In July 2017, the U.K.’s Financial Conduct Authority announced that the index that reflects the interest rate at which banks borrow from one another on an uncollateralized basis, commonly known as the London Interbank Offered Rate (“LIBOR”), would be phased out by 2021. LIBOR’s reputation was impacted by charges that banks manipulated the rate before and during the financial crisis, taking larger profits from derivatives based on the manipulated rates. Subsequently, the ICE Benchmark Administration established a new oversight committee and introduced new surveillance systems and analysis techniques which subjected LIBOR submissions to closer scrutiny, however, faith in LIBOR as a reliable reference rate quickly declined after the manipulation charges were acknowledged in the public domain.
At the beginning of April 2018, the Federal Reserve Bank of New York (the “New York Fed”) took the first significant step towards the transition away from LIBOR by publishing three alternative reference rates. The alternative reference rates are based on overnight repurchase agreement transactions which are collateralized by U.S Treasury securities. Each of the alternative reference rates are calculated based on transaction data from an underlying liquid market rather than subjective input. LIBOR, on the other hand, is formulated from pricing contributions from 17 panel banks rather than robust transaction data.
The first alternative rate is the Tri-Party General Collateral Rate (“TGCR”), which is a measure of rates on overnight, specific counterparty tri-party general collateral repurchase transactions secured by Treasury securities. The underlying securities of a general collateral transaction are not identified until the terms of the trade are agreed to. The TGCR is calculated as a volume weighted median of transaction-level tri-party repurchase data collected from The Bank of New York Mellon.
The second alternative rate is the Broad General Collateral Rate (the “BGCR”), which is a measure of rates on overnight Treasury general collateral repurchase transactions. The underlying securities of a general collateral transaction are not identified until the terms of the trade are agreed to. The BGCR is calculated as a volume weighted median of transaction-level tri-party repurchase data collected from The Bank of New York Mellon as well as GCF repurchase transaction data obtained from DTCC Solutions LLC.
The U.S. Alternative Reference Rates Committee (“ARRC”), which was formed by the New York Fed to address the discontinuance of LIBOR, identified the third alternative reference rate as the Secured Overnight Financing Rate (“SOFR”). SOFR is an index that reflects a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. SOFR includes all trades in the BGCR plus bilateral Treasury general collateral repurchase transactions cleared through the Delivery-versus-Payment service offered by the Fixed Income Clearing Corporation. The New York Fed has supported the adoption of SOFR as the leading index for U.S. dollar-based derivatives and loans to replace the dependence on LIBOR before the 2021 deadline.
Market participants should monitor the loan market for the adoption of alternative index rates, review safeguards and amendment procedures in agreements while continuing to review how the discontinuance of LIBOR impacts existing loan agreements and other transaction related documentation.
The ARRC is holding a public roundtable which will be taking place today July 19, 2018. The ARRC hopes to both recap the LIBOR succession plan and educate the financial market on contract fallback language for floating rate notes, corporate loans, securitizations and derivatives which should properly document the transition to a new reference rate. The amount of work which needs to be undertaken by market participants in the transition period could be vast and should not be underestimated. Mechanisms for closing out legacy contracts will need to be addressed in order to meet the demands of market participants who anticipated pre-determined and forward-looking floating rate payment structures.
For questions about this Client Alert or other LIBOR related matters, please contact Andrew Silverstein at (212) 574-1383 or silversteina@sewkis.com or Gregg Bateman at (212) 574-1436 or bateman@sewkis.com.
