The end of USD LIBOR

On November 30, 2020, The Federal Reserve Board, Federal Deposits Insurance Corporation and the Office of the Comptroller of the Currency (“US agencies”) issued a statement on the future of USD LIBOR.[1] The statement does not constitute an index cessation event under the IBOR Fallbacks Supplement or the ISDA 2020 IBOR Fallbacks Protocol and does not trigger the fallback language.[2]

The key highlights of the statement were:

·     1W and 2M USD LIBOR will cease after December 31, 2021;

·     All other USD LIBOR tenors will cease after June 30, 2023;

·     Legacy transactions can continue using USD LIBOR till June 30, 2023 (with the exception of 1W and 2M USD LIBOR; and

·     No new transactions referencing USD LIBOR after December 31, 2021.

The announcement was welcomed by market participants, especially banks. The statement was interpreted as an 18-month extension to the life of USD LIBOR. This extension is expected to reduce the volume of legacy contracts with weak fallback language that would have required remediation.

The ARRC applauded the concurrent statements by the benchmark administrator, its regulator (FCA) and the US agencies which provide clarity on the proposed path forward for USD LIBOR.[3]

The euphoria surrounding the statement is evidence that market participants were not well prepared for USD LIBOR to cease at the end of 2021. Limited progress had been made in remediating legacy contracts with references to USD LIBOR. Additional considerations that contributed to the extension include, lack of SOFR liquidity, limited use of SOFR in cash markets, unavailability of SOFR-term rates and credit sensitive index and pending legislative solution. Further, the disruption caused by COVID-19 on individuals, businesses, and the financial services industry, as well as, legislative priorities focused on COVID-19 relief, further complicated the transition path.

The statement by the US agencies delays the deadline for new product readiness by six-month from June 30, 2021 to December 31, 2021. The ARRC Recommended Best Practices for Completing the Transition from LIBOR published in September 2020 recommended that no new LIBOR based business and consumer loans should be originated after June 30, 2021. The six-month extension will provide much needed reprieve to several market participants that were not fully prepared to support SOFR-based products and instruments. Some market participants expressed concern that the six-month extension may have an adverse impact on SOFR market liquidity and may delay the speed and scale of adoption of SOFR in cash markets (bilateral and syndicated business loans, and consumer loans).

We recommend that banks accelerate their preparedness for new product linked to SOFR and stop issuing USD LIBOR based loans no later than September 30, 2021 (allowing a three-month buffer). Readiness for issuing SOFR products and instruments should not be contingent on the availability of term rates or a credit sensitive index. In parallel, banks should continue exploring the possibility of an IOSCO-compliant credit sensitive index or alternate rates that incorporate a credit spread.

The statement by the US agencies confirmed that December 31, 2021 will be the cessation date for 1W and 2M USD LIBOR. The 1W and 2M USD LIBOR is less commonly used (estimated less than 5%) compared to other USD LIBOR tenors (e.g. 1M USD LIBOR). Hence, the earlier cessation for 1W and 2M USD LIBOR is expected to be less disruptive to market participants. Earlier cessation of 1W and 2M USD LIBOR may also be a helpful “dry-run” for the big event on June 30, 2023.

At the ISDA webinar, The Path Forward for LIBOR, hosted on December 4, 2020, a panelist highlighted that “If the one-week and two-month tenors are last published at the end of 2021, contracts that use those tenors can obviously no longer use those tenors. However, those contracts would not immediately fall back to the fallback rate. Instead, because the other US dollar LIBOR tenors continue to be available and be representative, the ISDA documents contemplate the rate being determined using linear interpolation. This is not something Bloomberg would do. Rather, it is for the calculation agent under the swap.”[4] Hence, there are likely to be crucial differences between the cessation event of 1W and 2M USD LIBOR at the end of 2021, and the cessation of all other tenor points after June 2023.

It should be noted that several contracts that do not currently use 1W or 2M USD LIBOR as the base rate provide the option to the borrower to use those rates (e.g. “rates may be fixed for “Interest Periods” (as hereinafter defined) of 1, 2, 3 or 6 months as selected by the Company”). Although the use of 1W and 2M USD LIBOR is an option that is available, it is unlikely that a borrower would insist on the use of a ceased reference rate after 2021.

We recommend that banks identify all contracts with references to 1W and 2M USD LIBOR maturing after 31 December 2021, ensure that the contract has robust fallback language, co-ordinate with the client to remediate the legacy contract (i.e. either transition the contract to an alternate reference rate or amend the fallback language). Banks should start remediating all contracts with references to 1W and 2M USD LIBOR maturing after 31 December 2021 no later than Q1 2021.

The most significant part of the statement by the US agencies was the ability to use USD LIBOR for legacy transactions (initiated before 31 December 2021) till June 30, 2023. We believe as time progress the initial euphoria associated will this statement will be more normalized, and market participants will realized that this extension will not be the elixir for legacy remediation.

We estimate that more than 50% of outstanding transactions mature after June 30, 2023, and only 25% of the contracts mature between 31 December 2021 and 30 June 2023. USD LIBOR will continue to be used for new transactions (at least till 30 September 2021); albeit at a slower pace. Hence, the volume of transactions that will require remediation will continue to grow and be material.

The ARRC published its proposed fallback language for USD LIBOR contracts in May 2019 (updated in August 2020 for hardwired fallback language). Since then most banks have updated fallback language associated with new transactions and extension of legacy transactions (e.g. when a transaction is up for renewal). However, most banks have used the amendment approach rather than the hardwired fallback. Although this is an improvement it does not fully resolve contractual ambiguity and could result in financial, legal and conduct risk in the event of USD LIBOR cessation. Several banks are starting to incorporate hardwired fallback language in contracts, beginning with syndicated loans.

In light of the statement by US agencies, banks should reassess their legacy contract remediation strategy in two categories (based on the maturity date[5]):

·     Legacy contracts maturing after June 30, 2023 - Banks should engage with their clients to change the reference rate USD LIBOR to SOFR or other ARRs (pricing amendment). Banks should leverage their business as usual credit underwriting and review process to engage with clients to remediate legacy contracts rather than perform an ad-hoc remediation. Transition by fallback amendment should not be the preferred transition strategy for legacy transactions maturing after June 30, 2023. Any dependency on a legislative solution should be limited to true “hard legacy” contracts with the onus being on the banks to demonstrate their remediation efforts. LIBOR Program Office should provide insights on existing contract language to the business lines to prioritize the remediation of contracts that are deemed to be high risk. Banks had planned to reach out to their clients starting Q1 2021 to remediate legacy contracts; this would have been a significant challenge. The extension provides the banks with more flexibility to take a thoughtful approach to legacy remediation and phase remediation efforts in line with market developments and client readiness over the next 24 months (Jan 2021 to Dec 2022).

·     Legacy contracts maturing before June 30, 2023 – If the IBA and panel banks agree to extend the publication of USD LIBOR till June 30, 2023, the risk of LIBOR cessation before that day is low. It will still be prudent for banks to amend the fallback language for contracts maturing before June 30, 2023, at the earliest opportunity. The contracts maturing before June 30, 2023 are likely to be a lower priority and banks should leverage their business as usual credit underwriting and review process to incorporate robust fallback language. More importantly, if contracts maturing before June 30, 2023 are likely to be renewed or extended, banks should either transition the contract to SOFR or incorporate hardwired-fallback language. We do not expect banks to proactively transition clients from LIBOR to SOFR or ARR’s unless requested by a client, if the contract matures before June 30, 2023. Given that USD LIBOR will be available till June 30, 2023, and LIBOR and SOFR will be observable, proactive pricing amendment initiated by the bank could result in financial or legal risk (especially, if the client is worse off as a result of the pricing amendment).

We recommend that banks do not take their focus away from LIBOR transition. Although the volume of legacy contracts that may require immediate remediation have declined by 25% there continues to be a significant volume of legacy contracts that will require remediation.

Also, the ability to use USD LIBOR for legacy transactions till June 30, 2023 is dependent on the willingness and ability of the panel banks to continue submitting LIBOR and the administrator agreeing to publish USD LIBOR. Although the outcome of the IBA consultation is uncertain and a risk - we expect it to be low risk given the extensive engagement (surveys and informal sounding) with panel banks and the administrator submitting USD LIBOR ahead of the announcement by the US agencies. Market participants are uncertain if the USD LIBOR published between Jan 2022 to Jun 2023, will be different to the USD LIBOR we use today. Although it can be assumed that the FCA will deem the rate to representative, it is likely to be less liquid which could have an impact on market participants.

One of the main challenges of LIBOR transition has been the remediation of “hard legacy” contracts that reference USD LIBOR, do not have robust fallback language, and mature after the end of 2021. To address the problem of “hard legacy” contracts, the ARRC had proposed a legislative solution that would minimize the legal uncertainty and adverse economic impact in the event of LIBOR cessation. The extension announced by the US agencies does not address the issue of “hard legacy” but merely reduces the number of contracts at risk (i.e. contracts maturing after June 30, 2023). We recommend that the ARRC, banking and capital markets sector, and the federal and state legislature continue to push for a legislative solution.

The statement by the US agencies extending the life of USD LIBOR by 18 months (for legacy transactions) and 6 months (for new product readiness) will be helpful in a smooth and orderly transition. We expect the extension by US agencies will be combined with a heightened scrutiny on transition readiness across the regulated sector. To date, the supervisory expectations on LIBOR transition readiness has been applied with a relatively “light touch” especially, for non-GSIBs. We expect LIBOR transition readiness will be a core component of supervisory agenda in 2021.

USD LIBOR is on life support and banks should not assume that it will receive another jolt of life at the end of 2021 or before mid-2023. The IBA is consulting on the cessation of euro, sterling, swiss franc, and yen LIBOR after December 31, 2021. Although USD LIBOR is more extensively used both on-shore and off-shore, banks should not assume that it will continue to be extended.

The path to the demise of USD LIBOR is now clear. However, what remains uncertain is the speed and scale at which SOFR can replace USD LIBOR as the preferred alternate reference rate, especially in cash markets, without a term rate and credit sensitive index.

[1] https://www.federalreserve.gov/newsevents/pressreleases/bcreg20201130a.htm

[2]https://www.isda.org/2020/11/30/isda-statement-on-iba-uk-fca-and-federal-reserve-board-announcements-on-us-dollar-libor-consultation/

[3]https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Press_Release_Applauds_Milestone_Transition_US_Dollar_LIBOR.pdf

[4] http://assets.isda.org/media/f1a442f2/80e230bf-pdf/

[5] Additional considerations include, maturity date extension option, quality of fallback language, jurisdiction, borrower consent requirements, interest rate amendment provisions, etc.