The USD LIBOR transition’s final act

The long but steady transition of the U.S. dollar London interbank offered rate (LIBOR) has been a monumental undertaking. David Bowman, Senior Associate Director at the Board of Governors of the Federal Reserve System, describes it as “the financial market equivalent of swapping out the engine and electrical system of a jetliner while the jetliner is still flying.” We are entering the final act of getting “the jetliner with the new engine electrical system to land successfully in June of next year.”

Harry Lipman, Bloomberg L.P. Global Derivatives Product Manager, joined Bowman to discuss the work leading up to the transition, key accomplishments and challenges, and what to expect in the coming months.

(26:11) Explore what’s been accomplished and what remains to be done ahead of the June 2023 transition from USD LIBOR to SOFR.

LIBOR transition

The transition from USD LIBOR to SOFR is entering its final months. An alternative to LIBOR was once inconceivable, but recent years have seen tremendous progress in crafting legislation and creating new processes.

Accomplishments and challenges to date

Bowman noted accomplishments since the founding of the Alternative Reference Rates Committee, the group originally tasked with identifying risk-free alternative reference rates for USD LIBOR. One of those accomplishments was identifying the Secured Overnight Financing Rate as the rate that represents best practice for use in certain new USD derivatives and other financial contracts. However, several rates were created based on repo markets wholesale as ARRC collected data and underwent the rigorous publication process.

Another major achievement was the passage of legislation, first in New York and then federally, to help legacy LIBOR products. “The federal legislation is a key piece in addressing legacy contracts overall, giving an answer to every open contract,” Bowman said. Contracts without workable fallback language for LIBOR’s end will be replaced with a silver-based rate determined by the Fed.

The next challenge is determining how that will be implemented and communicated to all parties. The goal, according to Bowman, is to “communicate in a workable way so that everybody knows for any given contract what they’re supposed to be getting. That’s really the last step.”

U.S. transition to SOFR

Bowman explained that each market has moved to an overnight rate because those are, on a day-to-day basis, the only markets active enough to give a robust rate. The primary fallback is the overnight rate, with the U.S. using SOFR and the British pound and Swiss francs, for example, having their versions.

With an established term SOFR rate, the lending market is moving away from LIBOR. Bowman noted that “the Financial Stability Board, the ARRC, the U.S. official sector have emphasized that term SOFR is just a front-end tool and that most products, even most non-loan cash products, should be finding ways to use actual SOFR.”

To avoid re-creating the problems of LIBOR, it’s essential to keep the scope of use in balance, which allows for SOFR derivatives markets to be deep enough to create a useful term SOFR rate.

“I like to think the ARRC has found a successful balancing point in its recommendations for scope of use of term SOFR,” Bowman said. “Use of derivative markets should be minimal ⁠– for example, to “hedge a term SOFR cash product, a legacy product that potentially goes to term SOFR or a business loan where, otherwise, it was difficult to transition.”

Priorities for cash markets

By now, most markets have supplanted the use of LIBOR to a degree in which it’s difficult to compare new SOFR and LIBOR loans with a representative sample. ARRC’s focus is turning to legacy, preparing for June 2023, focusing on operational issues and providing resources for the transition.

Bowman hopes that “lenders and borrowers … begin to move early so that they can avoid some of the operational challenges that would occur if you tried to switch the entire lending market in a short period of time.”

Be prepared for the end of LIBOR

To complete the LIBOR transition, firms need to update system capabilities to ensure that they are using the right data and that they can handle the new rates, calculation, and valuation methodologies. To make the transition, firms need to ensure systems and risk management tools are operating effectively, and rely on vendors and solutions that support their LIBOR transition needs, enabling them to prepare for a post-LIBOR world. Bloomberg has stayed ahead of market developments, and delivers a comprehensive suite of solutions to help firms ensure they are well-positioned for the LIBOR transition’s final act.