London Interbank Offered Rates (LIBORs) are being replaced by Risk-Free-Rates (RFRs) with the reform leading to multiple impacts on market participants, including changes in the way certain products and contracts operate
The USD LIBOR panel will cease after 30 June 2023, and USD LIBOR rates will no longer be considered ‘representative’ of the market. What is the potential impact of such change and how might the relevant regulatory governing bodies differ in their legislative and regulatory approaches? Find out below.
Forward-Looking Term Rates and the expectations regarding their use
Forward-looking term rates have been created as an alternative replacement rate to LIBOR in their respective currencies. Regulators and official working groups have made clear that term rates have limited permitted use cases, and are not intended to be the replacement for the majority of LIBOR contracts. For USD LIBOR they continue to recommend the use of overnight SOFR and SOFR averages for all products.
On 21 April 2023, the Alternative Reference Rate Committee (ARRC) in the US published their update to the ARRC’s Term SOFR Scope of Use of Best Practice Recommendations. The ARRC has since introduced an additional, limited, recommendation regarding Term SOFR-SOFR basis swaps between dealers (e.g. BNP Paribas) and non-dealers (e.g. hedge funds, corporates).
‘Tough Legacy’ contracts
There has been significant progress concerning LIBOR transition since the reform was announced. However, whilst only representing a relatively minor share of the USD LIBOR market, a material volume of contracts is still expected to not transition prior to USD LIBOR panel bank cessation on 30 June 2023. These contracts are known as ‘tough legacy’ transactions. The remediation or solution of these contracts may depend on the governing law of the individual contracts.
US legislative solution: The ‘LIBOR Act’
The LIBOR Act will help to avoid additional disruption to the market by providing certainty for relevant contracts. This will be done by choosing the appropriate, Board selected, replacement rates per asset class, and providing safe harbour to counterparties to enact these changes to impacted contracts.
In 2022, the Consolidated Appropriation Act, 2022 was signed into law, containing the Adjustable Interest Rate ‘LIBOR’ Act. The LIBOR Act includes Federal legislation that covers all US governed law contracts which lack adequate fallbacks should the rate permanently cease.
The Federal Reserve Board (FRB) has subsequently adopted a final rule that identifies benchmark rates based on SOFR, which will replace LIBOR in certain financial contracts after 30 June 2023. See the Board memo for applicable rates per asset class.
Non-US governed law contracts – FCA announcement on synthetic USD LIBOR
The FCA announced their intention to compel ICE Benchmark Administration Limited (IBA) to continue to publish 1-, 3- and 6-month US dollar LIBOR settings using an unrepresentative ‘synthetic’ methodology, with an anticipated end date of 30 September 2024. BNP Paribas expects synthetic LIBOR to apply to the majority of non-US governed law contracts but each governing law will need to be independently assessed.
Key points to note on synthetic LIBOR:
- It is a temporary solution and should not be relied upon to transition away from LIBOR.
- It is permitted for all USD legacy contracts except cleared derivatives.
- It will not apply to counterparties who have adhered to the 2020 ISDA IBOR Fallbacks Protocol or to contracts under US governing law: Trades with robust fallbacks cannot be carved out or amended with the intent to use synthetic LIBOR.
- The FCA will review its decision prior to 30 September 2024. However, unless unforeseen and material events occur, it expects to follow the timeline and direction communicated.
- After 30 June 2023, the use of synthetic USD LIBOR for new transactions is strictly prohibited, without exceptions.
The USD LIBOR ICE Swap Rate, sometimes referred to as ‘CMS’, will permanently cease after this date and is unaffected by this FCA announcement.
What will happen to centrally cleared contracts?
Central counterparties (CCPs) have been supporting and extensively involved in the transition away from LIBORs. The CCP conversion events switching from USD LIBOR to a SOFR based rate, successfully took place between April and May 2023, for the majority of USD LIBOR trades. The Bank of England (BoE) published a news flash on the cessation of USD LIBOR panel rates at the end of June, which contains a schedule of planned CCP events.
Regulators have been consistent in their communication that all contracts, which reference USD LIBOR, will need to be actively transitioned to reference robust alternative rates such as SOFR if they mature after June 2023. The impact on unremediated trades may differ according to region and may therefore affect clients’ trades if they do not act soon.
Should you require more information or wish to discuss any of the information mentioned, please reach out to your usual BNP Paribas representative.