Libor’s Endgame in the U.S. Requires Urgent Preparation

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With many headlines competing for the financial world’s attention already this year, it would be easy to overlook one of the most significant changes that will take place in 2021: the end of Libor in new contracts. Once dubbed “the world’s most important number,” Libor is a benchmark interest rate with mind-boggling reach, impacting trillions of dollars in business loans, student loans, mortgages and more. Although Libor’s use is pervasive, the transactions on which its publication is based are limited, and the rate needs to be replaced expeditiously this year.

Regulators and Libor’s administrator recently outlined an endgame for the rate. Two critical milestones in making that endgame a reality were reached on Monday: the implementation of a protocol that will fortify derivatives contracts and the close of a consultation on how to move on with minimal disruption.

As chair of the Alternative Reference Rates Committee — a public-private committee convened and sponsored by the Federal Reserve to facilitate the transition in the U.S. — I know that these developments are particularly consequential for U.S. dollar Libor, which underlies about $200 trillion of financial contracts worldwide. (My views in this column reflect those of the ARRC and do not represent those of Morgan Stanley, where I am vice chairman of institutional securities.)

The proposed endgame provides more specifics about exactly how and when USD Libor will end. It calls for new use of USD Libor to stop as soon as possible and no later than the end of 2021. The plan also allows most existing USD Libor-based contracts to mature on their own terms by proposing that the chief USD Libor tenors stop publishing in mid-2023.

This should not be misconstrued as a reprieve. Rather, it sets a clear path for the transition. Enormous progress has been made, and with the end of new Libor approaching, our work remains as urgent as ever.

The ARRC has focused on facilitating a smooth transition from USD Libor to a more robust alternative, called the Secured Overnight Financing Rate, or SOFR. With the official sector’s support, our members are committed to making this transition a success because it ultimately affects everyone.

Based on roughly $1 trillion of daily transactions from a wide range of market participants and administered by the Fed, SOFR is undoubtedly the most suitable alternative rate for institutions of all sizes. The ARRC arrived at SOFR in 2017 after more than two years of research and consultation. The ARRC is making it as straightforward as possible for market participants to transition to SOFR ahead of the end of the year with tools like our best practices.  Importantly, the ARRC recently assessed how those best practices align with the proposed endgame and determined that our recommended dates are fully consistent.

Critically, as part of these recent announcements, U.S. supervisors urged banks to stop new Libor issuances as soon as it is practicable because of “safety and soundness risks.” They added that they “will examine bank practices accordingly.” This is a signal that market participants should immediately stop issuing USD Libor-based instruments and start writing SOFR into new contracts. They should also protect any outstanding Libor contracts from uncertainty by amending them to account for Libor’s end. 

In terms of existing “legacy” Libor instruments, stopping chief Libor tenors in mid-2023 would allow most to mature as originally planned. For contracts that mature after mid-2023, market participants should take proactive measures where possible. For derivatives contracts, that means adopting the International Swaps and Derivatives Association’s IBOR Fallbacks Protocol. For cash products, that means either renegotiating contracts or incorporating the ARRC’s recommended fallback language that clearly specifies which alternative rate the contract will utilize when Libor becomes unusable.

Still, this leaves one of the transition’s thorniest issues: legacy contracts that mature after mid-2023, do not have effective fallback language and cannot realistically be amended. This subset of contracts must be dealt with to avoid a financial and legal mess that could clog court systems for years.

Legislation is the best option to determine what happens to these contracts after Libor’s end. The ARRC has put forward legislation in New York State, the jurisdiction with a sizable portion of these tough legacy contracts. We also support similar legislation at the federal level to safely and legally designate an appropriate fallback approach.

Markets should welcome these announcements and the clarity they provide for the transition. Now that a proposed path is mapped out, the public and private sectors must work together with renewed urgency toward our common goal: preparing for no new Libor by transitioning all new activity to SOFR by the end of this year.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tom Wipf is the chair of the Alternative Reference Rates Committee and vice chairman of institutional securities at Morgan Stanley.

©2021 Bloomberg L.P.

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