The End of LIBOR: New Year’s Resolutions

‘Zombie’ LIBOR

In the UK FCA’s view, while synthetic LIBOR settings are:

a fair and reasonable approximation of what LIBOR might have been had it continued to exist, they are not representative of the markets that the original LIBOR settings were intended to measure.[1]

It is contemplated that synthetic USD LIBOR will be the sum of (i) Term SOFR plus (ii) the ISDA spread[2]. Thus, synthetic USD LIBOR will be a non-representative rate.

Term SOFR

Derivatives-Based Rate

Term SOFR is based upon derivative market transactions which rely on the continued existence of a deep and liquid derivatives market.

Limited Recommended Use

According to the UK FCA, the use of Term SOFR should be in line with the recommendations (which are not requirements) of the Alternative Reference Rates Committee (ARRC) and the Financial Stability Board (FSB) so as to maintain the integrity of the financial system.

ARRC is a group of private market participants created to help ensure a successful transition from USD LIBOR. FSB is an international body, comprised of central bankers and finance ministers that monitors and makes recommendations about the global financial system.

Disparate Worldwide Use[3]

In the loan markets, it appears that Term SOFR is widely being used in the United States, Africa, and the Middle East.

In contrast, risk-free rates (and not Term SOFR) are predominately being utilized in the European Union (except for leveraged loans) and in Asia.

Related Queries

In addition to the repeated concerns about the mismatch in benchmarks between loans/bonds and related caps/swaps, why are derivatives using an actual SOFR rate as the fallback while loan transactions are utilizing Term SOFR, a derivatives-based rate?

Stated slightly differently, shouldn’t (i) derivatives utilize a derivatives-based rate as the fallback (Term SOFR) and (ii) transactions utilize an actual rate as the fallback (SOFR) rather than a derivatives-based rate, both to facilitate ‘apples to apples’ transitions?

Tough Legacy Contracts

Magnitude

According to the UK FCA, ARRC estimated in 2021 that over $70 trillion of USD LIBOR exposures would remain outstanding beyond the USD LIBOR end date of June 30, 2023, on a global basis.

New York & Federal Law

As previously reported, there was a law enacted in New York in 2021 and, another law enacted federally in 2022, to deal with the LIBOR transition (US LIBOR Act), both of which are generally unfavorable to borrowers.[4]

Toughest Legacy Contracts

However, there is a pool of legacy contracts governed by non-US law that are not covered by the US LIBOR Act and, per the UK FCA, have no realistic prospect of being amended to move away from USD LIBOR by the end date.

These include a significant amount of bonds and securitizations referencing USD LIBOR that are governed by UK law, plus general delays in the LIBOR transition in developing countries. The use of synthetic USD LIBOR will allow for (i) an additional 18 months to so amend and (ii) further maturity of legacy contracts.

Regulator Concerns

No Change in Transition Economics

The UK FCA mentions, with respect to mortgages, that lenders can move borrowers to an alternative rate that is ‘clearly and transparently fair’ to the borrower, maintaining the same transaction economics both before and after the LIBOR transition.

The foregoing should probably apply to all financial instruments and not just home mortgage loans. It should also be a requirement of New York and Federal law though, unfortunately, it is not.

Risk-Free Rates

The UK FCA, the Bank of England, US regulators, and other regulators internationally (as well as this author) have been encouraging transition away from LIBOR to risk-free, or near-risk-free, rates. [5]  The UK FCA and US regulators have also cautioned against reintroducing weaknesses into the financial system by using reference rates with the same potential flaws as LIBOR.

Unfortunately, neither Term SOFR nor synthetic LIBOR are risk-free rates.

Usage Concerns

Enumerated below are some of the additional issues with the proposed use of ‘Zombie’ LIBOR:

• According to the UK FCA, it is an unrepresentative rate
   
• Consequently, there may be no viable fallback to USD LIBOR though it could be:
   
  • The last available LIBOR rate prior to the end date (meaning it converts to a fixed rate through maturity)
     
  • The base rate (e.g., prime, Fed funds rate)
     
  • Determined to be an impossibility of performance of the legacy contract

The foregoing will likely lead to disputes and litigation as to what is the fair and reasonable rate post-June 30.

New Year’s Resolutions

Set forth below are related resolutions for 2023:

• There will be a ‘smooth transition’ of USD LIBOR

 This same resolution was made in connection with New Year’s Resolutions for 2015, 2021 & 2022, and can safely be repeated for New Year’s 2024

• There is no assurance that ‘synthetic’ LIBOR will be available
   
• Term SOFR should be utilized for the transition for all loan/bond transactions
   
• Regulators are insisting that the LIBOR transition documentation be executed by year-end

The same three (3) foregoing resolutions were made in connection with New Year’s Resolutions for 2021 & 2022

It should be noted that most New Year’s Resolutions are meant to be broken and, often, repeated in subsequent years…

[1] See “Consultation on ‘synthetic’ US dollar LIBOR and feedback to CP22/11” of the UK FCA released on November 23, 2022, as CP22/21, which is used as the prime basis of this Client Alert.

[2] The UK FCA is not expected to announce this final decision until the end of 1Q 2023 or the beginning of 2Q 2023 – shortly before the USD LIBOR end date.

[3] See the publication of Allen & Overy LLP entitled ‘Term SOFR: six months on,’ dated December 13, 2022.

[4] See the Client Alert entitled ‘The End of LIBOR: The Twilight Zone™ Edition,’ dated March 11, 2021, the Client Alert entitled ‘Federal Law to the Rescue?’ dated November 3, 2021 (“Federal Law Alert – Part I”) and the Client Alert entitled ‘Federal Law to the Rescue? (The Senate Version),’ dated April 14, 2022.

[5] See the Client Alert entitled ‘Recommended Benchmarks or Credit-Sensitive Indices: The Best Path Forward,’ dated July 19, 2021, and the Federal Law Alert – Part I.