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LIBOR Update – IOSCO Voices Concern Over Widespread Use of Credit Sensitive Rates

September 13, 2021

On September 8, the board of the International Organisation of Securities Commissions (IOSCO) issued a statement  urging caution regarding the use of credit sensitive rates (CSRs) to replace LIBOR. To the good, IOSCO reiterated the importance of a “continued transition to robust alternative financial benchmarks, i.e., Risk-Free Rates, to mitigate potential risks arising from the cessation of LIBOR, including USD LIBOR.”

Over the past year, several CSRs have emerged to offer the market alternatives to the Secured Overnight Financing Rate (SOFR), the ARRC-recommended risk-free rate to replace USD LIBOR. (Additional detail on these CSRs can be found in the table below.)

In its statement, IOSCO expressed concern that widespread use of CSRs, instead of SOFR, may pose risks to financial stability. IOSCO highlighted SOFR’s robust underlying transaction volumes, observing they are “unmatched by other alternatives.”

IOSCO noted that CSRs will have to adhere to the IOSCO Principles on Financial Benchmarks  and that compliance with the IOSCO Principles is “not a one-time exercise and alternative benchmarks should be IOSCO compliant at all times.” In particular, IOSCO called on administrators to assess whether and to what extent the CSRs are “based on active markets with high volumes of transactions” and whether “such benchmarks are resilient during times of stress.”

Concern That CSRs Similar to LIBOR, Replicate LIBOR’s Shortcomings

A Comparison Across LIBOR Alternatives

An overview of the leading CSRs is provided in the table below. Like SOFR, the CSRs incorporate a bank credit risk component, which some view as more robust that the credit spread adjustment embedded in LIBOR. However, as noted above, the underlying transaction volume of the CSRs is a fraction of SOFR’s underlying volume.

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Update: ARRC Releases Term SOFR FAQs

August 27, 2021

On August 27, the Alternative Reference Rates Committee (ARRC) released frequently asked questions (FAQs) on best practice recommendations related to scope of use of SOFR term rates. As noted in an August 26 CREFC Alert, the markets and the regulatory community continue to prepare for the upcoming LIBOR cessation. The ability to utilize term SOFR rates is an issue important to CREFC members -- both balance-sheet and securitized lenders and servicers alike. 
  
The FAQs specifically and importantly address why limits to term rate scope of use are important, stating:

Term Rate for Commercial Real Estate Loans and Securities They Collateralize.

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No Summer Lull for the LIBOR to SOFR Transition

August 26, 2021

ARRC Recommends SOFR Term Rates

The momentum behind the forthcoming transition away from LIBOR continues to grow. As covered in a recent CREFC Alert, on July 29, the Alternative Reference Rates Committee (ARRC) announced its recommendation of CME Group’s forward-looking Secured Overnight Financing Rate (SOFR) term rates. This move followed the completion of a critical change in interdealer trading conventions that occurred on July 26 under the CFTC’s SOFR First initiative. The initiative requires interdealer brokers to switch from their current LIBOR-based pricing conventions for dollar swaps transactions to one that uses SOFR-based pricing conventions.
  
The goal of SOFR First was to increase activity in the overnight benchmark rate, thereby growing the liquidity needed for a Term SOFR. In an August 4 post, Clarus Financial Technology noted that over the week of July 26, 12.3% of trades were SOFR Swaps, up from 2.5% to 4% in prior weeks.
  
In advance of its formal SOFR term rate recommendation, the ARRC released recommended best practices for using SOFR Term Rates. Please see the August 4 CREFC Alert for more details, but highlights for commercial real estate (CRE) include:

New Contracts

• For new contracts, the ARRC supports the use of the SOFR Term Rates in areas where use of overnight and averages of SOFR has proven to be difficult. Specifically, the ARRC recognizes CRE loans as falling under the larger business loans category, which allows for the use of SOFR Term Rates in commercial mortgages and in turn the securitizations these loans collateralize.

Legacy Contracts: A New York Solution

• Forward-looking Term SOFR is the first step of the waterfall for ARRC fallbacks, as well as for legacy products under New York State legislation (which was signed into law on April 6, 2021) and addresses tough legacy contracts or those that reference USD LIBOR as a benchmark interest rate but do not include effective fallback provisions for LIBOR’s cessation. Following the formal recommendation of SOFR Term Rates, legacy contracts that have adopted the ARRC’s fallback language without modification to the rate waterfall will fall back to the SOFR Term Rates once the contractual LIBOR replacement date occurs.
• LIBOR-based instruments governed by New York law that do not provide effective fallbacks will transition to the applicable SOFR-based rate recommended by the ARRC, the Federal Reserve Board, or the Federal Reserve Bank of New York. 
    

Legacy Contracts: A Federal Solution

• Congress is also actively pursuing possible Federal legislation to solve the tough legacy problem. On July 29, the House Financial Services Committee (HFSC) passed a bill that would provide safe harbor for tough legacy USD LIBOR contracts if they switch to SOFR when the benchmark expires in June 2023. If the House and Senate vote to pass this bill, it will provide safe harbor under federal law for the toughest legacy contracts, including securitizations.
• A Federal legislative solution is critically important given the following weaknesses in the New York State legislation:
  • Trust Indenture Act. Due to federal protections in the Trust Indenture Act (TIA), state legislation cannot adequately address some of the issues related to the LIBOR transition in many floating rate notes, as reported by Risk.net. However, Federal legislation would pre-empt the TIA, which is meant to protect bondholders from being negatively impacted by contractual changes, and is a “major obstacle to the state-level fix.”
  • New York Contracts Only. The New York law cannot address contracts issued from other states. For example, most securitizations may be issued under New York law, but the loans underlying these transactions could be originated in several different states and therefore governed by many different state laws.
• LIBOR Replacement Rate – Point of Contention for Federal Legislation. Choice of replacement rate in a Federal law remains a point of contention. Supporters of alternatives to SOFR, such as Ameribor and BSBY, are advocating that these and similar rates be reflected in any Federal solution. While the proposed Federal legislation would provide safe harbor to only transactions that switch to SOFR, another Risk.net piece notes that an amendment to the bill, which was approved by the HFSC, adds a so-called ‘rule of construction’ that states “nothing in this Act shall be construed to disfavor the use of any benchmark rate on a prospective basis.” This type of language is not in the New York law.
• CREFC will keep our members apprised of any significant developments as the Federal bill progresses through the legislative process.  

Growing Regulatory Impatience with Pace of SOFR Take-Up?

As year-end 2021 approaches, regulatory scrutiny on the financial sector’s LIBOR transition plans will certainly intensify. Earlier this year, banking organizations were put on notice by their supervisory agencies that they should stop originating LIBOR product by the end of 2021. On August 24, Treasury Secretary Janet Yellen, Federal Reserve Chair Jay Powell, Securities and Exchange Commission Chair Gary Gensler, New York Federal Reserve Bank President John C. Williams, and Commodity Futures Trading Commission Acting Chair Rostin Behnam released a letter to nonfinancial corporate stakeholders following a discussion of their experiences and concerns as they prepare to transition from LIBOR. 
  
This letter was in response to an April letter from the U.S. Chamber of Commerce, the National Association of Corporate Treasurers, and the Association for Financial Professionals, who shared that companies were finding it difficult to get LIBOR transition-related information from their banks. 
  
The regulators acknowledged the challenges that the corporations have faced in obtaining SOFR-based loan agreements. They state:

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