Regulators are increasing pressure on financial institutions to demonstrate that they are proactively addressing the transition away from LIBOR. On December 23, 2019, the New York State Department of Financial Services (NYDFS) issued a letter to New York-regulated depository and non-depository institutions, insurers and pension funds seeking assurance that their boards of directors and senior management are on top of the thorny issues that surround the anticipated demise of the widely used London Interbank Offered Rate (LIBOR).1
The transition away from LIBOR, a rate that continues to be used in trillions of dollars’ worth of transactions, will be complex and take time to implement. Regulators are warning that insufficient preparations for the transition to alternative rates could have a negative impact on the safety and soundness of the financial markets globally and could adversely affect the financial condition of individual institutions with LIBOR exposure. While certain issues with respect to the transition are still being addressed and debated—including the particular appropriateness of alternative reference rates and mechanisms to address unilateral or bilateral changes to LIBOR-based transactions—standing by to await resolution of these issues is no longer a viable option for many financial institutions. Regulatory mandates like the NYDFS’ recent letter make it clear that if they have not already done so, financial institutions should: (1) be aware of their specific exposures to LIBOR, including beyond December 31, 2021; (2) consider the impacts of the LIBOR cessation on LIBOR-based transactions and their business generally; and (3) formulate and implement plans to address the currently inevitable transition away from LIBOR.
The United Kingdom’s Financial Conduct Authority (FCA) previously announced that LIBOR is expected to disappear after December 31, 2021, when panel banks will no longer be required to submit transaction data to the FCA that is used to determine the rate.2 The FCA has concluded (as have other regulators) that LIBOR is no longer viable because the underlying market that LIBOR seeks to measure—the market of unsecured wholesale term lending to banks—is no longer sufficiently active to produce reliable rates of interest. The largest classes of instruments referencing LIBOR are over-the-counter and exchange-traded derivatives, but a large number of loans (including those related to retail mortgages and consumer loans), floating rate bonds and notes, and securitized products also reference LIBOR. Accordingly, many products that reference LIBOR will be impacted by LIBOR’s demise, and the transition to alternative reference rates will impact a broad range of issuers, lenders, borrowers, investors, derivatives counterparties, and consumers, as well as their advisers and intermediaries. In the United States, the Alternative Reference Rates Committee (ARRC) has selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR.3 However, SOFR is different from LIBOR; in particular, SOFR is overnight/backward-looking and secured while LIBOR is a term rate and unsecured. Accordingly, certain adjustments to SOFR—i.e., a credit spread and averaging (or potential term rate)—are necessary to prevent a value transfer when adopting SOFR as a fallback to USD LIBOR in legacy instruments.
Other Regulatory Actions
The NYDFS is just the most recent regulator to require that entities prioritize the transition away from LIBOR. Other regulators have also been emphasizing the importance of a timely preparation by requiring regulated market participants to disclose in public filings, or report to regulators directly, the manner in which they are preparing for LIBOR’s demise and the progress that they have made so far. In July 2019, staff of the Securities and Exchange Commission (SEC) published a statement to encourage market participants—including public companies (whether or not financial institutions), investment advisers, investment companies and broker-dealers—to commence or carry on the following two action items in connection with the LIBOR transition: (1) appropriate disclosures of material exposure to LIBOR; and (2) the type of activities that market participants should engage in to manage such risk.4As a result of the statement, many public companies addressed the potential impact of the LIBOR cessation and transition in their recent SEC filings, including 10-Ks and 10-Qs.5 On December 30, 2019, the SEC published a public statement on the role of audit committees in financial reporting, in which it provided key reminders regarding the oversight responsibilities of such committees and stated that it encourages “audit committees to understand management’s plan to identify and address the risks associated with reference rate reform, and specifically, the impact on accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR.” In September 2019 the Federal Housing Finance Agency issued a Supervisory Letter to the Federal Home Loan Banks prohibiting them from: (1) purchasing investments in assets tied to LIBOR with a contractual maturity beyond December 31, 2021, after December 31, 2019; and (2) after March 31, 2020, entering into all other LIBOR-based transactions involving advances, debt, derivatives, or other products with maturities beyond December 31, 2021.6 In the United Kingdom, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) requested that supervised banks and insurance companies submit a summary of their plans to prepare to transition away from LIBOR and toward alternative interest rate benchmarks.7
Elements of Transition Plans and Resources
To prepare for the upcoming transition and in response to these regulatory requests, financial institutions have developed, or are in the process of developing, LIBOR transition plans. Broadly speaking, such LIBOR transition plans include the following items:8
- Determining direct and indirect exposure (and scope and sources of such exposure) to LIBOR, including in financial instruments and contracts that mature after 2021, by developing an inventory of financial instruments impacted by LIBOR;
- Identifying and evaluating the scope of existing financial instruments that may be affected by the transition, and the extent to which such financial instruments already contain appropriate fallback language or would require amendment, either through unilateral or bilateral amendments or through industry-wide tools, such as protocols;
- Evaluating and monitoring the impacts across businesses and the risks inherent in the transition, including litigation and other financial risks and nonfinancial risks;
- Consideration of and, where necessary, implementation of, enhancements to infrastructure, models and systems to prepare for a smooth transition to alternative reference rates;
- Consideration of governance, risk management, legal, operational, systems and operations, and other aspects of planning for the transition, including reporting, capital, accounting and tax;
- Active participation in working groups and responding to industry consultations, including of the ARRC, the International Swaps and Derivatives Association (ISDA), and the Loan Syndications and Trading Association (LSTA); and
- Educating clients and conducting appropriate outreach.
In addition, financial institutions are using resources developed by regulator-sanctioned working groups and trade associations, including:
- ARRC — The ARRC has developed recommended USD LIBOR fallback contract language that financial institutions should consider implementing in instruments referencing LIBOR on a going-forward basis. To date, the ARRC has released its recommended USD LIBOR fallback contract language for new originations of Floating Rate Notes (April 25, 2019), Syndicated Business Loans (April 25, 2019), Bilateral Business Loans (May 31, 2019), Securitizations (May 31, 2019), and Adjustable Rate Mortgages (November 15, 2019).9
- ISDA Benchmarks Supplement Protocol — A contractual supplement to derivatives trading documentation that amends the 2006 ISDA Definitions and adds triggers and fallbacks to determine a replacement rate with respect to any benchmark.10 The ISDA Benchmarks Supplement was developed in response to the EU Benchmarks Regulation, which requires, as of January 1, 2018, that certain parties produce and maintain robust policies including “written contingency plans” that apply upon a material change or cessation of a benchmark, but was drafted generically and is used irrespective of whether parties are in scope for the EU Benchmarks Regulation.11 The Supplement can be agreed to on a bilateral basis or via an ISDA Protocol, and parties can opt to have the Supplement apply to legacy transactions.
- ISDA 2006 Definitions — ISDA is in the process of publishing amendments to its 2006 Definitions to include written triggers and fallbacks for USD LIBOR and other IBORs. The fallback for USD LIBOR in the amended 2006 Definitions will be SOFR applied on a compounded basis in arrears. The amendments to the 2006 Definitions will apply on a going-forward basis to transactions that incorporate the 2006 Definitions. For legacy transactions that use either the 2006 Definitions or an earlier version, ISDA is developing a protocol that will amend such transactions upon adherence by the parties to the protocol.
- CFTC MRAC — The US Commodity Futures Trading Commission (CFTC) Market Risk Advisory Committee (MRAC) published a standard set of disclosures that market participants may use with all clients and counterparties with whom they continue to transact derivatives referencing LIBOR and other IBORs.12
- Resources developed by other trade associations, including the Loan Syndications and Trading Association, the Loan Market Association, and the Securities Industry and Financial Markets Association.
We anticipate that LIBOR transition plans will need to be flexible to address continuing market and regulatory developments, including resolution of currently debated issues such as those noted in this article. As a result, continued review and, if required, adaption of plans will be necessary, but will not obviate the need to commence or continue efforts to address the LIBOR transition.