR First, related to non-linear derivatives, took effect on November 8; and on December 13, the Interest Rate Benchmark Reform Subcommittee of the MRAC issued a user guide for the fourth and final phase of SOFR First, encouraging all market participants to replace the use of USD LIBOR with SOFR in new exchange-traded derivatives beginning in 2022.

With that, in their user guide, the CFTC cited the Federal Reserve’s November 2021 Financial Stability Report, noting that SOFR activity has represented 60–100% of total interdealer swap transactions on most days since SOFR First took effect on July 26. While overall trading slowed near the holidays, SOFR trading was up relative to that of LIBOR, representing 60–70% of LIBOR volume, the highest relative ratio to date.

    Figure 1. Comparison of LIBOR and SOFR trading volume in Q4 2021. Source: Chatham Financial and DTCC

    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. Among our client base, we began to see derivatives indexed to CME Term SOFR close in early November with volume ultimately representing nearly 20% of all non-LIBOR transactions on which Chatham advised in Q4 2021. Certain market participants, however, are uncomfortable with Term SOFR, given the depth of liquidity in the futures markets that underlies it.

    Continued use of LIBOR

    As we have discussed previously, U.S. prudential regulators have encouraged banks to cease entering into new LIBOR-based loans and derivatives beginning in 2022. However, the prudential regulators have acknowledged certain “limited circumstances” where it may be appropriate for banks to continue to use USD LIBOR, including contracts executed to hedge the borrowers’ pre-existing exposure to LIBOR-indexed contracts executed prior to December 31, 2021.[1]

    For borrowers attempting to utilize these exceptions, Chatham has seen many banks requiring the borrower to submit documentation confirming the pre-existing nature of the risk. 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.” Based on this guidance, the CFTC indicated in their User Guide that one might expect lower activity and higher transaction costs in USD LIBOR-based markets.

    USD LIBOR transition legislation and litigation

    Over the past quarter, there have been several significant developments in LIBOR-related legislation and litigation.

    On December 8, 2021, the U.S. House of Representatives passed the Adjustable Interest Rate (LIBOR) Act of 2021, which seeks to insert by operation of law a risk free rate fallback into certain LIBOR-indexed contracts. This federal legislation tracks with a similar law enacted by the State of New York in March 2021, aiming to incorporate the same provisions for contracts governed by New York law. As discussed in an earlier update, the bill also seeks to incorporate a provision allowing parties to make conforming changes to any covered contract as well as to provide market participants with a safe harbor from liability arising from the transition away from LIBOR. The bill now moves to the U.S. Senate for consideration.

    On December 23, 2021 a federal judge ruled against plaintiffs who sought the immediate discontinuation of LIBOR. The plaintiffs in the litigation, McCarthy v. Intercontinental Exchange Inc., allege that the process and procedures used to set LIBOR are inherently anticompetitive and a violation of the Sherman Act. In ruling against the plaintiffs, the court found that the potential harm resulting from the dislocation of the broader financial markets from the immediate discontinuation of LIBOR outweighed the potential harms claimed by the plaintiffs. Chatham will continue monitoring this litigation as pieces of it are still ongoing.

    In a separate case, a U.S. federal court revived antitrust litigation accusing several financial institutions of conspiring to fix the LIBOR interest rate benchmark. The court of appeals’ ruling was a procedural victory for plaintiffs and overturned the district court’s decision that it lacked jurisdiction to hear the plaintiffs’ claims. This decision did not rule on the merits of this long-standing litigation, In re LIBOR-Based Fin. Instruments Antitrust Litigation, and the case was returned to district court for further proceedings.

    GBP LIBOR transition update

    We are now past the last days of GBP LIBOR, though the FCA and other bodies have committed to publish a “Synthetic LIBOR” through the end of this year (subject to possible continuations). Synthetic LIBOR consists of:

    1. The Term SONIA rate (published by ICE Benchmark Administration (IBA) or Refinitiv and currently in the public domain free of charge) plus
    2. The appropriate credit adjustment spread for one-, three-, and six-month tenors based off of the ISDA five-year historic median calculations published in March. Under this methodology, the credit adjustment spread for a three-month term is 11.93 bps.

    Synthetic LIBOR has applied to debt instruments whose interest periods have reset since the beginning of the year by operation of law, and market standard pre-cessation triggers are unaffected. For those debt instruments that are still indexed to GBP LIBOR and will not transition to SONIA as of their next interest rate reset date, synthetic LIBOR will apply to those debt instruments as of their next interest rate reset date.

    Looking ahead

    As the market moves to a post-LIBOR environment, please contact your Chatham representative if you have any questions about transitioning your portfolio to a new rate.

    [1] The limited circumstances specifically identified by the US prudential regulators are: (I) transactions executed for purposes of required participation in a central counterparty auction procedure in the case of a member default, including transactions to hedge the remaining USD LIBOR exposure, (ii) market making in support of client activity related to USD LIBOR transactions executed before January 1, 2021, (iii) transactions that reduce or hedge the institution’s or any client of the institution’s USD LIBOR exposure on contracts entered into before January 1, 2022; and (iv) novations of USD LIBOR transactions executed before January 1, 2022.

    Need help with your LIBOR transition?

    Ask the Chatham team about how the LIBOR transition could impact your loans and derivatives.

    About the authors

    • Matt Hoffman

      Director
      Business Development

      Real Estate | Kennett Square, PA

      Matt is a Director on Chatham’s Real Estate team. He works with clients, industry partners, and policymakers, using Chatham’s unique experience and expertise to benefit individual clients and the industry.
    • Kevin Jones

      Director
      Treasury Advisory

      Corporates | Kennett Square, PA

      Kevin Jones serves Chatham’s corporate clients in interest rate and foreign currency hedging advisory. Kevin’s expertise spans risk quantification and analysis, hedging strategy development, market dynamics, and trade execution.
    • John Hutchinson

      Kennett Square, PA

      John Hutchinson is a quantitative analyst on Chatham’s technology team and a core member of the IBOR transition working group.
    • Kristianna Nelson

      Director
      Treasury Advisory

      Corporates | Kennett Square, PA


    Disclaimers

    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.

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