Perspectives | 1 May 2020
The Alternative Reference Rates Committee (ARRC) continues to support market participants in their efforts to transition from USD London Interbank Offered Rate (LIBOR) towards the Securities Overnight Reference Rate (SOFR). Following the Financial Conduct Authority’s (FCA) March 2020 statement that the expected LIBOR cessation deadline remains unaltered – i.e. end of 2021 – ARRC published a set of key objectives for 2020, aiming for a smooth IBOR transition. In line with this, the Working Group has also proposed a legislative solution to minimize market participants’ exposure to legal and litigation risk and announced the development of recommended “Best Practices” for the industry to boost the transition’s progress further.
ARRC’s
defined objectives[1] are
accompanied by priorities and milestones to be achieved during the year 2020.
The objectives defined for 2020 are:
- boost usage and liquidity of SOFR;
- enhance market infrastructure to support SOFR;
- improve contractual fallbacks;
- focus on consumer products;
- provide support on legal, tax, accounting and
regulatory matters; and
- stimulate outreach, education and global
coordination.
Aiming to support SOFR usage and liquidity, amongst
others, the Working Group (WG) has set a deadline for September 30, 2020 to
establish a request for proposal (RFP) process in selecting an administrator
for a forward-looking term rate. By the same date, the WG plans to meet its
target of improving contractual fallbacks by establishing an RFP process to
select an administrator to publish the spread adjustments and spread-adjusted
rates. It also plans to publish a set of revisions to business loans’
hardwired fallback language by June 30, 2020.
In addition, the WG is guiding participants on an
ongoing process with their operational and infrastructure changes that are
necessary for the post-LIBOR era. Complementary to that, it is supporting its
objective to provide more clarity on consumer products by publishing
recommended fallback language for new IBOR-linked student loans and guidance
for new SOFR-linked loans by June 30, 2020. The process of providing support
with tax, accounting, legal and regulatory issues will continue throughout
2020.
Notably, as part of its support with legal issues,
ARRC recently proposed a legislative solution to “minimize legal uncertainty and adverse
economic impact associated with LIBOR Transition”[2]. Due to a large
volume of financial contracts not having embedded fallback languages that
account for a permanent LIBOR cessation, there is considerable risk of
participants incurring financial losses due to unresolved legal issues. In
response to that, the WG is providing legal certainty with issues that may
arise under New York law. For example, in the event that a legacy contract’s provision falls back to a Libor-base rate then, under the proposed
legislation, this should be overridden with a fallback language that falls to
the recommended benchmark replacement rate. Such a solution would avoid the
referencing of a benchmark rate that is no longer representative and reduce the
likelihood of incurring legal and economic consequences.
ARRC’s proposal provides legal clarity to market participants by
addressing cases of specific types of contracts. In the US, some contracts such
as floating rate notes, securitisations and syndicated loans require the
consent from each holder to change the benchmark interest rate. As this
involves a significant operational burden – especially if retail investors are
involved – the proposed legislation would nullify this mechanism and implement
a fallback language that would continue to reference an interest rate in the
wake of LIBOR’s death. Similar to
this is the situation for derivative securities that cannot be amended under
the International Swaps and Derivatives Association (ISDA) protocol. ISDA
requires both parties of the derivative contract to adhere to the protocol in
order to change the contract’s
provisions. As such, the WG’s
legislative proposal aims to solve situations where
the adherence of both parties is operationally hard to achieve by defining the
polling mechanism as void.
The WG’s initiatives to ensure a smooth transition away from IBOR seem to be helpful for market participants as they provide clarity to situations where there is ambiguity. In fact, Tom Wipf – ARRC’s chair – has stated that market participants are recognising how much harder transition would be in the absence of any legislative proposal, referring to the one discussed above[3]. Despite ARRC’s dynamic approach to publishing its objectives for 2020 and the milestones it sets out to achieve, progress still lies within the hands of market participants. They should be proactive in identifying their IBOR exposures and setting up plans to transition away from LIBOR without incurring financial losses.
Article written by Grigorios Alogoskoufis and Pauline Pélissier.
[1] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_2020_Objectives.pdf
[2] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Proposed-Legislative-Solution.pdf
[3] https://www.risk.net/regulation/7525036/lawyers-pick-holes-in-libor-statutory-fix
