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SFIG has its own recommended best practices for Libor transition

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The Structured Finance Industry Group has issued its own set of recommended best practices for the phasing out use of the London interbank offered rate as a benchmark for securitizations and for the transition to a replacement benchmark.

Published on Dec. 18, it differs slightly from one released just two weeks prior by a broader group of capital market participants convened by the Federal Reserve, the Alternative Reference Rates Committee.

In the event of a transition, both the SFIG and ARRC support the use of a forward-looking term Secured Overnight Financing Rate, as modified to reflect the difference between SOFR, which is a risk-free rate of return, and the credit and liquidity components of Libor.

And like ARRC's latest consultation, the SFIG "green paper" outlines steps that could be used to make the smoothest transition to a new fall-back rate (such as a forward-looking term SOFR) in the event of Libor's demise.

One difference, according to Sairah Burki, SFIG's head of ABS policy, is that SFIG's recommendations would make it somewhat easier to ditch a SOFR-derived benchmark in favor of a new benchmark that has yet to be developed.

The distinction is notable because the Structured Finance Industry Group is part of the ARRC; Burki is a member of the latter's securitization working group.

Capital markets participants are racing against time. After 2021, a group of panel banks that submit quotes for Libor will no longer be compelled to do so, which means the benchmark could cease to exist Even now, it's questionable whether there is enough actual interbank lending to support a robust benchmark; the quotes that banks submit are largely estimates.

Yet Libor is used as a reference rate for an estimated $240 trillion of derivatives, securities and loans globally, according to banking and financial services consultancy Oliver Wyman. The $1.1 trillion leveraged loan market and the $583 billion in outstanding U.S. collateralized loan obligations are a small portion compared to the trillions in contracts tied to the swaps market, which sees more than $800 billion in daily transactions.

Like ARRC's consultation, SFIG's green paper includes a discussion of events that would trigger a discontinuance of Libor, a "waterfall" of replacement benchmarks, and the determination of a spread over a benchmark. The trigger events for discontinuing the use of Libor, for examples include a regulatory edict to end Libor or the cessation of published rates by the Libor administrator (currently the ICE Benchmark Administration).

Some pre-cessation triggers including a five-day stoppage in publishing Libor, or if enough banks drop out of providing quotes.

And both ARRC and SFIG’s recommended steps toward choosing a replacement rate would begin with a term SOFR rate determined by a relevant governmental body (such as the Fed) along with a replacement spread to cover a gap between it and the final Libor rate. If a regulatory body recommendation is not available, the next step would be a form of the daily SOFR rate compounded for the term rate of a contract – and again, only if a replacement spread has also been decided on by market participants.

But there are some variances between the SFIG and ARRC papers. In one instance, Burki said, SFIG "decided we wanted to keep it simpler" in securitizations through bypassing a complex "re-testing" measure the ARRC included that could be used to withdraw a replacement rate for a new subsequent benchmark that is later developed and ranks higher on the waterfall chart.

"We felt that if you’ve gone beyond step one, two or three and gone to a government-sponsored fallback rate, it really did not make as much sense to offer a retesting," she said, "because at that point it’s very unlikely you’ll get to a SOFR rate."

SFIG's green paper also includes more suggestions from trustees and calculation agents on matters pertaining to which parties have the right to identify trigger events or who carries out noteholder votes - steps that Burki believes will be part of future ARRC consultation reports.

The protocol for trigger events seeks to address what market participants have criticized as a hodgepodge of methods (if any are in place at all) to bring investors and asset-backed issuers to agreement. Any new rate would have to include a spread that compensates for any loss of potential value transfers between counterparties. And without common definitions and language, updating deal documents for these rate changes present a potential legal quagmire.

Deciding on fallback rates for securitizations has been a slow process; few participants are making active plans to replace Libor with a rate that both investors and issuers can agree to. Typical documents for collateralized loan obligation documents, for example, only allow managers to change deal terms, including benchmark rates, with unanimous investor consent. Any replacement rate would have to provider returns equivalent to what investors could expect from Libor.

A replacement rate could very well be a new iteration of Libor. In the fall of 2017 ICE Benchmark Administration president Tim Bowler told an industry conference group that his organization – which administers the daily publication of six different Libor rates – could continue publishing Libor rates for loans and financing contracts using financial transactions rather than “expert” internal opinions that currently determine the rates. (The replacement rate event waterfall is not triggered so long as a Libor rate is published.)

This year, ICE launched a new program allowing panel banks to use wholesale financial transactions (if sufficient volume exists) instead of in-house estimates to fulfill daily rate quotes.

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