On May 20, 2016, the New York Federal Reserve Bank's Alternative Reference Rate Committee ("ARRC") released an interim report announcing its preliminary recommendations on a replacement for LIBOR, the interest rate benchmark that dominates the leveraged loan market and has been the subject of ongoing controversy as a result of alleged illegal manipulation in the rate setting process. Voting members of the ARRC include regulators from the Federal Reserve Bank of New York and the Treasury Department, and representatives of major global banks (Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, Nomura, RBS, Société Générale, UBS and Wells Fargo).
The ARRC narrowed its list of LIBOR replacements to two preliminary candidates — the overnight bank funding rate and an overnight Treasury-backed general collateral repo rate. The ARRC is now soliciting email comments from a wider group of users of interest rate derivatives, asking for their input by July 15, 2016. Thereafter, it is expected that the ARRC will select one of the two candidates as a final replacement rate for LIBOR and determine a process for implementing the replacement benchmark in the marketplace.
The ARRC's interim report submitted consultation questions, listed on Annex A hereto, to users of interest rate derivatives. It also provided a basic outline of the transition mechanics. The ARRC envisions a paced transition plan, whereby, as of some future date, derivatives clearinghouses (such as LCH.Clearnet and CME Group) will use only the new reference rate on newly registered swap contracts. Over time, legacy contracts using LIBOR will mature, be closed out or be liquidated. This will leave a clearing pool of products that references only the new benchmark rate.
The ARRC report did not give specific dates for the selection of a final replacement rate or the transition plan, but officials have publicly commented that those dates could come sooner than many market participants might expect. Federal Reserve Gov. Jerome Powell told reporters, "The plan is for the committee to pick a rate later this year with the expectation that trading in the new rate could begin as early as next year." The impact on leveraged finance will ultimately be significant, as once LIBOR is phased out, new loans will by necessity reference the new rate and outstanding loans may need to be amended to reference the new rate.
A full copy of the ARRC's interim report can be found here.
Annex A – Questions for Consultation
- The ARRC has narrowed its focus to two potential alternative rates, the Overnight Bank Funding Rate ("OBFR") and an overnight Treasury general collateral repo rate. Do you have a preference between these two rates? If so, why?
- Is there another potential rate that you believe should be considered by the ARRC?
- With respect to an overnight Treasury general collateral repo rate, the ARRC itself has expressed a preliminary preference for a rate that includes both cleared and uncleared triparty and bilateral transactions. Recognizing that no entity has committed to producing such a rate, would you prefer a repo rate that includes only triparty transactions or one that includes both triparty and bilateral transactions? Would the inclusion or exclusion of bilateral data materially influence your preference for a repo rate as a benchmark or cause you to prefer a repo rate to the OBFR?
- What concerns, if any, do you have that the alternative reference rates identified by the ARRC might be subject to manipulation if they were adopted? Are there concerns that the underlying markets, at times, could be highly concentrated or not sufficiently deep to discourage collusion? How do any concerns compare with similar concerns regarding already existing USD reference interest rates?
Paced Transition From Effective Federal Funds Rate to the New Rate
- Would the paced transition plan preliminarily outlined in the interim report lead you to seek to trade instruments and hedge risk linked to the new rate chosen by the ARRC?
- Are there considerations, such as the existence of a basis market between the new rate ultimately chosen by the ARRC (new rate) and the effective federal funds rate, (EFFR) that would aid in smoothing a paced transition for your firm? Are there potential disruptions that would concern you under such a plan? What are your biggest concerns relating to the paced approach outlined in this paper?
- Under the paced transition plan, if
markets referencing the new rate were sufficiently liquid would
- Be willing and able to trade to convert legacy contracts referencing EFFR as the floating index in your swaps to reference the new rate, and receive/pay any transparent at-market price change, given a basis market?
- Be willing to amend your ISDA credit support annexes to reference the new rate as the interest rate for cash collateral and receive/pay any transparent at-market price change due to change in discount regime?
- Be willing to migrate cleared positions that had price alignment interest ("PAI") based on the EFFR to contracts that had PAI based on the new rate, assuming you would be compensated for price changes?
- Could you transition only certain segments of your EFFR trading? If so, which segments would be easier to transition and what share of your trading do they comprise?
- If you could not transition certain segments of your trading, what would need to change to allow you to do so (external factors, internal systems, etc.)?
Transition from LIBOR
- Could you and would you be willing to transition some or all of your derivatives trading currently referencing LIBOR into overnight index swaps ("OIS") or futures referencing an alternative rate chosen by the ARRC if the OIS and futures market were sufficiently liquid?
- What criteria would you use to determine whether the OIS and futures markets referencing an alternative rate chosen by the ARRC were sufficiently liquid (Bid/ask spread, price impact, trade size achievable, trade frequency, etc.)? Would you be willing to participate initially at wider bid/ask spreads and without a long history of swap volume in the new rate in order to support the transition of the market to a more robust benchmark? Are there other considerations besides liquidity that would influence your choice?
- Could you transition only certain segments of your LIBOR trading, and if so, which segments would be easier to transition and what share of your trading do they comprise?
- If you could not transition certain segments of your LIBOR trading, what would need to change to allow you to do so (external factors, internal systems, etc.)?
- What concerns, if any, would you have to transitioning away from existing reset and payment conventions in OTC derivatives referencing LIBOR?
- Do you think the paced transition would have an adverse impact on the corporate bond market, consumer loans or securitizations? What would be needed for these types of products to reference the new rate?
- Do you have any other comments, concerns or questions regarding the preliminary plans outlined in the interim report?
- Are you interested in participating in a roundtable with the ARRC to further discuss the issues in this interim report
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