On July 9, 2018, the Alternative Reference Rates Committee (the "ARRC") announced voluntary guiding principles for market participants to use in developing new LIBOR fallbacks for cash products, which include USD LIBOR floating rate notes.1
As we discussed in an earlier article in this publication, issuers of floating rate notes have begun to adjust their LIBOR fallback mechanisms to avoid having their floating rate notes default to fixed rate notes when LIBOR ceases to be published in 2021.2 Some of the issues we discussed in our article are covered in detail in the ARRC announcement: the need for an exact definition of what constitutes a LIBOR cessation, the use of a substitute rate, adjustments to the substitute rate to account for the various LIBOR tenors and the extent of discretion allowed to the entity that chooses the substitute rate or makes necessary adjustments to that rate.
We summarize the points in the ARRC announcement below and raise a few questions.
It's time to get your head out of the sand. At this point, issuers should have some improved fallback language in place. The process will be iterative, and issuers should be willing to adjust their disclosure over time until "absolutely the most robust language possible has been identified."
The goal is uniform precision. More flexibility and discretion may be used in the beginning of the process, with a view to moving toward more specific language that removes ambiguity as to how fallbacks and adjustments will be selected. As a market consensus emerges on the key items (i.e., specific triggers, the successor rate, the spread adjustment mechanism, and the term structure), then disclosures should become more uniform and eliminate unnecessary variations. Limited discretion minimizes opportunities for dispute.
No mavericks. Draftspersons should keep an eye out for what is developing in other asset classes; for example, loans and derivatives. Revised fallback mechanisms for LIBOR floating rate notes should not be drafted in a vacuum.
Yes, SOFR is the new rate. The secured overnight financing rate ("SOFR") or a benchmark based on SOFR should be the replacement rate for LIBOR where appropriate and practicable.
No more polls. Stating the obvious, the ARRC discourages market participants from relying on the existing LIBOR fallbacks, which create the illusory situation of calculation agents calling up banks to get quotes for rates in a situation where a rate based on quotes was not published.
Where's the beef? The ARRC release states that "[m]echanics for determining successor rates, spread adjustments and term structures should be feasible from an operational perspective."
Agreed. The adjustment to move from a forward-looking term rate (LIBOR) to a backward-looking secured rate (SOFR) is the missing piece of the LIBOR replacement puzzle. According to published reports, this adjustment will not be fully determined until late 2021, just in time for LIBOR cessation. The ARRC release notes that market participants should understand "how any successor rate may behave relative to LIBOR in different stages of the economic cycle and in different economic conditions."
The ARRC release does not address the complexity of building an adjustment mechanism that will allow SOFR to behave like LIBOR in normal and stressed environments. Although SOFR with an adjustment may track a LIBOR tenor in a normal market, there may be a divergence in stressed economic conditions. That raises the question of how will "stress" be defined and how will a spread be triggered? Who will determine the parameters? The ARRC release does state that the fallback language "should explicitly allow for a spread adjustment to minimize valuation changes" and that the calculation agent or similar entity making the adjustment should be adequately protected in making any determinations. Future failure. The ARRC release recommends that draftspersons make the new fallbacks "future proof"; i.e., address a potential cessation of the replacement rate. The rate formerly known as LIBOR. Assuming that SOFR has a successful run over the next few years and quants have come up with a workable risk spread adjustment and term structure, by 2021 the market will have a new "risk-free" rate that walks and talks like LIBOR, but will operate under an assumed identity.
Coordination with global regulatory push to eliminate LIBOR. While the ARRC release focuses on the details, both UK and U.S. officials are trying to drive LIBOR out of the picture. The UK Financial Conduct Authority Chief Executive Andrew Bailey characterized the current pace of the switch from LIBOR to a replacement rate as "not yet fast enough." Mr. Bailey noted in a recent speech that new LIBOR-based swaps contracts are still being written and introduced. In the same vein, David Bowman, a senior official at the Federal Reserve Bank, said that the stock of LIBOR-based contracts needed to be reduced.3
Originally published in REVERSEinquiries: Volume 1, Issue 4.
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1 The ARRC Guiding Principles can be found at: https://goo.gl/eppZRt.
2 Our earlier article on replacing LIBOR fallback mechanisms can be found at: https://goo.gl/XYuESX.
3 See "Global Regulators Push for Faster Transition Away From LIBOR," Wall Street Journal (July 12, 2018).
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