Libor’s final days

One too many obituaries have been written for the London interbank offered rate (Libor) in the decade since the 2012 market-rigging scandal that precipitated its downfall. Great lives lend themselves easily to a beginning, middle and end, but it is not so simple in markets, let alone with a benchmark rate that once underpinned $300tn-worth of financial contracts.

On June 30, 2023, yet another milestone in the saga looms: the end of US dollar Libor. It will mark the end of a two-year process by which UK and US regulators have tried to map out an orderly transition from Libor to other reference rates.

While the Financial Conduct Authority (FCA) announced the cessation of Libor in March 2021, in reality it took almost a year to begin weaning financial markets off the benchmark rate.

The first step was to wrap up Libor settings – calculated using submissions from a panel of banks – for all sterling, Swiss franc, euro and Japanese yen tenors, as well as for one-week and two-month US dollar tenors by December 31, 2021.

The second, perhaps more important, step is the upcoming June deadline for all remaining US dollar tenors. After that point, around $95tn in contracts – from debt instruments to derivatives – will have their Libor reference rates automatically swapped over to so-called fallbacks and other alternative rates.

Fallbacks refer to the replacement rates that would apply should the relevant benchmark become unavailable during the life of the contract.

Nathaniel Wuerffel, a senior vice-president at the Federal Reserve Bank of New York, likens the pervasiveness of Libor in the financial system to clamming with his family in Oregon.

“As the water recedes from the mudflats, the clams are everywhere. And then, if you want to go get the clams, you have to dig deep. And it’s a messy job,” he says. “That really strikes me as what the Libor transition has been like [for all of us at the Fed].”

This analogy belies the complexity of the transition. Beyond the more eye-catching headlines of ‘palace intrigue’ – as accused traders are acquitted of their role in the rate-fixing scandal – a silent revolution has taken place in the shift from Libor to the Fed’s chosen new reference rate, the secured overnight financing rate (SOFR).

The great changeover

According to database Debtwire Par, by the end of April 2022 around 96% of recently issued US loans had SOFR as their benchmark. “SOFR, so good,” many have quipped.

Unlike Libor, a credit-sensitive rate, which includes the cost of funds to banks, SOFR is a risk-free rate tied to the cost of borrowing against US treasuries (i.e. overnight repurchase agreements). Therefore, Libor is an unsecured lending rate, whereas SOFR is a secured rate. Theoretically, this leaves SOFR less open to the sorts of market manipulation that plagued Libor in the past.

But it has not been an easy road. “At the end of 2021, we had an average daily volume of 36 contracts trading in our SOFR options,” said Sean Tully, a senior managing director at CME Group, a financial derivatives exchange. “I was feeling uncomfortable, to be perfectly honest, about where we were.”

However, as of February 2023, CME Group is seeing about 2.5 million contracts traded on average every day, alongside $12.8bn in cleared SOFR-based swaps.

In less than a year, the situation has been flipped on its head. According to the Financial Stability Board, comprising central bank governors and regulators from across the world’s largest economies, SOFR is now the predominant reference rate in cash markets, while almost all new US dollar syndicated loans refer to the new rate, compared with 30% in December 2021.

At the beginning of 2022, if you told a borrower you wanted to price something on SOFR, “people would look at you as if you had two or three heads”, says Tal Reback, a director at private equity firm KKR.

Even when Libor was in its final stages, market participants struggled to part ways with the tarnished benchmark rate. Indeed, a Financial Times report that investment groups Jefferies and Antares Capital had pitched a $395m Libor-indexed loan to investors, despite ongoing efforts to have it outlawed, raised eyebrows in January 2022.

“It has become business as usual now,” says Ms Reback, praising the ease with which firms have adapted to using SOFR, as if it had never been otherwise.

Legacy issues

Still, she argues that for legacy Libor loans – those that pre-date the transition – “we are well behind where we should have been with less than six months left”. In particular, “tough” legacy contracts could prove even more difficult to solve as liquidity in Libor-instruments shrinks, while operational traffic jams at agent banks, drafting amendments and the potential use of a synthetic version of Libor could further delay the transition.

These tough legacy contracts are contracts that have Libor wording, which are unable, before the June deadline, to either convert to another rate or be amended to include fallback provisions.

In 2020, the Bank of England’s Tough Legacy Taskforce identified four common characteristics that make contracts more difficult to transition, regardless of asset class, including: where there are structured transactions, with Libor referenced in one or all of the constituent elements; where the distribution of a product is broad; the volume of outstanding contracts; and the nature of the customers involved.

As the process has unfolded, bonds, derivatives, and bilateral and syndicated loans have emerged as the main stumbling blocks to a full transition from US dollar Libor to SOFR.

For example, a legacy bond often requires the consent of some or all its bondholders to amend its provisions, which do not contemplate the permanent discontinuation of Libor. This is further complicated by the fact that many originators or sponsoring entities no longer exist, or the economic interest in the transaction has been sold to a third party. In these cases, it is very unlikely, or even impossible, that the bond will be transitioned by consent, which highlighted the need for a legislative solution to avoid potential litigation.

Luckily, this is a marginal issue, and more than 90% of outstanding Libor contracts are in derivatives products, where the transition has been aided by the use of standardised contracts, centralised clearing and the widespread adoption of the International Swaps and Derivatives Association’s (Isda) Ibor Fallbacks Protocol.

The protocol replaces Libor language with a version of SOFR plus a credit spread adjustment (CSA), which reflects the historical difference between the outgoing and incoming rates.

In contrast to cash products, which require bilateral negotiations, the Ibor protocol applies that uniform set of fallbacks for all legacy derivatives through a handful clearinghouses, such that an industry-wide approach is possible.

According to Isda, more than 15,500 buy- and sell-side entities have signed onto the protocol, including large financial institutions, as well as smaller banks, college endowments and charitable foundations.

“I was very clear to my internal risk people that we were going to sign it,” says Chris McAlister, global head of derivatives trading at multinational insurance firm Prudential. “It was the single most important thing we could do.”

He adds: “We would not have taken on any new external counterparties that had not signed that protocol, so I think that was a really important tool that the market had at its disposal.”

In order to prevent a clog in the system, both CME and LCH, another large clearing house, have chosen to stagger the dates in April and May, well ahead of the deadline, for when their remaining cleared US dollar Libor derivatives will be switched over to SOFR.

“The sheer volume of trades that will be affected means firms should take the time between now and June 30 to fully understand how the fallbacks will work and how their mechanics compare to standard SOFR overnight index swaps,” says Ann Battle, head of benchmark reform at Isda.

Loan bottleneck

Bilateral and syndicated loans face many of the same challenges as bonds, with lender consent thresholds for amendments, in addition to the large volumes of contracts and diverse nature of the borrowers. For example, retail holders of mortgages who are not actively engaged in the Libor transition could find themselves in its crosshairs.

According to data collated by KKR, as of December 31, 2022, only about 21% of the syndicated loan market had transitioned to SOFR, with lower-rated loans lagging behind most.

David Ridley, a partner at law firm White & Case, says there is “a lot of wood to chop”, and fears a bottleneck for some banks and lenders the closer the deadline comes.

“In the first month of this year, we’ve seen an uptick in amendments getting launched, so it seems like people are focusing and paying attention, and trying to move things forward,” he says. “However, it’s a huge job that remains, and we’re going to see a large number of amendments come into the market in the coming months in order to meet that deadline.”

One issue facing parties is the troubled market for new loan issuance. Last year, Russia’s invasion of Ukraine, rising interest rates and decades-high inflation raised the spectre of a recession, and sent the loan market into a tailspin. New refinancing activity – transactions which would normally allow lenders to revisit existing debt and convert it to SOFR – all but dried up, putting the brakes on what otherwise had been a smooth transition. The slowdown saw the collapse of big-ticket transactions, including Citigroup and Bank of America abandoning part of a planned $2.9bn debt sale to fund Apollo Global Management’s takeover of auto parts manufacturer Tenneco, after steep discounts and higher yields failed to allay the concerns of investors.

The trouble banks have had in syndicating their loans means that there is a backlog on their books, which makes them reluctant to go out and underwrite new deals, exacerbating the problem. This has further called into question the use of CSAs, as SOFR unexpectedly rose higher than Libor in July 2022 amid the market turmoil.

The Alternative Reference Rates Committee, an industry body under the Federal Reserve, published the CSA numbers in March 2021 based on the median difference between Libor and SOFR averaged out over a five-year period, meaning the figures are static and do not reflect market shifts in either rate. As a result, many new deals have been done without the CSA, or at a flat rate of 10 basis points (bps) (as opposed to 11bps, 18bps, 26bps, and 43bps for one-, two-, three-, and six-month tenors, respectively).

Whether or not the CSA is applied will depend on which approach – amendment or hardwired – is taken to the fallback language. The former relies on the parties agreeing on a replacement rate, whereas the latter specifies the choice of replacement rate upfront.

Minimising fallout

Where possible, regulators have striven to put in place safety nets that minimise the risk of disputes and costly litigation. That is why Libor acts were passed at the New York state and US federal levels. Under the New York bill, the right to rely on SOFR plus a spread adjustment as a suitable fallback was enshrined in law, with contractual continuity and safe-harbour provisions to shield parties from liability under potential lawsuits.

While Libor loans under English law typically fall back to the cost of funds, similar loans under US law tend to fall back to the prime rate, which as of February 2023, was priced at 7.75% compared with 4.89% for three-month SOFR, making it a deeply unattractive prospect for borrowers.

If not SOFR, the prime rate or the cost of funds, however, market participants may rely on synthetic Libor, a non-representative set of Libor tenors, that the FCA will run until September 30, 2024, for use in all remaining legacy contracts, except for cleared derivatives.

Edwin Schooling Latter, director of markets and wholesale policy at the FCA, has previously warned that synthetic Libor will not be for new business, and should only be seen as “a smoothing of the off-ramp”, in a similar vein to what happened with yen Libor.

A final decision is pending review, but should become available soon. An FCA spokesperson said: “We are currently considering responses and we expect to announce our decision late first quarter or early second quarter of 2023.”

Chris Palmer, head of the Libor transition programme at JPMorgan, says: “Whether it happens to be June or September next year is somewhat irrelevant. It’s more about picking a date, sticking to the date and then everyone knows it. The trouble with this programme has been the lack of clarity throughout. It’s been difficult because, as you can imagine, clients don’t want to move until they know what’s happening.”

Whatever the case, Fitch Ratings forecasts that as the SOFR debt pipeline builds, so, too, will “the depth and liquidity of SOFR swap trading, which may mean the market coalesces around SOFR over time”.

Mr Ridley at White & Case agrees: “Our expectation is that once the dust settles, the entire US loan market, with de minimis exceptions, will be a SOFR market.”