Feature: Libor part 2

FEATURE

That’s the way to do it –Sofr saves the day

Regulatory measures have largely resolved headline issues for USD Libor transition as Sofr becomes cheaper borrowing choice

The SRP database still lists 217 USD Libor products across 16 national databases maturing before the USD Libor cessation date of 30 June 2023, including 24 US jurisdiction products worth US$235m. The major payouts across all databases are some form of floater (US$2.3bn), range (US$958m), or accrual (US$900m).

Bigger by far is the volume that matures after the Libor cessation date: 829 products across 16 different SRP databases, including 520 products worth US$3.6 billion in the US. Again, the muchdebated range accrual payoff is prominent.

It’s not clear how much of this has a discretionary route to transition, and how much might be classified ‘tough legacy’ volume. Relieved by recent regulatory and legal developments, lawyers and bankers helping transition the huge USD structured products books away from Libor have stopped quoting how much of the estimated US$15 trillion outstanding in ‘tough legacy’ contracts rests on their shoulders.

“It’s still a big number, but we now have legislative solutions for a US dollar US- or New York law-governed US dollar Libor note… so I think people aren't really so much worried about the upcoming USD Libor cessation,” says Bradley Berman (below left), who represents structured product issuers as counsel in Mayer Brown’s New York-based Corporate & Securities practice. “There's really not much left to do,” he says. “These outstanding USD Libor notes are going to change over to Sofr as a matter of law, and I would imagine issuers as a courtesy would tell their holders that coming in the next quarterly payment, your interest will be calculated in a different manner.”

The market has Division U of Biden’s Economic Continuity & Stability Act to thank. This, the Adjustable Interest Rate (Libor) Act (Airla), was enacted on 15 March as a federal solution for ‘tough legacy’ and other difficult to resolve contracts. The USD market had already gained breathing space in March last year when the Bank of England extended USD Libor cessation to end-June 2023, allowing a huge swathe of products to roll off before deadline.

Tim Bowler, president of Libor administrator ICE Benchmark Administration, sums up the market’s relief.

“We were pleased that the US dollar panel banks agreed to continue providing Libor submissions for the main US dollar Libor settings until end June 2023,” he says, “giving the market a long run-in and some breathing room to manage the larger and more complicated US dollar market transition, particularly coming out of the pandemic.”

The new law is also a game changer. Like the New York solution

I can't see a need for synthetic US dollar Libor, no, not here in the US

Bradley Berman, Mayer Brown

FEATURE

it followed, Airla is tilted towards Sofr as Libor replacement. It nullifies polling provisions for live tough legacy notes and difficult to resolve contracts, switching them to Sofr by operation of law on 30 June next year, and protecting contractual rights and obligations in transitioned contracts.

For contracts where discretion is possible, ‘determining persons’ who switch to Sofr and make necessary benchmark-confirming changes will have safe harbour from dispute. The new law can’t be used to legally challenge a product transitioned by discretionary route to a non-Sofr rate, but its protections do not apply if that alternative rate is chosen.

Thanks to such hearty-carrot / soft-stick Sofr first measures by US regulatory agencies, Sofr has overcome early resistance to become the dominant index for new trading and lending transactions, including structured products.

“Structured products have been using Sofr now for a good two years,” says Berman. “You're not really seeing people using the other typical US rates like Fed Funds in the structured notes context.”

This should in turn inform the approach taken by USD Libor-linked note issuers in the rest of the world, who have been waiting for US issuers to lead the way.

LIQUIDITY SWELL Liquidity has been building in the Sofr derivatives markets. More than 90% of flow OTC instruments now reference Sofr. On the exchange-traded front, CME Group reported Sofr futures open interest had surpassed five million contracts on 22 April. Although traded Sofr options lag, a record was set on 3 May with an open interest of over two million contracts. Early May also saw the CME Group announce a Sofr-first for options programme for the summer months, with fee waiver and other market-making initiatives.

In early March the notional traded volume of Sofr swaps overtook Libor swaps for the first time. Early this month, in the latest instalment in its trade-switching initiatives, the CFTC proposed rule changes to align swap clearing requirements with the new overnight rates.

Does all this progress mean there is no need for synthetic USD Libor? “I can't see a need for synthetic US dollar Libor, no, not here in the US,” Berman says. “Everybody was concerned about being sued, and now I think that's pretty much resolved.”

There are, however, some open questions. “A lot of plaintiffs’ lawyers are clever: will they find something to cry about? Probably. Will they be successful?” Berman shrugs.

Airla has closed one door left ajar by the New York Law it built upon. By providing that replacing USD Libor with Sofr does not amend or modify a contract, or affect the rights or obligations it confers, the statute pre-empts legal challenge arising from a contradiction between Airla’s Sofr-First provisions and noteholders’ right – encapsulated in the 1939 Trust Indemnity Act – to unanimous agreement on modified terms.

Without this legally mandated approach to transitioning, investors could have challenged issuers if spread-adjusted Sofr were to diverge to disadvantage from Libor.

This is not merely theoretical. The 5 March 2021 spread adjustments were set two years before USD Libor’s cessation. And Libor’s credit sensitivity may combine with Sofr’s transactional basis to mean a single adjustment cannot account for fluctuations between the two rates. Stress and irregularity in the repo market can create volatility for Sofr that would not impact on Libor.

An oft-quoted event occurred on 17 September 2019, for example, when Sofr soared from 2.43% to 5.25%, before falling back to 2.55% the following day. The spread between Libor and Sofr also widened dramatically after the Federal Reserve cut US rates in March 2020 as a reaction to Covid-derived economic difficulty.

However, IBA’s Bowler says the long lead time to transition has given markets the chance to adjust. “The Isda fixed-spread adjustments for US dollar Libor were fixed in March 2021, so this has been known and priced into the markets now for almost a year and a quarter,” he says.

Potential for rate envy may, however, lurk offshore, within large, multi-jurisdictional note programmes. Ashurst head of global markets Michael Logie asks, “What if you're relying on fallbacks, or your consent solicitation takes you different place, or US law leads you in a slightly different way? You may end up having different rates for similar products. And that just will exacerbate potential legal issues, because whenever you've got benchmarks to compare your product with you may be asking for trouble.”