This month, the Bank of England and the Financial Conduct Authority issued letters urging U.K. bank executives to get the ball rolling on plans to transition to Libor replacement.
Participants at IMN’s ABS East conference in Miami got more or less the same message firsthand. “I still see a concerning lack of preparation and people being proactive at very large institutions,” said Eli Stern, a principal at consulting advisory firm EY.
“Even walking around here and talking to people ... they’re saying, ‘I’m just going to wait to see what happens,' " he said. “That’s not going to cut it."
Stern added, “I’m curious to see how regulators will start to respond if they start to see blatant lack of preparedness.”
He was among five panelists who expressed a mix of dismay and alarm that firms seem to be dragging their feet on planning for a transition to a new benchmark rate for loans and derivatives contracts once the London Interbank Offered Rate is no longer available.
After 2021, the FCA will no longer require 16 global panel banks to submit daily quotes on interbank lending rates varied by term and currency.
Several audience polls during the panel discussion underscored either the apathy or bewilderment in how firms expect to move forward with a replacement rate that will cover an estimated market of $200 trillion in loans and swaps/derivatives contracts.
Nearly 72% of attendees polled electronically said their institutions were either only going to get involved “at the appropriate time” or “let the market figure it out”; only 12.5% stated their firms were actively engaged with a companywide program planning on transitioning to a future alternative benchmark, while 15.7% stated these initiatives were siloed within a business-line level.
While waiting on the market may be seem like the path of least resistance, there’s a price for kicking the can down the road, the panelists warned. More than $500 billion of outstanding student loans and consumer and corporate debt are pegged to Libor, and in many cases, the language in loan documents does not ensure a smooth transition to a new rate. Typically, for example, there are clauses requiring both issuers and investors to subsequently agree on a new rate.
“People are beginning to focus on legacy transactions that will mature after 2021 or before 2021 if the market moves away from Libor prior to that. And a majority of these transactions do not have robust fallback language, or fallback language at all,” said EY’s Stern.
The contracts should include details on trigger events for a new rate, the definition of the new rate, any necessary spread adjustments and timings to compensate any loss of potential value transfers between counterparties, he said. And it won’t be simple to update deal documents, which “may not be easily searchable” for rate-transition clauses.
Part of the problem may be the lack of an attractive alternative. Over 65% of respondents agreed that the loan and securities markets should have a market-based, forward-looking term rate – a benchmark more suitable for longer-tenored paper than alternative overnight rates like the Secured Overnight Funding Rate (SOFR) that the Federal Reserve of New York has published since April.
The Fed’s introduction of SOFR was designed to deal with the immediate need of transitioning to an overnight rate for the swaps contract making up a majority of the outstanding derivatives markets. In August, the ARCC announced plans to begin developing a term rate based on SOFR.
In July, Fannie Mae issued a three-tranche, $600 billion deal tied to overnight SOFR with short-term maturities of between six and 18 months. A Fannie Mae official said the SOFR rate was benchmarked in support of the rate offered by the Fed’s Alternative Rate Reference Committee (ARCC), of which Fannie is a member.
“The more people move to these alternative rates the less pressure that heaps on the Libor submitters,” said Chris Killian, a managing director of securitization for the Securities Industry and Financial Markets Association (SIFMA).
The end of Libor is not necessarily a fait accompli. While the FCA will no longer require panel banks to submit quotes by 2021, nothing would prevent them from continuing to estimate the rates they would pay for bank-to-bank funding among various term lengths (daily, weekly, one to six months, or annually) among five different currencies.
The Libor rate is administered by the ICE Benchmark Administration. Last February, the ICE administration president Tim Bowler told attendees of the Structured Finance Industry Group’s annual asset-backed securities conference in Las Vegas that ICE was looking to publish the Libor benchmark rates past 2021.
This spring, ICE launched new methodology on quote submission asking banks to base the rate on actual transactions rather than estimates. The so-called “waterfall” method would involve banks using average rates available from wholesale, insured funding transactions between banks as well as issuance or trading of debt instruments in the primary and secondary markets. “Expert” estimates would be permitted if banks have insufficient transaction volume to derive the quotes.
The Fed’s new Secured Overnight Funding Rate is deemed acceptable for derivatives contracts as an overnight rate, but was not suitable for loans because it represents risk-free financing that does not reflect banks’ funding costs.
