The End of LIBOR? ‘Zombie’ USD LIBOR to Appear on July 1

Subject to appeal, ICE Benchmark Administration Limited (IBA) will be required to publish synthetic USD LIBOR beginning on July 1 so as to reduce any market disruption and maintain the orderliness of the financial system.

General

The UK FCA’s announcement on April 3, and the related Notice of Designation and draft Notice of Requirements, are the basis of this client alert. (See our previous alerts on ‘Zombie’ LIBOR here and here.)

The UK FCA concluded that synthetic LIBOR was necessary due to a relatively small, but still material, subset of legacy contracts that will not be able to transition away from USD LIBOR by June 30, 2023 – the end date of the remaining USD LIBOR tenors. There is estimated to be trillions of dollars (give or take) of such legacy contracts. Likely impacting consumers, including their pensions and investments, the UK FCA is requiring synthetic USD LIBOR in light of its consumer protection mandate.

The synthetic rate will apply to all USD LIBOR financial instruments, except cleared derivatives, which had not transitioned to an alternative benchmark by June 30. It is expected that synthetic USD LIBOR will no longer be published after September 30, 2024.

Legacy Use Only

As the use of USD LIBOR was prohibited subsequent to January 1, 2022, for any new facilities, subject to limited exceptions, the use of synthetic USD LIBOR is also prohibited for use in any new facilities but with no exceptions. Presumably, new use includes renewals or extensions of existing facilities.

Rationale

All of the USD LIBOR Panel Banks communicated to IBA that they would not be willing to continue contributing to USD LIBOR’s calculation after June 30^th. LIBOR Panel Banks have expressed their concern about the legal and reputational risks associated with continuing to contribute to LIBOR. As a result, the UK FCA decided that it would not use its benchmark regulation powers to compel continued panel bank contributions to USD LIBOR.

In the UK FCA’s view, an interest rate benchmark that includes an element of credit risk, such as LIBOR, is inherently more vulnerable to volatility during times of market stress.

Precedent

Synthetic benchmarks for the following currencies were published, and are expected to be published, for a significant period of time after cessation and being deemed unrepresentative by the UK FCA as summarized below:

The foregoing illustrates that the additional transition period contemplated for synthetic benchmarks for USD LIBOR exceeds the transition periods for both Yen LIBOR and Sterling LIBOR, which is especially significant if the original USD LIBOR end date is considered.

Methodology

For 1-Month, 3-Month, and 6-Month USD LIBOR, IBA is required to utilize the relevant Term SOFR and respective ISDA spread adjustment. The ISDA spread adjustment is utilized for calculating the spread between LIBOR and risk-free rates.

However, like LIBOR, Term SOFR is not a risk-free rate. Though Term SOFR uses Daily Simple SOFR (a risk-free rate) as its base, it is ultimately a rate derived from the futures market.

Set forth below is 1-Month USD LIBOR and 1-Month Term SOFR, along with the ISDA benchmark spread adjustment of 11 basis points, for each quarter in 2022 and the 1^st quarter of 2023 prior to and subsequent to Federal Reserve Fed Funds rate increases, as well as the differential between such rates:

Historical Differentials

Differentials between 1-Month USD LIBOR and the new synthetic rate are highlighted in (i) green if beneficial or neutral to borrowers and (ii) yellow if beneficial to lenders. Of course, the foregoing are historical and are not a reflection of future differentials.

This synthetic methodology is to provide ‘a fair approximation of LIBOR’ according to the UK FCA. However, it should be noted that removing the ISDA spread adjustment, at least from an historical perspective for the dates enumerated, would have led to a new synthetic rate closer to 1-Month USD LIBOR than the new synthetic rate established by the UK FCA.

Resurrected Concerns

Enumerated below are some further issues in connection with utilizing ‘Zombie’ USD LIBOR:

• Whether synthetic USD LIBOR, which the UK FCA has deemed to be unrepresentative of the underlying market that USD LIBOR was intended to measure, will be considered a viable substitute for USD LIBOR
• Resultant impact on the availability of legal protections provided to lenders under the Federal Adjustable Interest Rate (LIBOR) Act
• Securitization and bond financing concerns in light of the upcoming end of LIBOR and the commencement of the use of synthetic LIBOR on July 1
• Look for future insights from our team on the foregoing, hopefully before Zombie USD LIBOR actually appears…