Act Now, and Choose Wisely

October 27, 2021
Nathaniel Wuerffel, Senior Vice President
Remarks at the 2021 ISDA North America Conference (delivered via videoconference) As prepared for delivery

Good afternoon. I would like to thank ISDA for inviting me to speak at today’s conference. In my remarks, I will discuss the end of U.S. dollar (USD) LIBOR and the important choice that market participants need to make regarding their use of reference rates.1 As always, the views I express today are my own, and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

X Marks the Stop

Anyone who has been working on the transition away from LIBOR knows that it has been a long, multiyear adventure. Like any good adventure, it's been filled with puzzling problems, dangerous turns, and a few good plot twists. Growing up, I was a big fan of the Indiana Jones movies. They are classic adventure stories, with “Indy,” as he is called, following clues to ancient treasures. Of course, these treasures are very hard to find. As Indy tells some students at one point: “We do not follow maps to buried treasure, and ‘X’ never, ever marks the spot.”2

Well, in our adventure away from LIBOR, we actually do have maps to follow3 and in this case, X marks the stop.  I hope this is already abundantly clear, but we are at the end of the road for LIBOR. After December 31 of this year, most international LIBOR panels will stop, and the availability of certain USD LIBOR settings from January 2022 until June 2023 will only be appropriate for legacy contracts.4 Importantly, U.S. banking supervisors have issued guidance that new use of USD LIBOR should stop after this year. They have noted that entering into new USD LIBOR contracts after 2021 would create “safety and soundness risks” and bank practices will be examined accordingly.5 Recently issued interagency guidance clarifies that a new LIBOR contract would include an agreement that creates additional LIBOR exposure for a supervised institution or extends the term of an existing LIBOR contract.6 So in this case X marks a hard stop, subject to only very limited exceptions to support the transition from USD LIBOR.

Most market intermediaries have some connection with a bank, and market participants therefore should broadly expect that the guidance will impact them either directly or indirectly.  In other words, all market participants should feel a sense of urgency around the deadline.

This should be understood as global stop as well; the Financial Stability Board (FSB) has reinforced the message and timeline from U.S. regulators on a global scale, and FSB members will be reiterating these expectations to regulated firms in their own jurisdictions.7 This coordinated message from the official sector is important given the significant use of USD LIBOR worldwide.

So, with two months until we reach that stop, how are things going?

While progress is still needed in some key markets, I want to acknowledge important strides made over recent months in transitioning to robust alternative rates.

The first two phases of the CFTC’s Market Risk Advisory Committee’s “SOFR First” initiative for derivatives have been successfully implemented:8

  • On July 26, interdealer broker quoting conventions for linear swaps switched from USD LIBOR to the Secured Overnight Financing Rate (SOFR); and
  • On September 21, quoting conventions for interdealer cross-currency swaps referencing USD, sterling, Japanese yen, and Swiss franc LIBOR moved to each currency’s respective risk-free rate.9

These convention changes occurred smoothly and engendered a sustained shift from USD LIBOR to SOFR in interdealer markets. We estimate around 80 percent or more of interdealer linear swaps risk is now linked to SOFR, a notable shift in a market that was previously almost entirely USD LIBOR-based.10 Looking at the broader linear swaps market, the volume of SOFR swaps has been steadily increasing, and SOFR swaps now account for around a quarter of risk traded, many times higher than prior to the switch. By some measures, the switch from USD LIBOR to SOFR in interdealer cross-currency swaps has been even more successful.11

The SOFR First convention change for linear swaps also allowed the Alternative Reference Rates Committee (ARRC) to recommend SOFR Term Rates, consistent with the principles and indicators it established to do so, including limited scope of use.12 This has provided another tool for transitioning from USD LIBOR and marked the last step in the ARRC’s Paced Transition Plan.

Looking ahead, the SOFR First recommended convention change for non-linear derivatives will occur on November 8.13 The last phase of the SOFR First initiative will involve exchange-traded derivatives, such as Eurodollar futures.

In cash markets, we are seeing progress in the transition from USD LIBOR as well. In floating-rate notes and consumer lending products, USD LIBOR use has significantly declined and SOFR is well established.

There have also been signs of progress in the markets for bilateral and syndicated business loans. There is significant work yet to do, but banks are now taking proactive steps to reduce USD LIBOR-linked offerings and implement exception processes around new USD LIBOR contacts. The ARRC’s recommendation of SOFR Term Rates is a key transition tool for the loan markets, where moving from USD LIBOR to an overnight rate has been difficult and a forward-looking term rate can help overcome those challenges. A transition milestone was also recently crossed in the syndicated loans market, with the first term SOFR-linked leveraged loan deal issued earlier this month.

In order to promote a smooth end to new USD LIBOR contracts by year-end, the ARRC recently issued a “time to move recommendation” urging all market participants to leverage the next few weeks as a key window to reduce USD LIBOR activity.14 The ARRC believes that proactive reductions in new USD LIBOR contracts should apply across markets and across the full range of derivatives and cash products.

This is a concept I wholeheartedly support as a best practice approach to manage risks before the year-end deadline. Many firms have been working for years now to prepare for the end of USD LIBOR, and some have established internal dates to slow their use of new USD LIBOR ahead of year-end.  As market participants accelerate their work to reduce new use of USD LIBOR, prevailing liquidity in USD LIBOR-linked markets could diminish approaching year-end. Additionally, implementing significant process changes can be difficult late in the year given potential constraints on systems updates and testing (e.g., code freezes) and resource availability. Delaying your transition from USD LIBOR could risk financial, operational, and reputational consequences to your firm, and result in you not being well positioned at year-end to meet the supervisory deadline.

For those firms still entering new USD LIBOR contracts, my strong recommendation is this: act now to prepare for the end of LIBOR. Do not wait until December to move to alternative rates.

“You Must Choose… But Choose Wisely”

I’ve discussed the importance of acting now to move from USD LIBOR. But what reference rate you choose to move to is just as critical.

Let me return you to our LIBOR adventure.  As you know, in every great adventure the protagonist always faces difficult choices, as Indiana Jones did in his third outing.15 Indy and others have been searching for the cup of the Holy Grail. After many challenges, they reach its location. But the grail room is filled with many cups, and the wise old knight guarding it tells them: “You must choose… but choose wisely.” For there is a catch: drinking from the true grail offers eternal life, but drinking from a false one takes life away. The antagonist hastily grabs an eye-catching chalice, and drinks from it. Sadly, choosing the flashy chalice was a poor choice, and the consequences are quite dramatic, to say the least. Then Indiana must choose. He thinks more critically—Who would have made the grail? What would it be made of?—and selects a different cup from the many options. As we all know, Indy chose wisely, and went on to more adventures,16 with Harrison Ford still playing the character at age 79.

So, with this story in mind, my message for you as you consider alternative reference rates to USD LIBOR is:  choose wisely.

The LIBOR transition has been incredibly costly, and none of us want to go through a process like this again. For that reason, the official sector has long emphasized the importance of anchoring the LIBOR transition in rates that are robust enough to uphold the trillions of dollars in contracts that will reference them, and not reintroduce the vulnerabilities seen with LIBOR.

Fortunately, for many years now, the ARRC has been working hard to recommend answers to the toughest choices in the transition. The ARRC has developed tools to support a successful, lasting transition from USD LIBOR. After extensive public consultation, it recommended SOFR as USD LIBOR’s replacement. SOFR is a robust rate built on a durable base of overnight transactions in the Treasury repurchase agreement (repo) market. The median daily transaction volume underlying SOFR in 2020 was $1 trillion. For any given day last year, SOFR was calculated from over 5,000 underlying transactions. SOFR is produced by the New York Fed in accordance with the International Organization of Securities Commissions (IOSCO) standards for financial benchmarks. 

Like any reference rate based on an active market, SOFR moves in response to changes in the supply and demand for Treasury financing.  This is precisely how any reliable reference rate should operate:  reference rates should be representative of the underlying economic interest they seek to measure. SOFR is transparent and continually representative of the Treasury repo market. On a daily basis, the New York Fed publishes information on the distribution of rates and transaction volumes underlying SOFR.17  When trading conditions adjust in the Treasury repo market—as occurred recently—SOFR should adjust as well, and it does.  

In practice, day-to-day variations in SOFR will most commonly be smoothed through the use of averaging in financial contracts.  Like contracts that reference other overnight interest rates, almost any contract referencing SOFR will use averages of SOFR, and not the overnight rate itself. The New York Fed publishes SOFR Averages daily, providing a reliable official sector source from which to draw.

The ARRC has discussed that SOFR can be used in any type of contract.18 Policymakers have emphasized that it will be the dominant reference rate in derivatives and capital market products, and that market participants should not expect other rates to be widely available.19

When considering alternative reference rates to USD LIBOR—whether SOFR or another rate—market participants should carefully examine the construction of those rates and their underlying markets.20 We have seen recent innovation in reference rates, including those with credit-sensitive properties.21 It is understandable that credit-sensitive rates could be conceptually appealing for certain use cases,22 but it appears that at least some of the attraction is that credit sensitive rates behave very similarly to LIBOR and are based on the same short-term wholesale bank funding markets as LIBOR: commercial paper (CP) and certificates of deposit (CDs).  

Choosing reference rates only because of their similarity to LIBOR could very well end poorly.  Time and again the markets for CP and CDs have dried up in periods of stress, as they did in March 2020.23 Reference rates based on such fragile markets could result in rates that are not representative of the underlying interest one is seeking to measure, and worse could be a source of financial stability risk should significant exposures rest on top of such rates. For some of these same reasons, IOSCO recently highlighted regulators’ concerns that LIBOR’s shortcomings may be replicated by credit-sensitive rates that lack sufficient underlying transaction volumes.24

Riding Off into the Sunset

The transition from LIBOR has been a critical, global endeavor involving significant partnership between the official sector and private industry. Moving financial markets from LIBOR has been a complex challenge, but fortunately market participants have all the tools they need to transition in a way that is safe and smooth for their institutions and for markets overall, and in a manner that ensures we never have to repeat such a transition again.

As we approach the end of LIBOR, the responsibility lies with you to act now to make this transition successful. Be ready for the end of LIBOR. Proactively slow new use of USD LIBOR so you can safely meet the year-end supervisory deadline. And as you choose your replacement rate for USD LIBOR, examine the options carefully.

Like Indiana Jones, choose wisely. That way, you can safely bring this reference rate adventure to an end and set your sights on the next challenge that awaits.

1 I would like to thank Eric LeSueur for his help in preparing these remarks, with additional thanks to Betsy Bourassa, Jamie Pfeifer, and other colleagues in the Federal Reserve System for valuable comments and suggestions. 

2 Indy is contradicted by later events, when he finds a clue to the treasure marked by a giant X on the floor of a library.

3 See, for example, Global Transition Roadmap for LIBOR, FSB, and Guide on the Endgame for USD LIBOR, ARRC.

4 See remarks by Governor Randal Quarles: Goodbye to All That: The End of LIBOR, October 5, 2021.

5 Statement on LIBOR Transition, Board of Governors of the Federal Reserve System (Board of Governors), Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC), November 30, 2020.

6 Joint Statement on Managing the LIBOR Transition, Board of Governors, FDIC, OCC, National Credit Union Administration, Consumer Financial Protection Bureau (CFPB), and State Bank and Credit Union Regulators, October 20, 2021.

7 FSB statement on smooth and timely transition away from LIBOR, FSB, June 2, 2021.

8 CFTC Market Risk Advisory Committee Adopts SOFR First Recommendation at Public Meeting, CFTC, July 13, 2021.

9 Specifically, under this “RFR First” convention change, the quoting conventions for USD, GBP, CHF, and JPY legs of applicable cross-currency swaps switched to SOFR, SONIA, SARON, and TONA, respectively.

10 Estimated from Swap Execution Facility data via Clarus Financial Technology.

11 For example, over 90 percent of GBP-USD, USD-JPY, and USD-CHF interdealer cross-currency swaps executed since September 21 have referenced risk-free rates on both legs, based on Swap Data Repository data via Clarus Financial Technology.

12 ARRC Formally Recommends Term SOFR, ARRC, July 29, 2021.

13 CFTC’s Interest Rate Benchmark Reform Subcommittee Selects November 8 for SOFR First for Non-Linear Derivatives, CFTC, October 15, 2021.

14 ARRC Recommends Acting Now to Slow USD LIBOR Use over the Next Six Weeks to be Well-Positioned to Meet Supervisory Guidance by Year-End, ARRC, October 14, 2021.

15 Indiana Jones and The Last Crusade (1989).

16 In what was, for fans of the series, a rather polarizing outing involving aliens and Shia LaBeouf.

17 Additional percentile data is published on a quarterly basis.

18 An Updated User’s Guide to SOFR, ARRC.

19 Financial Stability Oversight Council (FSOC) meeting, June 11, 2021.

20 See comments from Governor Quarles on use of a rate other than SOFR in his October 5, 2021 speech. See also recent remarks by Acting Comptroller of the Currency Hsu, which discussed that OCC supervisory efforts will initially focus on non-SOFR rates.  

21 Forum on Ongoing Innovation in Reference Rates for Commercial Lending, New York Fed, November 18, 2020.

22 See minutes and presentations from Credit Sensitivity Group Workshop 1, New York Fed, June 4, 2020.

23 Box 1: March 2020 Experience Reinforces the Importance of LIBOR Transition, FSB 2020 Progress Report.

24 Statement on Credit Sensitive Rates, IOSCO, September 8, 2021. The statement notes: “In light of some alternatives being suggested, notably credit sensitive rates, IOSCO calls for greater attention to Principles 6 and 7 [of the IOSCO Principles on Financial Benchmarks]. Principle 6 asks administrators to take into account the ‘relative size of the underlying market in relation to the volume of trading’. Principle 7 emphasizes ‘data sufficiency in a benchmark’s design to accurately and reliably represent the underlying market’ measured by the benchmark.”  See also comments from FSOC principals at the June 11, 2021 FSOC meeting, including prepared remarks by SEC Chair Gensler.

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