What You Need to Know About LIBOR Transition to SOFR
What you need to know
On July 29th 2021, the Alternative Reference Rates Committee (ARRC) announced that it is formally recommending the CME Group's forward-looking Secured Overnight Financing Rate term rates (TERM SOFR) as the index to replace the sunsetting LIBOR (London Interbank Offered Rate). These rates are officially published on the CME website. WaFd Bank launched TERM SOFR loan products on January 1, 2022. Similar to LIBOR, TERM SOFR is available to WaFd Bank borrowers.
What is the Alternative Reference Rates Committee (ARRC)?
A group of market participants organized by the Federal Reserve and New York Fed to help ensure a successful transition from Libor to a more robust reference rate.
Objectives of ARRC:
- Identify alternative reference rates and determine whether identified alternative rates are compliant with the IOSCO's Principals for Financial Benchmarks.
- Identify best practices for contract robustness to ensure contracts are resilient to the possible cessation or material alteration of existing of new benchmarks.
- Develop an adoption plan to outline the necessary steps so that market participants could make the adoption more successful.
- Create a timeline and an implementation plan with metrics of success.
ISDA publishes updated protocol
ISDA Protocol Amendments and updated 2006 ISDA Definitions with fallbacks became effective
Cessation of remaining Libor Tenors
ARRC recommends a forward-thinking Term SOFR reference Rate
Cessation of week 1 & 2 month LIBOR, final deadline for LIBOR Originations
Cessation of remaining LIBOR Loans
Term SOFR Replacement Index In Use
The London Interbank Offered Rate (LIBOR) is a benchmark variable interest rate that major global banks have historically used to lend to one another, published daily by the Intercontinental Exchange Benchmark Administration (ICE). For many years, LIBOR has been the dominant benchmark rate for determining interest payments on variable rate financial products.
The methodology for calculating LIBOR has remained largely unchanged since it was introduced. Each day, a group of large banks, known as “panel banks,” report their funding rates to ICE, which averages, adjusts, and publishes those rates daily.
The “LIBOR transition” references the discontinuation of LIBOR and the transition away from LIBOR-based rates.
The LIBOR transition is happening because of two main concerns with the LIBOR calculation process:
- There has been a significant decline in the sample size for calculating LIBOR since the 2008 financial crisis. Fewer panel banks have been reporting, and those that do, report fewer quotes based on market transactions. Instead, LIBOR has increasingly relied on, what ICE calls, “market and transaction data-based expert judgment”. Therefore, concerns were raised about how well LIBOR reflects market realities.
- LIBOR's reliance on inputs from panel banks opened it to manipulation, and there have been a range of irregularities uncovered by regulators.
Tenors of LIBOR will not be published after June 30, 2023. Federal banking regulators instructed banks to stop originating new LIBOR loans no later than December 31, 2021.
Many different rates have been considered as replacement indexes by different institutions, with varying levels of market acceptance. Replacement and alternative rates include Wall Street Journal Prime (“WSJP”), SOFR, and BSBY.
The Secured Overnight Financing Rate (SOFR) represents the interest rate that banks impose on each other in making loans secured by U.S. Treasuries. SOFR is a daily, overnight, secured, risk-free rate, released by the Federal Reserve every morning.
“Term SOFR” is a forward-looking rate representing a projection of what daily SOFR will be on a certain date in the future. Unlike LIBOR, which is a forward-looking, credit-sensitive rate meant to reflect a bank's cost of capital, SOFR measures rates applicable to short-term, secured financing. Because SOFR is secured (while LIBOR is unsecured), SOFR has historically been a lower rate than LIBOR, which means it will require a spread adjustment if used as a replacement to a LIBOR-based loan.ARRC Recommended Rate – The Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Bank of New York, has recommended SOFR as a LIBOR alternative.
The Bloomberg Short-Term Bank Yield Index (BSBY) is a proprietary, credit-sensitive index, that incorporates bank credit spreads and calculates a forward term structure. BSBY seeks to measure the average yields at which large global banks accessed USD senior, unsecured, wholesale funding.
Despite ARRC's recommendation of SOFR as the replacement/alternative to LIBOR, some financial institutions prefer BSBY as a replacement rate, particularly because of its nature as a credit-sensitive, forward-looking term rate that has historically behaved very similarly to LIBOR.
Comparison of BSBY v. LIBOR
- Both reflect market lending costs
- As forward-looking rates, both anticipate policy rate moves
Comparison of BSBY v. SOFR
- Both are based on significant transactional volume (though SOFR's volume exceeds that of BSBY)
- Neither is reliant on expert judgment
- As a forward-looking rate, both BSBY and Term SOFR seek to anticipate movement in advance.
- SOFR is based on secured repo transactions and will respond to liquidity changes in that market. BSBY will respond to conditions in financial markets that affect pricing of short-term fundings
After carefully monitoring market developments and acceptance, WaFd Bank plans to follow the ARRC's replacement rate and spread adjustment recommendations to transition the commercial loans in the bank's portfolio by June 30, 2023. WaFd Bank intends to use to use the following Term SOFR plus a spread adjustment for commercial loans that were priced using LIBOR:
|Term||Tenor Spread Adjustment|
While this Adjusted Term SOFR will serve as the replacement rate for WaFd Bank's Commercial Loans whose rates have not otherwise been transitioned prior to June 30, 2023, affected commercial clients who would prefer to use alternative replacement rates have the option of WSJP, SOFR and BSBY. WSJP, SOFR and BSBY are available for pricing new commercial loans, or for pro-actively transitioning existing LIBOR loans prior to June 30, 2023.
Derivatives Products – LIBOR-based commercial loans that are subject to interest rate hedges, swaps, or other derivatives products will require coordination in advance of the June 30, 2023, transition deadline in order to transition both the underlying loan product and the derivative product to replacement rates that maintain the economics with as little cost and disruption to your client and WaFd Bank as possible.
LIBOR-based loans that mature after June 30, 2023, will need to be transitioned to an alternative fallback rate (Term SOFR, please see above for more information on fallback rates). Affected clients can expect to receive communication form their relationship manager during the first quarter of 2023 describing the details of the transition and any required actions.
Swaps and other derivative products define the index rate used separately from the underlying loan documents, and those currently referencing a LIBOR index will also need to be revised to use an alternate index rate when LIBOR becomes unavailable. For the derivative products to function as intended, the replacement index in the derivative should match the replacement index used in the underlying loan transaction. Existing LIBOR-based derivatives (and their related loans) will be transitioned to Term SOFR. This transition will need to occur prior to June 30, 2023.