LIBOR Transition: Takeaways from the Benchmark Rates Series Benchmark Rates Forum New York

Presenters at the Benchmark Rates Forum from KPMG, Bank of America Merrill Lynch, NatWest Markets, Wells Fargo, JP Morgan, TD Securities, RBS, Santander, Société Générale, UBS, the Federal Home Loan Bank of New York, the LSTA, Pendo Systems and Orrick addressed a wide variety of market, legal and other LIBOR transition issues (some also discussed at the recent ARRC Roundtable. Uncertain timing of the transition, the remaining uncertainty as to the alternative benchmark to be chosen by the market and the continued lack of preparedness of large parts of the market were recurring themes in many of the presentations.  We have summarized our key takeaways of the conference, building on our report from the ARRC Roundtable:

SOFR

• Resistance at this time to pricing loans off SOFR.
• Will a SOFR term structure emerge?
• "For now, give up on the term rate in SOFR. Stop thinking about it. Bet that there will not be an IOSCO compliant term rate." Derivatives market will not move to a term rate structure.
• Lack of term, lack of credit component; chicken and egg component re liquidity.
• Will FHFA and the GSEs establish a SOFR path that the loan market will follow? Maybe.
• U.S. Treasury move to SOFR-based floater product would make a big difference.
• Big swings in SOFR at yearend (repo yearend spike, etc.) have given people ammunition to push back against SOFR.  
• End user hedging demand still not there in the SOFR derivatives market.

What are best practices for issuing SOFR based instruments?

• Use uniform conventions so that operations can be built to support the market.
• SONIA market has used uniform conventions, although the SOFR FRN market has thus far not used uniform conventions.

What are best practices for issuing LIBOR based instruments?

• Don't . . . ! ("When you're in a hole, stop digging." Stop transacting in LIBOR.)
• If concern re market receptivity, continued uncertainty and operational challenges at this time preclude SOFR issuance, use ARRC recommended fallback provisions.

Alternatives to SOFR

• End user clients want a credit sensitive alternative for loans.
• Will a credit sensitive alternative benchmark emerge?
• ICE Bank Yield Index (BYI: "Bring Your Own Index")
  • BYI has same problem as LIBOR; not a lot of volume.
• Will segments of the market adopt different alternatives? Impact of lack of consistency if that is what develops?
• Client base is in a state of paralysis.

Basis Risk

• Consider basis between securitizations and other liabilities that adopt a specific fallback protocol and that fund specific assets that may not have adopted the same fallback protocol: CMBS/CLOs/RMBS/etc.
• Consider basis between liabilities that adopt a specific fallback protocol (e.g. including pre-cessation triggers) and related hedges that may not have adopted the same fallback protocol.

Uncertainty

• Uncertainty encumbers the transition.
• Tax and accounting uncertainty exist regarding impact of a transition.
• Clarity desired regarding the LIBOR end date: FCA/Fed?
• Delays updating systems so long as there is uncertainty that SOFR will be the loan market fallback.
• Market is reluctant to move until there is more certainty.

Additional Regulatory Considerations

• Regulatory carrots and sticks needed to encourage preparation for the transition.
  • Carrot approach: Do the right thing. Bowman's cupcake. More needed.
  • Stick approach:
    • Supervisory discussions: Tell us you're going to be able to transition at end of 2021 (Quarles/Fed has said this is coming).
    • Regulators will require plans even when uncertainty remains. Tim Geithner used to say, "Plan beats no plan."
    • Regulators are "likely to" penalize banks that use LIBOR after 2021.
• Fed is "likely to" want to hold off on the transition until the market is ready.

Will LIBOR continue to be available after 2021?

• Approximately 80% of attendees, as well as of the market, expect that LIBOR will continue to be quoted after 2021.
• "Zombie LIBOR" (very few quotes based on very few market transactions) could result in disputes under contracts that provide for a transition to an alternative benchmark once LIBOR is no longer available.
• Some people are still in a denial stage and do not want to transition; some are in the acceptance stage.
• Some traders strongly believe that LIBOR is not going anywhere.

Will LIBOR continue to be available after 2021 for Legacy Contracts?

• Fed may encourage continuation of LIBOR at least for legacy instruments.
• Will the Fed and the ARRC encourage the continued use of LIBOR, if available, for legacy contracts?
• Could minimize, although would likely not eliminate, possibility of disputes.

Will LIBOR remain available until the end of 2021?

• Some banks want to get off the panel.
• Banks feel "understandable discomfort" about continuing to provide submissions based on judgments with so little trading activity.
• Will FCA require continued submission of quotes?
• FCA has said that an announcement may be made that LIBOR is no longer representative of the market. This would preclude banks subject to the EU benchmark regs from using LIBOR. Could impact U.S. banks as well.
• Pre-cessation triggers built into the ARRC recommendations could result in early termination of LIBOR.
• Derivatives market currently does not include a pre-cessation trigger.

Legacy Contracts

• Many legacy fallbacks look for quotes for LIBOR in the market or to the last print. Not what the parties intended. Also not the universal fallback.
• What do we do with the legacy book/how do we remediate?
• Will New York State legislation "fix" the problem?
• Would state legislation survive a challenge under the Contract Clause of the U.S. Constitution?
• Will there be federal legislation?
• Contract Inventory and Exposure Assessment:
  • What are the fallback provisions in the hundreds or thousands of legacy instruments on the books of banks and their clients?
  • How will these instruments be remediated once the fallback provisions are extracted from the legacy instruments?
  • Impact assessment across organizations is critical.
• ISDA protocol expected to deal with legacy derivatives contracts.

Disclosure of the pending LIBOR transition to consumer borrowers

• Are consumers who are now entering into LIBOR based instruments being advised of the possible transition to SOFR (or another alternative benchmark) now that it looks like LIBOR will (may) no longer be available after 2021?

Syndicated and bilateral loans

• Can be more easily amended than other products.
• Loan market included fallback language early on – amended approach.
• Hardwired approach likely to wait for term SOFR or other clarification.
• Biggest hurdle is operationalization.

How to minimize possibility of disputes

• Avoid value transfer: fairness; communicate with counterparties where possible.
• Use market conventions; follow market consensus.

Princess Bride/Game of Thrones

• Is it "inconceivable" that LIBOR will continue beyond 2021?

[Vizzini has just cut the rope. The Dread Pirate Roberts is climbing up].
Vizzini: "HE DIDN'T FALL? INCONCEIVABLE."
Inigo Montoya: "You keep using that word. I do not think it means what you think it means."

-Princess Bride

• Lots of pitfalls in implementation of the LIBOR transition.

"If you think this will have a happy ending you haven't been paying attention."

-Game of Thrones