WASHINGTON – The transition of the financial industry to a new interest rate benchmark has so far been relegated primarily to investment.
Everything is about to change in the new year.
“For 2021, that’s all. It’s time to play, ”said Lary Stromfeld, a partner at Cadwalader, Wickersham & Taft. “And if you think about how much to do, two years isn’t a long time.”
The London Interbank Interest Rate, or Libor, is the most dominant interest rate benchmark in the world, but will probably not be available by the end of 2021. The Guaranteed Overnight Financing Rate, or SOFR, s ‘has developed as an alternative and gradually gained market share.
While financial institutions still have time before the deadline, regulators will be prepared for next year to give up softer ways to encourage banks to prepare for the transition, including institutional reporting and opinion pages of financial publications, in favor of more direct supervision. approximation.
Mark Chorazak, Cadwalader’s banking regulatory partner, said regulators are increasingly insistent because the change will affect a large number of financial contracts, which will involve counterparties and affiliated offices around the world.
“One of the reasons regulators go from a slow temperature to a boiling one is that it is recognized that not only is there a big volume issue, but the affected contracts are very scattered across an organization,” he said Chorazak. “There is a recognition that an organized transition will take a long time.”
Libor is referred to in $ 200 trillion in securities, derivatives and adjustable rate contracts. But the interbank lending market on which Libor is based has dried up and the rate was hit by the scandal, with dozens of banks involved in a rate manipulation scheme.
To address the issue, regulators and industry representatives formed the Alternative Reference Tariffs Committee in 2014, which identified overnight repurchase agreements as a deep, liquid market that would be durable and resilient. to manipulation. The SOFR benchmark was based on the overnight replacement market.
Tom Wipf, president of the ARC and vice president of institutional values at Morgan Stanley, said in a Bloomberg opinion piece earlier this month that a rapid adoption of SOFR instead of Libor is critical and that it is over. the time for companies to make the change. .
“Two years is a short period to close the rest of the tasks,” Wipf said. “The strength of individual institutions and the architecture of the financial system in general are based on everyone doing their part to ensure a smooth transition to SOFR.”
Regulators already began in 2020 to amplify warnings about the need for banks to focus on change.
The Financial Stability Committee, an international group of central bankers and financial regulators chaired by Federal Reserve Supervisory Vice President Randal Quarles, said earlier this month that market participants and regulators should start be serious about the Libor transition as it poses a risk to individuals. institutions and the financial system.
“Companies that have not started working in earnest and do not plan to complete them by the end of 2021 have significant financial and reputational risks,” the report states. “Companies should end the use of Libor in new contracts as soon as possible and, whenever possible, accelerate their efforts to eliminate their reliance on Libor on inherited contracts.”
Libor’s underlying market is based on estimates submitted by an increasing number of banks, and these banks will only have to submit these quotes by December 31, 2021. The Financial Stability Committee said in its report that there is an “appreciable risk” that Libor will cease to be published after this time, and that “transition long before that date would greatly minimize the risks to financial stability”.
Authorities are already increasingly insisting that banks quickly reduce their exposure to the Libor benchmark contract. The Bank of England’s Financial Policy Committee said in a reading of the October meeting that “there is no justification for companies to continue to increase their exposures to Libor” and that the committee “will consider other potential policy tools and supervision that authorities could deploy ”to reduce exposures to the Libor of companies.
In a September speech, John Williams, head of the Federal Reserve Bank of New York, warned that “everyone in the financial services industry should be aware that the date on which the existence of Libor can no longer be guaranteed is fast approaching “. At a hearing in Congress earlier this month, Treasury Secretary Steven Mnuchin said even officials could call on Congress to develop regulatory language to facilitate the impact on financial contracts.
Next year will likely focus on how banks plan to make a transition out of Libor. The New York Fed already began issuing daily SOFR rates in April 2018.
Hu Benton, vice president of banking policy at the American Bankers Association, said supervisors may be agnostic about a bank’s particular plan, but not having a plan (or at least an assessment of the institution’s exposure) may not be an option.
“All national regulators will have Libor as a hot topic,” Benton said. “I think regulators are sincerely and really interested in the market developing a solution … as long as the market doesn’t pretend this isn’t a problem we need to address.”
But the transition from Libor to SOFR (or some other rate) is not a simple matter of replacing one rate with another.
One challenge is that Libor provided companies with not only a one-time interest rate, that is, an immediate quote right now, but also a term interest rate for longer periods. This is due to the fact that banks lend not only overnight, but also for longer periods.
This is a convenient option for derivative and securities contracts that may have a maturity. However, because SOFR refers to a daily spot market, it is more difficult to find reliable estimates of SOFR rates.
The New York Fed took a big step in November by announcing its intention to publish compound average SOFRs daily for 30, 90, and 180 days, as well as a SOFR index that “would allow you to calculate compound average rates over custom time periods.” This index and the methodology behind it are open to public comment until January 10th.
Benton said the final shape of the New York Fed’s SOFR index and the methodology behind it could be a critical factor in expanding the adoption of SOFR and SOFR benchmark contracts. The deeper these markets are, the better.
“This is something that a lot of people in the industry are very interested in,” Benton said. “I’ve been as explicit as I could be with the rest of the ARC people about the importance of this [the index] and the basis for that is part of a more vigorous public discussion, because I think a lot of people really care what that is. “
Banks and other financial companies have begun to realize this. A study by Cadwalader and Sia Partners earlier this month found that almost 90% of the 75 companies they analyzed had already started their transitions outside Libor and that the largest and most internationally active companies had succeeded. more progress. Bradley Ziff, operating partner of Sia Partners, said the report’s findings suggest that very few banks start 2021 from scratch.
“Very few institutions have done nothing or very little, I would say,” Ziff said. “I think it’s a solid snapshot of the industry, coming to that conclusion.”
However, a group of regional banks told regulators in October that SOFR has disadvantages as an alternative to Libor, meaning that it may not work better as a benchmark for loan products.
And because Libor is such a widely used benchmark, banks are not the only type of counterparties that need to step in for the transition to be perfect. Cadwalader and Sia’s research suggested that non-bank companies are further behind in preparing for the change.
“If you look and identify where this lack of energy can go, you’re likely to be more on the side of the corporate and financial end user,” Ziff said.
That’s why non-bank regulators are increasingly devoting themselves to Libor-related exposures. Last summer, the Securities and Exchange Commission issued a staff statement urging listed companies not to issue new contracts linked to Libor. The statement encourages all companies “that have not yet done so to start the process of identifying existing contracts” and start thinking about how to manage Libor-related risks.
More recently, the Financial Accounting Standards Board adopted a guidance document that provides corporate entities with “optional records and exceptions to apply generally accepted accounting principles to contractual modifications and to cover the accounting relationships affected by the rate reform. reference “.
Stromfeld said some of these smaller or non-bank companies may be aware that Libor will leave, but expect markets to adopt an alternative with enough depth that there is little risk of having to make another transition in the future. But with the deadline set at just two years, there may not be time to wait for the perfect certainty, he said.
“Everyone has the same deadline,” Stromfeld said. “No one has the luxury of saying, ‘Okay, well, I’ll wait until the big boys understand everything and then I’ll do it,’ because it’s too late. You have to be willing to start.”