LIBOR transition update — Q4 2021 review

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 adopted “SOFR 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.

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.