The Transition Away from the London Interbank Offered Rate (LIBOR)*
by Cam Fuller, Senior Associate, Financial Market Infrastructure Function (FMIF), Federal Reserve Bank of New York and Grant Zappulla, Associate, FMIF, Federal Reserve Bank of New York
LIBOR is expected to go away sometime after 2021. A global effort is now under way to transition market participants to alternative reference rates.
The expected discontinuation of LIBOR is important for community banks because they may have LIBOR exposures on the asset or liability side of the balance sheet at the bank and/or bank holding company. Many financial contracts typically underwritten or purchased by community banks may reference LIBOR, including retail mortgages, commercial real estate (CRE) loans, or hedging instruments such as interest rate swaps. On the liability side, some debt instruments, such as trust preferred securities (TruPS), may be priced off LIBOR. Community banks with exposure to LIBOR may have increased operational, legal, and reputational risks. Planning for LIBOR’s cessation is prudent risk management.
This article provides background information on the transition away from LIBOR, discusses the planning efforts to move to alternative reference rates in the United States, provides some detail on one of those alternative rates, and recommends additional sources of information on these topics.
What is LIBOR?
LIBOR is a global financial benchmark and reference rate that is meant to represent the average rate that large banks pay for unsecured, short-term borrowing. It is calculated using an average of rates submitted by a panel of banks (referred to as a “panel bank”)1 and is published daily for five currencies — the U.S. dollar (USD), the pound sterling, the euro, the Japanese yen, and the Swiss franc — across seven maturities. LIBOR often serves as a reference rate on which the interest rate for other types of financial transactions is based. Today, LIBOR is referenced in a wide range of financial contracts, including mortgages, business loans, floating rate notes (FRNs), and derivatives.
Why might LIBOR go away?
Andrew Bailey of the UK’s Financial Conduct Authority (FCA),2 which regulates LIBOR, gave a speech in July 2017 stating that the reference rate will continue through the end of 2021, but after that date, its continued publication cannot be guaranteed.3 This watershed speech highlighted LIBOR’s uncertain future and accelerated a global effort to transition toward alternative reference rates.
During the financial crisis, regulators discovered that certain panel banks would purposefully misstate the rate they submitted to generate profits on trading positions tied to LIBOR and the marginal fluctuations thereof and to present a stronger credit profile during this period of economic stress.
Since the financial crisis, there has been a significant decline in the market activity underlying LIBOR (i.e., bank wholesale unsecured funding) due to a multitude of factors.4 Because of this limited underlying activity, panel banks often submit quotes based on expert judgment — or their best guess of what the rate should be — rather than on actual transactions. On average, Federal Reserve staff members estimate, there are six or seven transactions per day underpinning one- and three-month LIBOR across all the panel banks.5 The longer maturities have even fewer transactions.
What is the current estimated exposure to USD LIBOR?
Based on information from the “Second Report of the Alternative Reference Rates Committee (ARRC),” the estimate of transactions that currently reference USD LIBOR rates is approximately $200 trillion worth of derivatives and cash products.6 The vast majority of this exposure — $190 trillion — is found in derivative products, including interest rate swaps, options, and futures. Most derivative products are not typically seen on community bank balance sheets, although community banks may use derivatives, such as interest rate swaps, to hedge their LIBOR interest rate risk exposure. The remaining USD LIBOR exposure — approximately $10 trillion — can be found in various types of cash products. The cash products with the largest USD LIBOR exposure are FRNs at $1.8 trillion, syndicated loans at $1.5 trillion, retail mortgages at $1.2 trillion, and CRE/commercial mortgages at $1.1 trillion. Other products that reference LIBOR include other consumer loans, nonsyndicated business loans, and securitized products such as asset-backed or mortgage-backed securities and collateralized loan obligations. If the contracts underlying these transactions mature after 2021, the LIBOR rate will need to be replaced by an alternative reference rate when LIBOR is no longer published after 2021.
What are some of the risks for financial institutions associated with LIBOR going away?
Community banks may have exposure to the LIBOR rate if their contracts, or the legal document underlying the financial transaction, contain a reference to LIBOR for determining the interest rate. Many existing financial contracts do not contain appropriate “fallback” language to specify which interest rate should be used in the event that LIBOR is no longer published. Failure to determine a new rate acceptable to the parties of each contract may result in confusion about what to do under the contract (e.g., how to calculate interest payments). A lack of appropriate fallback language could also result in legal risk, as neither party to the contract may be willing to accept a reduced margin because of a change in the reference rate.
Uncertainty about the rates on assets and liabilities could result in increased interest rate risk exposure. In addition, LIBOR may be embedded in systems, formulas, and financial models; therefore, its discontinuance could also pose an operational risk for firms. Finally, effective and consistent communication would be necessary to inform key stakeholders and clients about the implications of moving away from LIBOR.
How are the Federal Reserve and market participants addressing the transition from LIBOR?
LIBOR’s uncertain future poses a risk to the U.S. financial system given the large number of financial contracts that reference USD LIBOR. In 2014, members of the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the ARRC, a working group that is led by market participants, to identify an alternative reference rate to USD LIBOR and to organize the U.S. response to the movement away from USD LIBOR. The membership of the ARRC originally consisted of global derivatives dealers; however, recognizing the impact that this transition will have on a wide set of market participants, the ARRC broadened its membership in 2018 to include a more diverse group of participants. This change in the group’s participants should promote a broad consensus on its recommendations and a variety of viewpoints. Community banks are represented on the ARRC through industry trade groups such as the Independent Community Bankers of America and the American Bankers Association.
What are the ARRC’s objectives?
The ARRC’s primary objectives are to identify an alternative risk-free reference rate to USD LIBOR, consider best practices for fallback language in financial contracts, and develop an adoption plan for transitioning to alternative reference rates.
The ARRC has made significant progress in meeting these objectives. In 2017, after considering several options, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative risk-free reference rate, and the Federal Reserve Bank of New York began publishing SOFR in April 2018. The ARRC has formed working groups to focus on providing suggested contract fallback language for a variety of financial products.7 In addition, the ARRC has turned its focus to issues affecting consumer products. The ARRC also adopted a transition plan in October 2017 that emphasizes the development of liquidity in contracts referencing SOFR in order to support the development of a term rate for SOFR with different tenors, such as a one- or three-month rate, in addition to the overnight rate.8
What is SOFR?
The ARRC identified SOFR as the rate that, in its consensus view, is the preferred risk-free alternative rate to USD LIBOR. SOFR represents the cost of borrowing cash overnight in the repurchase agreement (repo) market using U.S. Treasuries as collateral. It is fully based in observable transactions, calculated using data from multiple segments of the Treasury repo market. The ARRC discusses the rationale for selecting SOFR in its “Second Report,” dated March 2018.9 SOFR is published each business day on the Federal Reserve Bank of New York’s website.10
SOFR has a substantial number of underlying transactions, roughly $800 billion to $900 billion in average daily volume,11 and is a nearly risk-free rate that reflects general secured financing conditions in U.S. money markets. By comparison, LIBOR has approximately $500 million to $1 billion in average daily volume, depending on the tenor.12
What is the market adoption of SOFR to date?
Although market adoption of SOFR is voluntary, use of the rate in financial products has already begun. As of May 2019, the notional amount of debt issuance via SOFR-linked FRNs surpassed $100 billion.13 Issuers of these FRNs include Fannie Mae, Freddie Mac, Barclays, JPMorgan, Toyota, Federal Home Loan Bank, and Wells Fargo.
In the derivative markets, the Chicago Mercantile Exchange Group (CME), which operates an American options and futures exchange, launched SOFR futures in May 2018, and average daily volume and open interest have been on an upward trajectory since the launch. Furthermore, the London Clearinghouse (LCH), a British multi-asset clearing-house, and CME began offering cleared over-the-counter SOFR swaps in July and October of 2018, respectively.
What are some of the differences between LIBOR and SOFR?
SOFR is a secured rate, reflecting the cost of borrowing cash using U.S. Treasuries as collateral. LIBOR, on the other hand, is an unsecured rate. Therefore, SOFR is lower than the unsecured LIBOR because it does not reflect a credit risk premium. In addition, SOFR is an overnight rate, like the Prime Rate, whereas LIBOR is published for multiple maturities ranging from overnight to 12‑month (with the three-month tenor being the most common). Moving from a term unsecured rate to an overnight secured rate may affect the economics of a financial transaction (such as a loan) and is one of the challenges associated with this transition. Some type of spread adjustment will be needed when moving to SOFR, in the same way that loans based on the Prime Rate have different spreads compared with loans based on LIBOR. Although currently there is no SOFR term rate, building liquidity in the derivatives markets linked to SOFR will help with the development of a term structure for SOFR. The industry participants of the ARRC and its various working groups are discussing and working through these challenges, with a specific working group dedicated to the development of a forward-looking term rate.
Are there any supervisory expectations right now for Fed-supervised financial institutions?
In 2018, the Federal Reserve focused its efforts on increasing awareness of LIBOR’s possible cessation in 2021 and the need for supervised institutions to consider transitioning to alternative rates.14 To date, the Federal Reserve has not issued any rules, regulations, or guidance regarding the transition from LIBOR. The possibility that LIBOR is no longer available after 2021 is a material emerging risk, resulting from a change in market practice. As with all emerging risks, prudent risk management means that financial institutions should understand the emerging risk and the risk implications for the institution, as well as consider options for mitigating any potential negative impact.
What can firms do to prepare for a transition away from LIBOR?
An important first step for institutions in preparing for LIBOR’s possible discontinuance after 2021 is to understand their current financial exposure. Financial exposure is generally considered to be the size of activity tied to USD LIBOR across all financial products (e.g., if a bank has two $400,000 adjustable rate mortgages (ARMs) where the rate is tied to LIBOR, it has $800,000 in exposure to LIBOR in ARMs). As mentioned earlier, LIBOR can be found in a variety of products, including derivatives, business loans, mortgages, FRNs, securitizations, deposits, and debt.
Once an exposure is identified, financial institutions should understand the risk implications and determine the actions that may be necessary, such as communicating to clients and counterparties. Additionally, in order to better understand the legal and operational risks associated with each contract, financial institutions should evaluate the contractual terms that outline what happens if LIBOR goes away and whether that language is sufficiently clear for risk mitigation purposes. These considerations are important for existing contracts (particularly longer-dated contracts) as well as new contracts.
Where can I find more information on the LIBOR transition?
- * The opinions expressed in this article are intended for informational purposes and are not formal opinions of, nor binding on, the Federal Reserve Bank of New York or the Board of Governors of the Federal Reserve System.
- 1 A list of the banks that make up the LIBOR panel is available at www.theice.com/iba/libor.
- 2 The FCA regulates LIBOR’s administrator, ICE Benchmark Administration (IBA), as well as the panel banks that submit LIBOR quotes to IBA.
- 3 Andrew Bailey, "The Future of LIBOR," Bloomberg London, United Kingdom, July 27, 2017, available at www.fca.org.uk/news/speeches/the-future-of-libor.
- 4 The rate’s underlying market has a daily volume of between $500 million and $1 billion, depending on the tenor. See the “Second Report of the ARRC,” March 2018, page 1, available at www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report.
- 5 Randal K. Quarles, “Introductory Remarks of Alternative Reference Rates Committee Roundtable,” Federal Reserve Bank of New York, New York, July 19, 2018.
- 6 See the “Second Report of the ARRC,” March 2018, page 1, available at www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report.
- 7 See “ARRC Fallback Contract Language,” available at www.newyorkfed.org/arrc/fallbacks-contract-language.
- 8 More information on the ARRC and its progress on achieving its objectives is available at www.newyorkfed.org/arrc.
- 9 See www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report.
- 10 See https://apps.newyorkfed.org/markets/autorates/sofr.
- 11 Federal Reserve Bank of New York, “Secured Overnight Financing Rate Data,” available at https://apps.newyorkfed.org/markets/autorates/sofr.
- 12 See www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report.
- 13 CME Group, “Secured Overnight Financing Rate (SOFR) Futures,” available at www.cmegroup.com/trading/interest-rates/secured-overnight-financing-rate-futures.html.
- 14 The Federal Reserve conducted an Ask the Fed (https://learningcenter.frb.org/Learning/Event/1743/Ask-the-Fed--London-Interbank-Offered-Rate--LIBOR--and-Reference-Rate-Reform) webinar in June 2018, followed by an Industry Outreach webinar together with other Federal Financial Institutions Examination Council members in December.
- 15 See www.newyorkfed.org/arrc for more information.