LIBOR Transition Comparison: US vs. UK (Focusing on Interdealer Brokers)

As part of the ongoing transition from the London InterBank Offering Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) recommended by the Alternative Reference Rates Committee (ARRC) as an alternative rate, an advisory subcommittee of the Commodity Futures Trading Commission (CFTC)[1] announced on June 8, 2021, it was recommending that the interdealers it oversees exclusively use, effective July 26, 2021, SOFR rather than LIBOR for linear derivative trades.[2]

Early Use Recommended for Interdealer Brokers

The exclusive use of SOFR by interdealer brokers in a majority of derivative trades would be a large step forward for ARRC, and the announcement by CFTC’s Acting Chairman, Rostin Behnam, was applauded by Tom Wipf, ARRC Chairman and Vice-Chairman of Institutional Securities at Morgan Stanley, who added that implementation of the suggested transition to SOFR would “demonstrate definitive progress [towards]…SOFR term rates.”[3] The establishment of forward-looking term rates is especially important to borrowers as well as trust and securitization vehicles who have not, or cannot, adjust to SOFR/SONIA overnight, backward-looking rates.

It is important to note that (i) US regulators have insisted that no new financial instruments utilizing USD LIBOR as a benchmark be entered into after 2021 and (ii) active USD LIBOR rates are scheduled to no longer be calculated after June 30, 2023, although the LIBOR rates for all other currencies are scheduled to no longer be calculated after year-end.

Background

The CFTC is an independent agency of the Federal Government that regulates the US derivatives market and certain types of options and provides oversight, market surveillance, and enforcement in an effort to bring transparency, prevent fraud, and oversee merchants, dealers, and large traders.

ARRC is generally controlled by financial institutions and other private market participants. It includes, as ex officio members, banking and financial sector regulators.

An interdealer broker facilitates transactions among other dealers, investment banks, and financial institutions.[4] As such, interdealer brokers are sometimes referred to as ‘Market Makers’, quoting both sides of a market – bids and asks.[5] Linear derivative trades are trades in futures, forwards and swaps, representing a majority of the derivatives market.[6]

No Fair Credit Spread Adjustment Recommendations

No fair credit spread adjustment from LIBOR to SOFR has been established by ARRC after repeated aborted attempts to derive such a fair credit adjustment spread including, in particular, a fair credit spread adjustment for interbank dealers.

During an ARRC-sponsored webinar held on June 8, 2021, of particular note was the discussion of the wide acceptance of the United Kingdom’s alternative rate to LIBOR, the Sterling Over Night Indexed Average (SONIA), in the derivatives market.[7]

This was mainly attributed to the calculation of a fair credit adjustment spread from LIBOR to SONIA by the International Swaps and Dealers Association (ISDA)[8], as the median difference between LIBOR and SONIA over the previous five (5) years.[9] SONIA has been published since 1997 whereas, in contrast, SOFR has only been published since April 2, 2018.[10]

Caveats

However, there are a few caveats to bear in mind to effectuate the ‘smooth transition’ from LIBOR in the United States:

this action has only been approved by an advisory subcommittee of the CFTC so it still requires approval by the CFTC itself
since interdealer brokers interact with other dealers, investment banks and financial institutions, approval may also be required of the Securities and Exchange Commission (SEC), as well as the bank regulators including the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC), before becoming effective
ARRC has not proposed a fair credit spread adjustment
most importantly, this action (as well as all other ARRC actions) is merely a recommendation and not a requirement

From our solely US-based experience, it is not clear whether the ISDA recommended fair credit adjustment spread formula for SONIA is simply a suggested recommendation or is actually required. In any event, UK lenders have successfully adopted SONIA.

This may be one of the reasons why the expected end of LIBOR in the UK and elsewhere in the world remains on time, by year-end 2021, rather than the US deadline of June 2023.

[1] https://www.cftc.gov/About/CFTCOrganization/index.htm

[2] CFTC’s Interest Rate Benchmark Reform Subcommittee Recommends July 26 for Transitioning Interdealer Swap Market Trading Conventions from LIBOR to SOFR | CFTC

[3] The SOFR Symposium: The Final Year (“The SOFR Symposium: The Final Year”). https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/what-is-credit-adjustment-spread-supporting-slides.pdf [During this webinar, it was mentioned that recommended SOFR term rates should be available this summer.]

[4] https://www.investopedia.com/terms/i/inter-dealerbroker.asp

[5] https://www.investopedia.com/terms/m/marketmaker.asp

[6] Id.

[7] The SOFR Symposium: The Final Year.

[8] ISDA is a trade organization for the worldwide derivatives market participants.

[9] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/credit-adjustment-spread-methods-for-active-transition-of-gbp-libor-referencing-loans.pdf?la=en&hash=4C41CC67E9C81DC835644603D05ACE3120F66999

[10] https://www.newyorkfed.org/markets/reference-rates/sofr-averages-and-index