WASHINGTON — The financial industry's transition to a new interest rate benchmark so far has been mostly relegated to the back burner.
All that is about to change in the new year.
"Heading into 2020, this is it. It’s game time," said Lary Stromfeld, a partner with Cadwalader, Wickersham & Taft. "And if you think about how much needs to be done, two years is not a lot of time."
The London interbank offered rate, or Libor, is the most dominant interest rate benchmark around the globe, but it will likely be unavailable starting at the end of 2021. The secured overnight financing rate, or SOFR, has been developed as an alternative and has gradually gained market share.
Even though financial institutions still have time before the deadline, regulators stand poised in the coming year to forego softer forms of encouragement for banks to prepare for the transition — prodding through institutional reports and opinion pages of financial publications — in favor of a more direct supervisory approach.
Mark Chorazak, a bank regulatory partner with Cadwalader, said regulators are getting more insistent because the switch will affect a massive amount of financial contracts, involving counterparties and affiliate offices all over the world.
"One of the reasons why regulators are moving from a slow to a rolling boil is a recognition that there is not only a sheer volume problem but that affected contracts are dispersed widely across an organization," Chorazak said. "There's a recognition that an organized transition is going to take a lot of time."
Libor is referenced in $200 trillion in securities, derivatives and adjustable-rate contracts. But the interbank lending market that Libor is based on has dried up and the rate was dogged by scandal, with dozens of banks implicated in a rate-rigging scheme.
To address the problem, regulators and industry representatives formed the Alternative Reference Rates Committee in 2014, which identified overnight repurchase agreements as a deep and liquid market that would be durable and resistant to manipulation. The SOFR benchmark was based on the overnight repo market.
Tom Wipf, chairman of the ARRC and vice president of institutional securities at Morgan Stanley, said in a Bloomberg opinion article earlier this month that a speedy adoption of SOFR in place of Libor is critical, and time is running out for firms to make the switch.
"Two years is a short period to close out the remaining tasks," Wipf said. "The strength of institutions individually, and the architecture of the financial system broadly, relies on everyone doing their part to ensure a smooth transition to SOFR."
Regulators already began in 2019 to amplify warnings about the need for banks to focus on the switch.
The Financial Stability Board — an international group of central bankers and financial regulators chaired by Federal Reserve Vice Chairman for Supervision Randal Quarles — said earlier this month that market participants and regulators must start getting serious about the Libor transition because it poses a risk both to individual institutions and the financial system.
"Firms that have not begun this work in earnest, and do not have plans to complete it by end-2021, run significant financial and reputational risks," the report said. "Firms need to end use of Libor in new contracts as soon as possible and, where possible, to accelerate their efforts to remove their reliance on Libor within legacy contracts."
Libor's underlying market relies on estimates submitted from an increasingly small number of banks — and those banks will only be required to submit those quotes until Dec. 31, 2021. The Financial Stability Board said in its report that there is "appreciable risk" that Libor will cease publication after that time, and that "transition well before that date would greatly minimize risks to financial stability."
Authorities are already becoming increasingly insistent that banks reduce their Libor-referencing contract exposure promptly. The Bank of England's Financial Policy Committee said in a readout of its October meeting that "there is no justification for firms continuing to increase their exposures to Libor," and that the committee "will consider further potential policy and supervisory tools that could be deployed by authorities" to reduce firms' Libor exposures.
In a September speech, John Williams (pictured above), head of the Federal Reserve Bank of New York, warned that "everyone in the financial services industry needs to be aware that the date when the existence of Libor can no longer be guaranteed is fast approaching." At a congressional hearing earlier this month, Treasury Secretary Steven Mnuchin said officials may even ask for Congress to craft regulatory language to ease the impact on financial contracts.
The coming year will likely bring in to focus how individual banks plan to transition away from Libor. The New York Fed already began publishing daily SOFR rates in April 2018.
Hu Benton, vice president of banking policy at the American Bankers Association, said supervisors may be agnostic about a bank’s particular plan, but not having a plan — or at least an assessment of the institution's exposure — may not be an option.
"All the domestic regulators are going to have Libor as a hot topic," Benton said. "I believe the regulators are sincerely and genuinely interested in the market developing a solution … as long as the market doesn't pretend that this is not an issue that we need to address."
But the transition from Libor to SOFR — or some other rate — isn’t a simple matter of replacing one rate with the other.
One challenge is that Libor provided firms with not only a spot interest rate — that is, an immediate quote for right now — but also term interest rates for longer periods. That’s because banks would lend to each other not only overnight but also for longer terms.
That is a convenient option for derivatives and securities contracts that may have a term maturity. However, because SOFR references a daily spot market, coming up with reliable estimates for SOFR rates further out is more challenging.
The New York Fed took a big step in November by announcing its intention to publish daily compounded SOFR averages for 30, 90 and 180 days, as well as a SOFR index that would “allow the calculation of compounded average rates over custom time periods.” That index and the methodology behind it are open for public comment through Jan. 10.
Benton said the ultimate shape of the New York Fed's SOFR index and the methodology behind it could be a critical factor in expanding the adoption of SOFR and SOFR-referencing contracts. The deeper those markets become, the better.
"That's something that a lot of people in the industry are very interested in," Benton said. "I have been as explicit as I could be with the other folks in the ARRC about how important it is that [the index] and the basis for it are part of a more vigorous public discussion, because I think a lot of people really care about what that is."
Banks and other financial companies have started to take notice. A study performed by Cadwalader and Sia Partners earlier this month found that almost 90% of the 75 firms they analyzed had already begun their transitions away from Libor, and the largest and most internationally active firms had made the most progress. Bradley Ziff, an operating partner with Si Partners, said that the report's findings suggest that very few banks are starting 2020 from zero.
"Very few institutions have done either nothing or very little, I would say," Ziff said. "I think that's a solid snapshot of the industry, reaching that conclusion."
Yet a group of regional banks told regulators in October that SOFR has drawbacks as an alternative to Libor, namely that it may not work best as a benchmark for lending products.
And with Libor being such a widely used benchmark, banks are not the only type of counterparties that need to be involved for the transition to be seamless. The research by Cadwalader and Sia suggested that nonbank firms are farther behind in preparing for the switch.
"If you're going to look and identify where that lack of energy might come, it is likely to be more on the corporate and financial end user side," Ziff said.
That’s why nonbank regulators are increasingly chiming in about Libor-related exposures. Last summer, the Securities and Exchange Commission issued a staff statement urging publicly traded companies not to issue new contracts pegged to Libor. The statement encouraged all companies "who have not already done so to begin the process of identifying existing contracts" and start thinking about how to manage Libor-related risks.
More recently, the Financial Accounting Standards Board adopted a guidance document that provides corporate entities with "optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedge accounting relationships affected by reference rate reform."
Stromfeld said that some of those smaller or nonbank firms may be aware that Libor is going away but are waiting for the markets to adopt an alternative with sufficient depth that there is little risk of having to make yet another transition in the future. But with the deadline only two years away, there may not be any time left to wait for perfect certainty, he said.
"Everyone has the same deadline," Stromfeld said. "Nobody has the luxury of saying, 'OK, well, I'll wait until the big boys have it all figured out, and then I'll do it,' because by then it's too late. You've got to be willing to get started."
