In September, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York's Alternative Reference Rates Committee (the "ARRC") released a consultation proposing fallback language to be used in floating rate notes ("FRNs") linked to LIBOR if LIBOR ceases publication in 2021 (the "Consultation").1 As discussed in a prior issue of this publication, in its July 2018 Guiding Principles, the ARRC chose the secured overnight financing rate ("SOFR") as the "risk-free" replacement rate to be used when LIBOR is no longer available.2 The Consultation covers a number of areas, but this article focuses on proposed definitions of a LIBOR cessation and the proposed waterfalls of fallback rates and spread adjustments.
Because LIBOR is an unsecured forward-looking term rate (overnight, one week, one month, three months, six months and one year) and SOFR is a backward-looking overnight secured rate, drafting a LIBOR floating rate note with a built-in replacement rate based on SOFR is not easy. As noted in the Consultation, LIBOR may tend to be higher than SOFR during times of severe credit market stress, due to LIBOR including an element of bank credit risk. SOFR, an almost risk-free rate, is expected to be lower than LIBOR and, during those times of severe credit risk, may stay flat or even tighten. The Consultation addresses proposed adjustments that are intended to mitigate the differences between LIBOR and SOFR.3
Defining cessation triggers. The International Swaps and Derivatives Association ("ISDA") has proposed two triggers, each based on a permanent cessation of LIBOR:4
- a public statement or publication of information by or on behalf of the administrator of [the relevant IBOR] announcing that it has ceased or will cease to provide [the relevant IBOR] permanently or indefinitely, provided that, at that time, there is no successor administrator that will continue to provide [the relevant IBOR]; or " a public statement or publication of information by the regulatory supervisor for the administrator of [the relevant IBOR], the central bank for the currency of [the relevant IBOR], an insolvency official with jurisdiction over the administrator for [the relevant IBOR], a resolution authority with jurisdiction over the administrator for the [the relevant IBOR] or a court or an entity with similar insolvency or resolution authority over the administrator for [the relevant IBOR], which states that the administrator of [the relevant IBOR] has ceased or will cease to provide [the relevant IBOR] permanently or indefinitely, provided that, at that time, there is no successor administrator that will continue to provide [the relevant IBOR].
These fallbacks would be triggered at the actual time of cessation if it were later than the time of announcement.
The Consultation adds additional pre-cessation triggers, which allow for a transition from LIBOR to a replacement rate without a permanent discontinuance of LIBOR:
- An unannounced stop to LIBOR, or a
permanent or indefinite discontinuance not meeting the ISDA
- a Benchmark rate is not published by the administrator of such Benchmark for five consecutive business days and such failure is not the result of a temporary moratorium, embargo or disruption declared by the administrator of such Benchmark or by the regulatory supervisor for the administrator of such Benchmark and the Benchmark cannot be determined by reference to an Interpolated Period;
- A material change to LIBOR –
too few submissions from the panel banks:
- a public statement or publication of information by the administrator of such Benchmark that it has invoked or will invoke, permanently or indefinitely, its insufficient submissions policy; or
- LIBOR becomes useless:
- a public statement by the regulatory supervisor for the administrator of such Benchmark announcing that such Benchmark is no longer representative or may no longer be used.
The last two bullet points above refer to the "Zombie LIBOR" scenario. Currently, there are 16 panel banks submitting quotes for US dollar LIBOR to the Intercontinental Exchange, Inc. ("ICE"), the LIBOR administrator.
ICE has a minimum submission number of four panel banks. If ICE were to continue to publish LIBOR with only six submissions from the panel banks, one or both of the last two cessation events above could be invoked.
Defining a waterfall of fallback replacement rates. Once one of the cessation events has occurred, the next step would be to go to a fallback replacement rate. The Consultation proposes the following waterfall of replacement rates:
- Step 1: Term SOFR recommended by the
Relevant Governmental Body (ARRC) plus a spread
- This would be a forward-looking term rate (e.g., 3-month SOFR)
- Term SOFR does not yet exist
- Step 2: Compounded SOFR plus a spread
- "In arrears" – forward-looking - the rate is calculated over the interest period for the FRN with a lockup period at the end; the rate will not be known at the start of the interest period5
- "In advance" – backward-looking – calculated at the start of the interest period using the historic Compound SOFR rate for the period that ends immediately prior to that date (the rate will not change even if it deviates during the relevant interest period)
- Step 3: Spot SOFR plus a spread
- Locks in the overnight rate for the duration of the interest period, and will not change during the interest period
- This option uses an overnight rate for the whole term with no adjustment
- Step 4: Replacement rate recommended by Relevant Governmental Body (ARRC) plus a spread
- Step 5: Replacement rate in ISDA
Definitions at such time plus a spread
- This option uses the fallbacks in ISDA Supplement No. 57 for USD-SOFR-COMPOUND6
- This would look first to the ARRC replacement rate for SOFR, then to the Overnight Bank Funding Rate and then to the Federal Open Markets Committee (FOMC) Target Rate
- Step 6: Replacement rate determined by issuer or its designee plus a spread
- Issuer/calculation agent discretion model
Defining a waterfall of spread adjustments. Once a replacement benchmark rate is determined, then a spread adjustment will be needed to make the LIBOR and SOFR rates more comparable.
- Step 1: Spread recommended by
Relevant Governmental Body
- ARRC for USD FRNs
- Step 2: Spread in fallbacks for
derivatives in ISDA definitions
- But ISDA has not analyzed whether its spread adjustments would be appropriate for nonderivatives
- This will apply only if using the ISDA fallback replacement benchmark
- ISDA anticipates this spread will be available through a vendor screen
- Step 3: Spread determined by issuer
or its designee
- Using an "industry accepted" adjustment
For each cessation trigger and the steps in the two waterfalls above, the Consultation requests input from market participants as to their feasibility and other aspects. The deadline for market participants to respond to those questions is November 8, 2018. The Consultation also includes draft fallback language to be used in new issuances of FRNs. The Consultation is an important step forward for draftspersons. Although the actual spreads have not yet been determined, once the ARRC receives feedback from market participants and releases its final disclosures, issuers of FRNs will have a good starting point for their LIBOR replacement disclosures.
1 The Consultation is available at: https://goo.gl/u8686g.
2 REVERSEinquiries, Vol. 1, No. 4: https://goo.gl/LhBygw.
3 See the Consultation at 4.
4 The ARRC is consulting with ISDA on the LIBOR transition.
5 Recent compounded SOFR FRN offerings have used the in arrears calculation, without a spread, as they are standalone SOFR FRNs and do not have to address LIBOR transition issues.
6 We discuss ISDA Supplement No. 57 in REVERSEinquiries, Vol. 1, No. 6, available at: https://goo.gl/wLZvsM.
Originally published in REVERSEinquiries: Volume 1, Issue
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