As the COVID-19 pandemic has swept across borders, immobilizing the United States and much of Europe, it has introduced profound stress and uncertainty into almost every area of the global economy. The fallout has had two primary consequences for financial markets that reference the London Interbank Offered Rate (LIBOR) as a benchmark, which were already undergoing a transition to alternative benchmarks at the end of next year. First, market volatility and the decoupling of LIBOR from alternative benchmarks have focused attention on the pricing of credit risk. Second, institutions have understandably shifted their resources to maintaining business continuity and mitigating market risk in the near term, raising questions about whether key LIBOR transition milestones will need to be adjusted.
These transition uncertainties will need to be addressed with appropriate planning. To be successful in the months ahead, institutions should proactively assess and manage evolving transition timetables and execution risks, coordinate closely with clients and regulators, and continue preparing for critical bodies of contract remediation and operational work. As we discuss later in this article, there are six specific actions institutions can take in order to manage uncertainty around their transition away from LIBOR.
The first area of uncertainty concerns the pricing of LIBOR relative to alternative benchmarks, particularly the Secured Overnight Financing Rate (SOFR) recommended by the Alternative Reference Rates Committee (ARRC) as the primary alternative to USD LIBOR. US credit markets began to show signs of strain in mid-March as corporate and financial borrowers sought to tap funding markets to reinforce cash reserves—just as lenders began withdrawing from money-market funds that supply short-term credit. In this cash-crunch environment, LIBOR and SOFR were always expected to fix at different levels: LIBOR is an unsecured rate that incorporates the credit risk of lending between banks, while SOFR is a secured rate based on repurchase agreement transactions collateralized by risk-free US Treasury securities.
But by March 16, the LIBOR-SOFR spread had dramatically widened. This occurred as the Federal Reserve slashed interest rates, increased liquidity support for overnight repurchase agreement markets to $500 billion, and announced a series of emergency credit and asset purchase programs. SOFR declined from 110 basis points to fix at just 26 basis points, while 3-month LIBOR continued to fix at around 90 basis points. The spread of roughly 65 basis points (from 26 to 90) had doubled by the following week as money-market investors returned to the repurchase agreement market, with excess liquidity propelling SOFR further downward (Exhibit). On March 27, SOFR reached a record low of only 1 basis point while LIBOR followed other unsecured rates further upward, increasing by 20 basis points.
As of this writing, liquidity conditions in the short-term funding markets appear to be tempering. However, market volatility is likely here to stay, raising questions around the behavior of LIBOR in absolute terms and relative to secured rates like SOFR. Three observations, in particular, stand out:
- The recent behavior of LIBOR has not inspired confidence in its reliability under stress. Throughout the latter half of March, LIBOR increased only modestly as liquidity conditions deteriorated across unsecured short-term funding markets, including commercial paper. Beginning in early March, the spread between 3-month commercial paper and LIBOR began to widen dramatically, reaching a high of 250 basis points and remaining at elevated levels until early April. That LIBOR did not respond to stressed market conditions suggests its limitations as an unsecured funding benchmark, and only reinforces the imperative for institutions to transition sooner rather than later.
- LIBOR’s recent behavior relative to SOFR underscores the risk associated with repricing legacy derivative contracts once LIBOR is discontinued. In consultations published by the International Swaps and Derivatives Association (ISDA), market participants have reached a preliminary consensus for estimating the credit differential that will be used to translate legacy derivative contracts from LIBOR to SOFR. The preferred methodology, a five-year historical median spread between LIBOR and SOFR, would not reflect LIBOR-SOFR spreads if they remain at heightened levels. This could result in ISDA contracts seeing a sizeable change in pricing after LIBOR discontinuation is announced.
- The differential behavior of LIBOR and SOFR under stress reopens questions around the pricing of new loans linked to SOFR. This is because banks will continue to fund new loans using credit-sensitive unsecured rates, while pricing those loans using risk-free secured rates like SOFR. Given that these rates diverged so dramatically in recent weeks, institutions are concerned about their ability to manage the asset-liability mismatch in their loan books. This has led institutions with sizeable loan portfolios, including both national and regional banks, to advocate for credit-sensitive alternatives to SOFR, such as AMERIBOR or the ICE Bank Yield Index, or for the creation of a dynamic credit spread for SOFR-linked loans. While credit-sensitive alternatives could find a role as LIBOR recedes, it remains to be seen whether these rates would receive broad industry acceptance. However, if an unsecured benchmark develops alongside SOFR in the United States, institutions will clearly need to prepare for the additional complexity of transitioning multiple rates at the same time.
How these risks will unfold in the coming months remains unclear. But institutions should continue to closely watch and prepare for the potential impacts of volatility on transition execution. Without a clear-eyed view of how market risks could evolve, institutions potentially leave themselves exposed to unfavorable outcomes.
A second area of uncertainty concerns the timing of key LIBOR transition milestones. Institutions are intensely focused on ensuring business continuity in the near term, raising questions about the feasibility of meeting the current LIBOR transition timetable. While the FCA has made clear that the ultimate transition target date of December 31, 2021 has not changed, they have been less assertive about key interim milestones landing in 2020 and 2021.
Indeed, the market fallout from the COVID-19 crisis has already had an impact on several milestones. The US Federal Housing Finance Agency recently extended by three months its deadline for federal home loan banks to cease entering into LIBOR-linked instruments that mature after 2021. Similarly, multiple clearinghouses recently elected to defer the transition of discounting for Euro-cleared derivatives from EONIA to €STR from June to July 2020.
There is speculation concerning further extensions. The United Kingdom’s Financial Conduct Authority (FCA), which regulates LIBOR, has suggested that several UK milestones may be pushed back— acknowledging that there has “been an impact on the timing of some aspects of the transition programs of many firms. Particularly in segments of the UK market that have made less progress in transition and are therefore still more reliant on LIBOR, such as the loan market, it is likely to affect some of the interim transition milestones.”
Still, the FCA and the Financial Stability Board (a consortium of national and international regulators) have made clear that the ultimate timing of the LIBOR transition has not changed. At the end of 2021, LIBOR panel banks will not be compelled to continue making LIBOR submissions. In the FCA’s words, “[t]he central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.
Managing uncertainty ahead
Given the current market uncertainty, it may be tempting for institutions to pause their LIBOR transition planning efforts until further clarity is obtained. This would be a mistake. The transition will continue to move forward, and institutions that remain focused on mitigating transition risks, proactively engaging clients and regulators, and preparing for major bodies of contract remediation and operational work will set themselves up for success. Toward that end, we propose six actions institutions can take in order to manage transition uncertainty.
- Develop a view on key transition risks and scenarios. The timing and execution of the LIBOR transition will continue to be subject to risk. Institutions should regularly review the expected timing of key interim milestones, such as the release of the ISDA protocol to facilitate amended contract definitions, and evaluate how any adjustments could impact other transition milestones further downstream. Market participants should also take stock of milestone execution risks under different market scenarios, as increased volatility will result in potentially different levels of exposure and operational complexity when interim milestones do occur.
- Consider defining fallback rates now instead of later, especially for loans. Market uncertainty will likely increase the time and effort needed to negotiate fallback rates for loan products. Consequently, institutions should consider fallback provisions that define the fallback rate upfront—the so-called “hardwired” approach to fallbacks—rather than solely requiring counterparties to negotiate upon LIBOR cessation— the “amendment” approach. The amendment approach is particularly problematic for loans that default to the prime rate if a new fallback has not been selected. Given that the prime rate is substantially higher than alternative benchmarks, a delayed or failed negotiation could be costly.
- Step up communications with clients. Although the current market and transition environment remains fluid, institutions should aim to engage clients on the implications of recent developments. This is the time to provide thought leadership around the potential effects of benchmark volatility on client portfolios and LIBOR transition planning. Although clients may have questions that do not yet have definitive answers—such as whether additional interim transition milestones will be extended—proactive and consistent communication will ensure that they are prepared for this next phase of the transition.
- Remain actively engaged with regulatory authorities and industry bodies. While consultations and other forms of regulatory and industry engagement can be time consuming, they offer a unique opportunity to shape the design of key transition decisions. Institutions concerned about managing the asset-liability mismatch in loans, for example, are expected to meet with US regulators in a series of credit sensitivity workshops, which will explore challenges and methodologies for supplementing SOFR-based loans with a dynamic credit spread. These forms of engagement provide valuable information to regulators regarding the concerns and preferences of market participants.
- Continue preparing for contract remediation. Preparations for contract remediation, including contract analysis and client outreach planning, do not depend on market conditions to the same extent as other efforts. Given that contract remediation is a substantial body of work, institutions should continue to inventory legacy contracts, analyze existing terms, and develop client-outreach playbooks in advance of key contract remediation triggers, notably the forthcoming ISDA protocol.
- Prioritize key areas of operational uplift. Operations and technology teams will continue to be preoccupied with managing increased transaction volume as a result of market volatility. However, these teams should continue preparing for key transition events with hard deadlines in 2020, including the transition of major clearinghouses to €STR-based discounting in July (previously planned for June) and SOFR-based discounting in October.While these and other hard targets may very well be delayed, operations and technology teams should continue to ensure readiness under current timetables.
 The ARRC is a group of private-market participants convened jointly by the Federal Reserve Board and the Federal Reserve Bank of New York.
 Eurex Clearing Circular No. 032/2020, www.eurexclearing.com; CME Group Advisory Notice No. 20-168, www.cmegroup.com. In the Euro area, the Working Group on Euro Risk-Free Rates (a group of private-market participants organized by the European Central Bank) has recommended the Euro Short-Term Rate (€STR) as the primary alternative to the Euro Overnight Index Average (EONIA) legacy benchmark.
 Financial Conduct Authority, “Impact of the coronavirus on firms’ LIBOR transition plans,” March 25, 2020, www.fca.org.uk
 Financial Conduct Authority, “Impact of the coronavirus on firms’ LIBOR transition plans,” March 25, 2020, www.fca.org.uk