With just 27 months remaining until LIBOR may become unusable or unavailable, firms need to accelerate their LIBOR transition planning. Based on a recent series of conversations with large financial services clients, industry associations and national RFR working group participation, there are a number of key next steps which U.S. firms will need to respond to in order to facilitate a successful transition away from LIBOR to the Secured Overnight Financing Rate (SOFR).
- Central Counterparty Clearing houses will shift from using LIBOR to SOFR for key activities – The most important CCP’s, The Chicago Mercantile Exchange and the London Clearing House will replace LIBOR with SOFR for Price Alignment Interest, the mechanism by which CCP’s charge or compensate counterparties for interest on posted margin. CCP’s will begin using a SOFR based yield curve to value the financial instruments and positions. Current proposals for this transition involve CPP’s executing a series of LIBOR SOFR basis swaps, the broader mechanics of this CCP transition will need to be carefully considered and consulted on by the wider industry over the remainder of 2019 for expected transition in mid 2020.
- Financial technology system providers will release software upgrades and modifications that support SOFR linked products – Market participants are being asked by the Alternative Reference Rates Committee and the Official Sector to build in a significant amount of flexibility into their financial technology infrastructure to prepare for the various styles of SOFR transitions. Major systems that’s are used by large financial institutions to book, value, process and transact in LIBOR based products are making this task easier for their users by developing standardized enhancements and system modifications to support SOFR linked products. Based on our discussions with financial systems providers, a significant number of these updates for the many of the most widely used systems across both cash and derivative products will go live or be made available in the first half of 2020.
- The U.S. Department of the Treasury will assess the feasibility of and ultimately decide to issue SOFR linked debt – The Department of Treasury is currently completing a technology system upgrade which is expected to go live in the first half of 2020. After this upgrade is completed the Treasury Borrowing Advisory Committee (TBAC) which is currently Chaired by the Treasurer of Goldman Sachs will hold conversations to assess the feasibility of issuing SOFR linked sovereign debt. Conversations with Primary Dealers indicate that an issuance size of approximately $20 to $30 billion is a reasonable expectation that would contribute significantly both in principle and in practice to the development of a SOFR product ecosystem.
- Year-end stress testing submissions for the largest banks will need to consider SOFR for the first time – As part of the U.S. Federal Reserve’s Comprehensive Capital Adequacy and Review (CCAR) exercise the largest banks are required to project 9 quarters forward into the future to ensure they have sufficient capital to withstand hypothetical adverse and severely adverse macroeconomic scenarios. The establishment of these stress tests have by in large been viewed as successful by regulators in the U.S. and abroad who have also provided clear communications that these tests are set to evolve in line with market structure. As such, for CCAR submissions due at the end of 2019, the last and ninth quarterly projection will be the first quarter of 2022 which is after date at which Andrew Bailey of the FCA’s important agreement with Banks to continue to submit LIBOR contributions is due to expire. Regulators have made it very clear that the base case scenario used by Banks in LIBOR transition planning should be to expect a cessation of LIBOR at the end of 2021.
- Efforts by industry working groups to identify regulatory blockers will shift from planning to implementation – Industry working groups have been meeting regularly for some time now to identify regulatory blockers and impediments that must be overcome to facilitate a successful transition away from LIBOR. These working groups must progress from a discussion and planning phase to drive implementation and execution. The regulatory community has by in large requested that the identification of regulatory dependencies be market driven. Working groups on both sides of the Atlantic have now made robust progress on identifying issues in areas including taxation, hedge accounting, capital implications, margining and best execution. Once the communications from the working groups have been made public the onus will be on the official sector to act swiftly and decisively in implementing the recommendations of these groups with the goal of ensuring the path of least resistance for market participants is a transition away from LIBOR.
- U.S. Government Sponsored Enterprises (GSE’s) will write new SOFR linked adjustable rate mortgages for consumers – The ARRC has recently released a white paper outlining a proposed approach whereby SOFR could be used as the basis for adjustable rate mortgages (ARM) and there is a related consultation so seek consensus on associated issues. The GSE community was quick to endorse the proposal and are working to modify their systems to operationalize the SOFR based ARM blueprint. The establishment and proliferation of a SOFR linked ARM market by perhaps the most important mortgage writers in the US will eventually have flow on effects for securitized products that repackage consumer mortgages in the U.S. This will also help pave the way for the transition of other LIBOR linked consumer products like auto-loans, student loans and credit cards.
- Artificial Intelligence (AI) providers will further repurpose their technology making the task of contract repapering more accurate and efficient – For larger and more complex financial institutions that often have hundreds of thousands of contracts drafted over many years across various business units, assessing the feasibility of utilizing AI is a must. Selecting a representative sample of contracts for analysis by an AI tool has become best practice and will help to quantify the magnitude of the of the task and well as help frame the level of effort required to successfully repaper. As AI tools continue to self-improve they will become more intelligent in identifying LIBOR based contract language. There is an additional benefit of potentially reduced legal fees. Contract language amendment efforts should partner with the client communication / outreach work stream as part of a carefully considered client communications strategy.
- LIBOR transition will become a key public policy issue for the USA – Federal Reserve Chairman Jerome Powell was recently quizzed on the risks of LIBOR transition at a Congressional hearing. In June, Congresswoman Nancy Pelosi attended a LIBOR Transition conference hosted by the Bipartisan Policy Center at the U.S. Chamber of Commerce in Washington, D.C. and asked an industry panel what Capitol Hill could be doing to help facilitate the transition. Members of U.S. Congress will use their platforms to raise awareness of the systemic risk that LIBOR poses and will help educate Main Street on the need and urgency of a transition to SOFR. LIBOR transition will eventually come to the attention of the U.S. House Committee on Financial Services who were involved in other key financial services changes like Dodd Frank and more recently Current Expected Credit Loss.