Market participants must act now as US Libor ends

It is no secret that US dollar (USD) Libor is coming to an end. By the end of this year, banks must stop writing new USD Libor contracts. The clock is ticking; with just three months to go, significant work remains.

As chair of the Alternative Reference Rates Committee (ARRC), the group of private market participants convened by the Federal Reserve to help ensure a successful transition from USD Libor, I urge all market participants with Libor exposures to immediately act and base their new contracts on the Secured Overnight Financing Rate (SOFR) — the ARRC’s recommended alternative to USD Libor.

We at the ARRC firmly believe that SOFR is the strongest alternative rate for institutions of all sizes. The rate is based on nearly $1tn of daily transactions conducted by a diverse set of borrowers and lenders in the Treasury repo market. This is much larger than the transaction volumes in any other US money market.

Put simply, SOFR is the only USD Libor replacement that is based on an underlying market that is vast enough — and liquid enough — to support the trillions of dollars’ worth of contracts that will reference it. To avoid repeating this arduous global reference rate transition ever again, we must make sure today’s solution is robust.

Understanding SOFR

SOFR is the most robust, resilient alternative rate, and it is best suited to truly anchor this transition.

In March, Libor’s regulator, the Financial Conduct Authority, and its administrator, the ICE Benchmark Administration, outlined precisely when the publication of representative Libor will end: December 31, 2021 for two of the lesser-used USD Libor settings, and June 30, 2023 for the remaining, more widely USD Libor settings.

These announcements align directly with previous US supervisory guidance, which encourages banks to stop entering into new USD Libor-based contracts as soon as practicable and in any event by December 31.

The good news is that there are tools available to ease the transition away from USD Libor to rates directly linked to SOFR — be it SOFR itself or averages of SOFR, including the averages published daily by the New York Federal Reserve.

In addition, as we entered the transition’s homestretch in the third quarter of 2021, the ARRC achieved key milestones related to its recommendation of a SOFR term rate that helps ensure market participants have everything they need, including for the subset of products where use of SOFR itself and averages of SOFR has proven to be difficult.

In July, inter-dealer brokers changed USD linear swap trading conventions from USD Libor to SOFR. This convention switch is part of the Commodity Futures Trading Commission Market Risk Advisory Committee’s SOFR First initiative — which is a phased effort for switching trading conventions from Libor to SOFR for USD linear interest rate swaps, cross currency swaps, non-linear derivatives and exchange-traded derivatives. This, along with the publication of recommended best practices and conventions for employing the SOFR term rate in loans paved the way for the ARRC to formally recommend CME Group’s forward-looking SOFR term rate.

This announcement is a massive achievement for the USD Libor transition specifically and for financial stability overall, as market participants now have what they need to use SOFR in all its forms across financial products. It is important to emphasise that, as laid out in its recommended best practices, the ARRC supports the use of the SOFR term rates because we recognise that there are certain areas where adapting to an overnight rate has been difficult, including in the business loans market. So, the ARRC recommends that market participants continue using SOFR itself and SOFR averages in areas where possible, including floating rate notes, many consumer products and securitisations — and does not support the use of SOFR term rates for the vast majority of derivatives, except for end-users to hedge cash products using the SOFR term rates.

These landmark moments are the culmination of months of steady momentum in the transition away from USD Libor, largely driven by announcements defining what the end of USD Libor will look like, how legacy contracts will be safeguarded and ways in which SOFR liquidity is deepening.

There have also been milestones in address challenges related to legacy USD Libor contracts. In April, Libor legislation was signed into law in the state of New York. The text of the legislation was initially presented by the ARRC last year and aims to address those contracts that are governed by New York law, mature after mid-2023 and do not have effective fallbacks. This is important because New York law governs a significant share of the financial products and agreements referencing USD Libor. This legislation provides legal clarity for these contracts and will lessen the burden on New York courts, since uncertainty about how to handle these contracts after Libor stops being published would have undoubtedly prompted disputes.

Later, in July, the House Financial Services Committee advanced the Adjustable Interest Rate (Libor) Act of 2021 bill. This federal legislation builds on the success of the New York law and, if passed, will significantly reduce operational and legal risks for market participants nationwide.

We cannot allow this promising momentum to falter. As we approach the end of the year, the ARRC encourages market participants to move full-steam ahead on three key priorities to ensure a successful Libor transition.

Use SOFR

First, all new contracts should be based on SOFR.

Supervisory guidance calls for banks to stop issuing new contracts on Libor no later than this year. Firms should only be entering into contracts based on Libor alternatives, and SOFR is the ARRC’s recommended choice among Libor alternatives.

Despite Libor’s fast-approaching end, exposures remain stubbornly high, as highlighted in a March 2021 ARRC progress report. Although the report highlighted the considerable uptick in SOFR trading activity, it also found areas where progress has been slow. Outstanding USD Libor exposures have increased from $199tn to $223tn between 2016 and 2020. That is unacceptable — especially as we enter the transition’s homestretch.

Use the AARC

Second, firms should use ARRC fallback language and renegotiate contracts where possible.

It is estimated that roughly two-thirds of current USD Libor exposures will mature before the end of June 2023, markedly reducing the number of legacy Libor contracts that must be dealt with after Libor’s cessation. However, an estimated $74tn of USD Libor exposures will remain outstanding beyond June 2023.

This underscores the necessity of finding solutions for legacy Libor contracts not covered by New York legislation — including by using the ARRC’s fallback language.

Support the legislation

Third, we must continue to support the federal legislation as it advances through the system.

Of the estimated $74tn in USD Libor exposures outstanding beyond June 2023, an estimated $1.9tn in exposures will remain in bonds and securitisations, many of which may have no effective means to transition away from Libor after its cessation. While New York legislation was a significant milestone, it only deals with New York-governed contracts. Federal legislation that specifically addresses these contracts is essential.

Time to act

Now that market participants are equipped with all the tools necessary to move to SOFR, achieving these three priorities is the clear path forward. All we need now is for market participants to take swift action and execute on these goals. The ARRC has provided the tools to write new contracts on SOFR, the educational materials to inform their institutions and the fallback language, and the New York legislation provides a statutory remedy for those contracts that do not have effective means to transition away from Libor.

Time is of the essence. Take action now — a successful Libor transition depends on it.

Tom Wipf is Alternative Reference Rates Committee chairman and vice-chairman of institutional securities at Morgan Stanley.