Preparing for the Cessation of LIBOR

LIBOR is going away—now what? Cynthia Meyn

Photo: iStock.com/MATJAZ SLANIC

The final publication of LIBOR, originally slated for Dec. 31, 2021, and recently delayed until June 30, 2023, is approaching. This article serves as a guide on how actuaries can navigate through this extensive and important international effort.

LIBOR Overview

LIBOR is the acronym for London Inter-bank Offered Rate. LIBOR started in the late 1960s as a fairly simple polling process of collecting, averaging and distributing interest rate quotes from U.K.-domiciled money-center banks every day. The purpose of LIBOR was to enable syndicated loan issues to reference independently obtained floating rates. Eventually, in 1986, the British Banking Association (BBA) in London evolved and formalized the process of collecting and processing the data.1

Originally, LIBOR was quoted in just a few currencies—such as GBP, DEM, JPY and USD—and for just a few forward terms—such as overnight, one month or three months. By 2008, LIBOR had evolved into the base quotation rate for most major currencies in the world, and for trillions of dollars of products worldwide. LIBOR underpinned consumer products, such as mortgages, credit cards, annuities, mutual funds and student loans, as well as institutional products, such as syndicated loans, corporate debt, repurchase agreements (repos), hedge funds and asset-backed products. Additionally, the past three decades were marked with exponential growth of LIBOR-dependent derivatives, such as interest rate swaps, credit default swaps, futures and options. These derivatives are fed by innumerable yield curves and volatility surfaces driven by countless bid-offer, basis and credit spreads that are all rooted with reference to LIBOR. Today, hundreds of trillions of dollars of retail and institutional products depend on LIBOR.

Why LIBOR Is Going Away

By 2008, approximately “60 percent of prime adjustable-rate mortgages (ARMs) and nearly all subprime mortgages were indexed to the U.S. dollar LIBOR” rate.2 LIBOR had become arguably marbled throughout the worldwide financial services infrastructure to the point of inextricability. Then the financial crisis of 2008 revealed the fatal flaw of LIBOR—its lack of independence and history of manipulation by the banks. Quite simply, LIBOR was rigged.

Market participants began to question the integrity of LIBOR and the polling process as early as 2017. It subsequently was revealed that LIBOR submissions did not always correlate to, nor did they depend upon, actual transactions. Manipulation and loopholes in favor of the submitting banks was alleged, as an artificial perception of being a receiver of falsely higher-than-market rates would help their creditworthiness.

Investigations by regulators into the alleged rigging of LIBOR proceeded. In June 2012, Barclays Bank was fined 59 million sterling pounds by the Financial Services Authority (FSA) and US$360 million by U.S. authorities for false reporting of LIBOR from 2005 to 2009. Other significant banks, including J.P. Morgan Chase, UBS and Bank of America, were investigated as well.3

As an interim step, on Feb. 1, 2014, the Intercontinental Exchange (ICE) took over the administration of LIBOR after a rigorous selection process. The transition to ICE LIBOR was smooth. According to ICE: “LIBOR is currently calculated for five currencies (USD, GBP, EUR, CHF and JPY) and for seven tenors in respect of each currency (overnight/spot next, one week, one month, two months, three months, six months and 12 months). This results in the publication of 35 individual rates (one for each currency and tenor combination) every applicable London business day.”4 However, because LIBOR continues to be a forward-quoted rate, without being definitely dependent upon actual transaction history, regulators have mandated that the use of LIBOR must cease for all use cases in those five currencies.

The Future of USD LIBOR Is SOFR

In the United States, where the marketplace historically has been highly dependent upon USD LIBOR, the Federal Reserve Board and the Federal Reserve Bank of New York (New York Fed) jointly convened a group of private-market participants in 2014. This committee, known as the Alternative Reference Rates Committee (ARRC), aims to “ensure a successful transition from USD LIBOR to a more robust reference rate.”5

In 2017, Andrew Bailey, the then-chief executive officer of the U.K. Financial Conduct Authority (FCA), announced the FCA would cease compelling banks to submit quotes to LIBOR after year-end of 2021.6 Also in 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the more robust reference rate.7 The ARRC deemed SOFR preferable over LIBOR because the underlying markets of SOFR—the U.S. Treasury repo market with its more than $1 trillion in daily volume—gives SOFR depth, transparency and permanence. The New York Fed, in cooperation with the Office of Financial Research (OFR), publishes SOFR each business day at approximately 8 a.m. ET. While other alternative rates exist, such as fed funds, the focus of the ARRC and New York Fed has been on SOFR.

There are very important mechanical differences between LIBOR and SOFR: SOFR is a compounding, arrears-set rate, while LIBOR is a forward-looking, anticipatory rate. Efforts are underway to publish a term structure. Additional information about the nature of SOFR, the User Guide and the Paced Transition Plan are available on the ARRC website.

The differences in the two indices (LIBOR vs. SOFR) will impact numerous valuations, risk factors and the processing systems of numerous bond holdings, derivative hedges, actuarial liability calculations and in-force policies at most insurance carriers or reinsurers. All five LIBOR currencies are moving to alternative rates, as shown in Figure 1.

Figure 1: LIBOR Benchmark Alternatives by Country

Currency/Country Replacement Benchmark Extended Name
USD/United States SOFR Secured Overnight Financing Rate
EUR/Europe ESTR Euro Short-Term Rate
GBP/Britain SONIA Sterling Overnight Index Average
CHF/Switzerland SARON Swiss Average Rate Overnight
JPY/Japan TONAR Tokyo Overnight Average Rate

Change Is Certainly Going to Come

Because of the underlying differences between LIBOR and SOFR—and because of the widespread impact—switching is going to be difficult. However, the switch is already underway, and the New York Fed has no intent of slowing down. If anything, market participants are picking up the pace and the switch is happening.

On Oct. 16, 2020, the end stage of LIBOR was hastened as major investment banks and clearinghouses shifted the discounting rate for more than $80 trillion in notional from effective fed funds to SOFR.8 According to the CME Group, SOFR futures volume has averaged $130 billion per day in notional for year to date (YTD) ending Sept. 30, 2020.9

Additionally, the International Swaps and Derivatives Association (ISDA) announced new contractual language that markets can incorporate into their master agreements. For counterparties who have not yet amended their swaps, the fallback rate for USD LIBOR shall be SOFR plus a spread adjustment.10 The next step in the ARRC’s Paced Transition Plan is for “the creation of a term reference rate based on SOFR derivative markets,” with an original target date of June 30, 2021.11

Figure 2 shows a recent estimate of securities and instruments outstanding as of Sept. 30, 2020, with the stated target date by the New York Fed and ARRC of when new issuance in those instruments will cease.

Figure 2: USD LIBOR Marketplace by Asset Class*

Volume (in $ billions) Percentage LIBOR Most Likely Replacement Rate ARRC Target Date to “Sunset” New Issuance
Loans Syndicated loans ~3,400 97% SOFR in arrears June 2021
Corporate business loans 1,650 30%–50% SOFR in arrears or advance June 2021
Noncorporate business loans 1,252 30%–50% SOFR in arrears or advance June 2021
Commercial real estate/commercial mortgages 3,583 30%–50% SOFR in arrears June 2021
Retail mortgages 9,608 15% SOFR in advance September 2020
Credit cards 846 Low SOFR in advance, other n/a
Auto loans 810 Low SOFR in advance, other n/a
Consumer loans 139 Low SOFR in advance, other n/a
Student loans 1,131 7% SOFR in advance, other TBD
Bonds Floating/variable-rate notes 1,470 84% SOFR in arrears December 2020
Securitization Residential mortgage-backed securities ~7,500 24% SOFR in arrears June 2021
Commercial mortgage-backed securities ~636 4% SOFR in arrears June 2021
Asset-backed securities ~1,400 37% SOFR in arrears June 2021
Collateralized loan obligations ~300 71% SOFR in arrears September 2021
Over-the-counter derivatives Interest rate swaps 106,681 65% SOFR in arrears June 2021
Forward rate agreements 29,044 65% SOFR in arrears June 2021
Interest rate options 12,950 65% SOFR, various June 2021
Cross-currency swaps 22,471 65% SOFR, TBD June 2021
ETDs Interest rate options 20,600 98% SOFR in arrears June 2021
Interest rate futures 12,297 82% SOFR in arrears June 2021

>$5 trillion estimated USD LIBOR exposure

$1–$5 trillion estimated USD LIBOR exposure

<$1 trillion estimated USD LIBOR exposure

*Data as of October 2020. Some overlap exists between syndicated loans as corporate loans.
Source: Oliver Wyman, estimated based upon industry surveys and Federal Reserve data

Managing the Change—A Four-Part Plan

As insurance companies, pension plans, mutual funds and other asset owners move into 2021, actuaries need to get ready. Hopefully many insurance carriers have allocated resources to the project, as both the New York Fed and the FCA are quite serious about change.

Step 1: Impact Analysis

The impact analysis is a key first step to managing the transition from LIBOR to SOFR. To start, all market participants should create a task force or steering committee comprising cross-departmental subject-matter experts and leaders from legal, risk management, actuarial, finance, accounting, investment management, investment operations and information technology (IT). Each department should assess the extent to which LIBOR permeates the organization.
Here are some examples the typical insurance carrier should consider:

  • Asset positions in bonds, loans, mortgages, structured debt, collateralized loan obligations and privately placed credit that depend on LIBOR
  • Hedges, such as interest rate swaps or options, that depend on LIBOR in several currencies
  • Complex liability actuarial analysis based on seriatim data and forecasted interest rates, where those calculations may embed LIBOR into the yield analysis or discounting
  • Annuity policies and mutual funds that also may reference LIBOR
  • Accounting systems may be accruing interest using LIBOR and may be unable to leverage published SOFR rates
  • Risk management, trading and hedging systems likely reference yield curves that may in turn reference LIBOR

Essentially, every asset owner should take a deep dive across the organization to create the list and assess the full impact. Note that some of the industry, particularly around cleared derivatives, has already changed as described previously.

Step 2: Strive to Amend Active Securities

While the derivative marketplace moves ahead with change and new issuance of SOFR-based securities is on the rise, a problem remains for the large body of early-vintage U.S. securities that are dependent on LIBOR. Deep in the offering memorandum of securities, “fallback language” (hopefully) exists. Fallback language dictates through contractual language what will happen to securities if LIBOR ceases to be published, such as the trigger events and replacement rate.

Newer securities that rely on LIBOR can be issued with ARRC-recommended fallback language. According to the New York Fed, the ARRC-recommended fallback language is for market participants’ voluntary use in contracts that reference USD LIBOR, and it was developed with the goal of reducing the risk of serious market disruption in the event that LIBOR was no longer usable.12 However, older securities, aged syndicated loans or asset-backed securities may have either unacceptable fallback language or nonexistent fallback language. This is attributed to the fact that prior to 2007, not all issuers, lenders or underwriters contemplated the fact that LIBOR would cease to exist—and some fallback language was designed for short outages of perhaps one or two days. Indeed, some fallback language unintentionally results in floating rate notes—commonly held by insurance carriers—converting into permanently fixed-rate notes referencing the last tick of LIBOR.

Every asset owner should be culling through its trove of terms and conditions to classify and understand the next steps around nonexistent or unacceptable fallback language. Once that is done, there are additional actions that need to be taken depending on the asset type:

  • For listed securities, the agent banks are working to issue consents for replacement fallback language. Be sure to connect with your broker-dealer salesperson to understand what the consent and corporate action amendment process will be for your company’s securities. Some of this activity is being facilitated by the New York Fed and the Securities Industry and Financial Markets Association (SIFMA).
  • For syndicated loans, the Loan Syndications and Trading Association (LSTA) published a concept credit agreement, which describes “a term loan referencing daily simple SOFR or daily compounded SOFR (“compound the balance” approach).13 Lenders should reach out to agent banks to begin the process to amend loans that have nonexistent or unacceptable language. Lenders of bilateral loans should reach out directly to their counterparties.
  • For derivatives, on Oct. 23, 2020, ISDA launched its IBOR Fallbacks Protocol, which “enables market participants to incorporate the revisions into their legacy noncleared derivatives trades with other counterparties that choose to adhere to the protocol.”14 Counterparties of derivatives should work through ISDA and existing system infrastructure to adhere to the protocol in advance of the fallback effective date, which is Jan. 25, 2021.

One problem that continues is garnering consent for aged-old securities. Efforts to achieve consent have failed without 100 percent participation in the consent process. The New York Fed is addressing this issue by proposing legislation in New York. In March 2020, the ARRC published “Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition.”

The goal of this legislative solution is to provide a path forward to mandate the use of ARRC fallback language for many types of securities—including floating rate notes, securitizations, consumer ARMs, business loans and municipal bonds—where consent may not be achieved by Dec. 31, 2021. The LSTA and ISDA likewise are working to achieve mandated fallback language for syndicated loans and derivative products.

Step 3: Enable Change—Capital, Risk, Operations and IT

While the legal and risk teams pursue the amendments described, the operations and IT teams should not stand by idly. A full inventory of “things that need to change”—from capital allocations down to market data feeds—should be compiled and acted upon.

Here are a few questions the typical insurance firm, or any asset owner, should consider:

  • Policy administration. Do any of your policies (e.g., annuities) reference LIBOR, and has your firm begun the process to amend or discontinue the policies?
  • Liability calculations and capital sufficiency. Has your firm understood and planned for the impact to capital requirements when your liabilities and hedges no longer reference LIBOR?
  • Is the overall impact to the balance sheet in terms of liabilities, assets and hedges, along with the consequential risk sensitivities, well understood?
  • Internal system code. Are the data feeds, databases and programmed logic able to collect, store and operate with SOFR rather than LIBOR?
  • Derivatives. Are your trading floor(s) and associated risk management systems able to function in a world without LIBOR, and have you begun to adhere to the ISDA protocol?
  • External third-party vendors. Are your vendors for policy administration, investment management, investment accounting, hedge processing, custody and principal and interest (P&I) payment reconciliations sufficiently retrofitted?

Identifying and accomplishing the multitude of tasks may require a dedicated project manager to help prioritize and track the plethora of changes—both internal and external—that will impact your firm as the worldwide marketplace moves across the finish line.

Step 4: Testing for Day T Readiness

Testing is going to be tough. There are two major types of systems and two major aspects to be tested with regard to the change to SOFR. Additionally, there are various players in the financial services ecosystem, and interoperable testing is going to be crucial. Let’s break down the current testing underway and consider some proactive actions.

First and easiest, firms should look at systems and operations:

  • Internal systems and operations. Asset owners and managers should retrofit all internal standard operating procedures and systems to enable the day-to-day processing of SOFR-denominated instruments. Many such instruments already are issued and trading on the secondary market. Specifications for details around SOFR calculations are available on the ARRC website and also can be obtained from most broker-dealer counterparties. A simple toggle between the rates is highly unlikely to work without recoding some internal systems and operational procedures.
  • External systems. Many asset owners and managers have outsourced key functions, such as investment accounting and custody. All asset owners and managers should ensure their material vendors can certify and demonstrate that they are prepared to process SOFR and/or that they already process SOFR for some clients. For highly important vendors, where failure for Day T readiness would be a fatal flaw, customers are advised to mandate evidence of readiness, interoperable testing protocols and user acceptance.

Next, two key functions should be tested to ensure a smooth transition:

  • First, the actual cutover of the securities and positions held on the balance sheet must be rehearsed. As noted, fallback language will take effect—mostly on Jan. 1, 2022, or shortly thereafter. The communication of the change, particularly fallback language dictated through legislation, is not well understood. A working assumption is emerging where several participants are discussing the concept that fallback language amendments passed through legislation and/or through a successful consent process will be communicated through the “freeform extension fields” within the standard corporate action messaging systems and protocols that exist today. Those messages would include the effective date and other data around the change from LIBOR. Asset owners and managers should work with their broker-dealer counterparties, custodians and agent banks, as well as corporate action data feed vendors, to understand and arrange repeated testing for each asset class. The rehearsals should practice the communication of the amendment and effective date, and the conversion process itself and the valuation impact.
  • Second, the day-to-day processing of SOFR or another alternative rate as a substitute for LIBOR must be rehearsed. This is a bit easier, as numerous examples of such securities exist in the marketplace today, and the major clearinghouses already have changed the discounting method for derivatives, as previously noted.

Testing is the only way an insurance carrier truly can be sure what the impact of the cessation of LIBOR means across the board for the organization.

Conclusion

As we head into 2021, it has become clear that LIBOR will cease to be published in its current form. Once we cross into July of 2023, banks will not be compelled to submit quotes to ICE or any other administrator; thus, LIBOR will either cease to be published or it will cease to have sufficient, verifiable liquidity and evidenced transactions underneath it.

I hope you will view 2021 as a call to action to eliminate your firm’s dependency on LIBOR as quickly as possible. We must all get ready and embrace the bold new world of transparent and evidence-based index rates, without LIBOR. May it rest in peace.

Cynthia Meyn is currently co-chair of the Day T Readiness Subcommittee within the New York Fed’s ARRC Operations and Implementation Committee and is the former chief operating officer at Venerable Holdings Inc.

References:

  1. 1. Bajpai, Prableen. Why BBA LIBOR Was Replaced By ICE LIBOR. Investopedia, March 31, 2015.
  2. 2. Schweitzer, Mark, and Guhan Venkatu. Adjustable-Rate Mortgages and the Libor Surprise. Federal Reserve Bank of Cleveland, January 21, 2009.
  3. 3. Supra note 1.
  4. 4. International Exchange. LIBOR. International Exchange.
  5. 5. Alternative Reference Rates Committee. About. Federal Reserve Board and Federal Reserve Bank of New York.
  6. 6. Supra note 4..
  7. 7. Alternative Reference Rates Committee. Transition from LIBOR. Federal Reserve Board and Federal Reserve Bank of New York.
  8. 8. Alternative Reference Rates Committee. Transition from LIBOR. Banks Brace for “Big Bang” Switch on $80 Trillion Worth of Swaps. American Banker, October 15, 2020.
  9. 9. CME Group. CME Term SOFR Reference Rates. CME Group.
  10. 10. Stromfeld, Larry, Nihal S. Patel, and Rachel Chiger. An Overview of the ISDA IBOR Fallbacks Supplement and Protocol. The National Law Review, October 24, 2020.
  11. 11. Supra note 7.
  12. 12. Alternative Reference Rates Committee. Summary of ARRC’s LIBOR Fallback Language. Federal Reserve Bank of New York, November 2019.
  13. 13. Loan Syndications and Trading Association. LSTA’s SOFR Concept Credit Agreement–Daily Simple SOFR/Daily Compounded SOFR. Loan Syndications & Trading Association, October 5, 2020.
  14. 14. International Swaps and Derivatives Association. ISDA Launches IBOR Fallbacks Supplement and Protocol. International Swaps and Derivatives Association, October 23, 2020.

Copyright © 2020 by the Society of Actuaries, Schaumburg, Illinois.