Rebuttable 

NYDFS requirements

In December last year, the NYDFS (New York Department of Financial Services) required each of the regulated financial institutions supervised by NYDFS to submit a plan for addressing the LIBOR cessation and transition risks. Reflecting the urgency of the regulator’s concerns, the institutions were required to submit the plan within less than 2 months, by early February this year. (The deadline was later postponed by 45 days to late March.)

Specifically, NYDFS required the plan to include the following 5 items, without providing further details:

1. Programs that would identify, measure, monitor and manage all financial and non-financial risks of transition;
2. Processes for analyzing and assessing alternative rates, and the potential associated benefits and risks of such rates both for the institution and its customers and counterparties;
3. Processes for communications with customers and counterparties;
4. A process and plan for operational readiness, including related accounting, tax and reporting aspects of such transition; and
5. The governance framework, including oversight by the board of directors, or the equivalent governing authority, of the regulated institutions.

Analyzing & assessing alternative rates – What is required?

Financial institutions subject to the requirements are likely scrambling to put together a LIBOR transition plan to meet the deadline. Toward this effort, the 2nd required item (“processes for analyzing & assessing alternative rates) seems to pose the lowest hurdle. After all, the ARRC (Alternative Reference Rates Committee), with the implicit approval & supports by the FRB, has chosen SOFR to replace LIBOR; more than $300b of cash instruments have been issued; the daily trading volumes of the SOFR futures contracts set a record, exceeding 80k contracts, recently; and LCH cleared more than $200b of SOFR swaps in January 2020. Moreover, Fannie Mae & Freddie Mac announced on 2/5 that they would no longer accept ARMs based on LIBOR by the end of 2020, and that they planned to begin accepting ARMs based on SOFR later in 2020.

Choosing SOFR, therefore, seems to be a path of the least resistance, particularly for budget-constrained institutions. In that case, the descriptions for item #2 should be simple and straightforward.

However, it is not clear at this point what additional information NYDFS will require for item #2 even if an institution simply decides to choose SOFR to replace LIBOR, as recommended by ARRP. Does the plan need to describe how the institution reached the decision to choose SOFR? Does the plan need to compare, analyze and assess the benefits & risks of other alternative rates? Does the institution need to discuss with its customers and counterparties and incorporate their positions and preferences into the analyses & assessments? Does the plan need to analyze and assess compliance with the 19 IOSCO principles?

Regardless of what the regulator(s) will specifically require in the LIBOR transition plan regarding alternative rates, and notwithstanding the fact that ARRC has recommended SOFR, it should be recognized that one size may not fit all. SOFR may not be the most appropriate replacement for LIBOR for some institutions, such as community and regional banks that depend substantially on unsecured funding. Furthermore, the regulator(s) may require an institution to develop and describe an independent and complete process & framework for analyzing and assessing alternative rates, even if the institution chooses SOFR to replace LIBOR. The spike in the repo market volatility in mid-September last year exemplified some of the shortcomings of SOFR, and demonstrated the need to be abreast of the pros & cons of other alternative rates.

Other alternative rates

If an institution desires or is required to analyze and assess alternative rates, what would be the right approach? In April last year, the Federal Reserve gave a broad-stroke clue that a bank should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”.

To get started on this due diligence process, the table below lists information associated with some of the alternative rates. The information may be helpful to form the basis for developing a due diligence process to analyze and assess the alternative rates for replacing LIBOR, as required by NYDFS & FRB. Other currently available alternative rates not listed in the table include OIS, Effective Fed Funds, PRIME, Certificate of Deposit, Cost of Savings Index, etc.

EU Benchmark Regulations “representative” requirement

In a speech on 7/12/2018, the head of the British financial regulator, FCA (Financial Conduct Authority), Andrew Bailey, declared that the regulator could prohibit LIBOR from continuing to be used for new businesses, if it determines that LIBOR no longer sufficiently “represents” the market. (EU Benchmark Regulations, Article 11(1)(a): “[T]he input data [of a benchmark] shall be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure.”) Such a determination might not have been overly difficult, if LIBOR had remained a poll-based benchmark. As Mr. Bailey asserted in the same speech, “[LIBOR] relies on the so-called judgment of the panel banks. […] [T]o continue in the new regulated world of benchmarks, LIBOR has to be representative. I struggle to see the case for this judgment.”

LIBOR, however, has evolved.

Reformed LIBOR and permissible “waterfall” input data

ICE, the administrator of LIBOR, has reformed LIBOR to incorporate a “waterfall” of input data types, including transactions, transaction-derived data, and expert judgments. (See here.) Moreover, the EU Benchmark Regulations explicitly permit an interest rate benchmark to incorporate these hybrid types of input data. (See table below.)

Determining “representative”

Since the EUBMR explicitly permit an interest rate benchmark to incorporate such “hybrid” input data types, the Reformed LIBOR can satisfy the “representative” requirements even if it incorporates non-transactional data (e.g., judgments). The question then is: How does one determine whether the Reformed LIBOR is “representative”? According to what criteria? What are the parameters and factors to be used?

The EUBMR do not provide a clear answer to these questions. However, logically such a determination may depend on the following factors, among others:
• Total number of input data;
• Total number of transactional data;
• Total number of judgments;
• Percentage of transactional data;
• Percentage of judgments;
• Variations in the numbers & percentages;
• Etc.

Recognizing the shrinking unsecured interbank funding markets, the Reformed LIBOR broadens the sources of its transaction data to include certificates of deposit and commercial papers. Whether the expansion in data sources will be sufficient to satisfy the “representative” requirements, however, remains uncertain.

ICE Bank Yield Index

In a clear effort to further expand the sources of transactional data, ICE created the Bank Yield Index (BYI) to supplement LIBOR as a credit-sensitive interest rate benchmark. According to ICE, BYI is derived from two types of input data:

1. Wholesale, primary market funding transactions executed by large, internationally active banks (e.g. inter-bank deposits, institutional certificates of deposit and commercial paper); and
2. Secondary market transactions in wholesale, unsecured bonds issued by large, internationally active banking groups.
   

Below figure shows the average numbers and volumes of transactions underlying BYI. (See here.)

Will these expanded data satisfy the “representative” requirements? The answer remains blowing in the wind! The regulators will eventually need to step up to resolve the issue.

[Update 4/13/2019: Last Wed, Randal Quarles, Vice Chair for Supervision of the Federal Reserve and Chair of the Financial Stability Board (“FSB”), gave a speech at an FSB roundtable on reforming interest rate benchmarks. On the topic of choosing a replacement rate, Mr. Quarles did not foreclose the adoption of rates different from SOFR (or other risk-free rates). Instead, he established the principle that banks should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”. Mr. Quarles concluded that SOFR satisfied the due diligence requirements. However, the other benchmark rates (e.g., ICE BYI) may also satisfy the requirements, and thus be a potential candidate to replace LIBOR.]

IBA, the administrator of the ICE Bank Yield Index (“BYI”) (see here & here), may have gained some ground in promoting BYI as a replacement for LIBOR. According to ARRC meeting minutes and agenda, IBA has been scheduled to make a presentation to ARRC on BYI at the ARRC April meeting. The presentation supposedly was requested by ICE in response to comments on BYI made at the February ARRC meeting. However, the fact that ARRC specifically discussed BYI in its meeting seemed significant. Moreover, there have been claims (although unconfirmed) that large banks “don’t like SOFR” (see here), but instead endorse BYI (see here).

This development increases the chances that multiple benchmarks (e.g., BYI, AMERIBOR, etc), in addition to SOFR, may co-exist post-LIBOR, as I discussed previously here & here. That is, even if LIBOR is eventually phased out, it is increasingly likely that BYI and potentially other benchmarks administered by private parties may partly replace LIBOR, for example, for the cash markets, while SOFR is used for the derivative markets.

For the regulators, however, the co-existence of private benchmarks with SOFR raises the question of whether these private benchmarks are qualified to replace LIBOR, free from the issues that plagued and doomed the latter. For example, the regulators desire a transaction-based benchmark to replace LIBOR. But, what are the minimum number or volume of transactions underlying a benchmark that can pass muster with the regulators? SOFR has a trading volume of nearly $1 trillion across thousands of transactions each day. BYI, on the other hand, may cover less than $10 billion of daily transactions across less than 200 daily transactions. Moreover, these numbers are the totals over various tenors from 5 to 500 days. The respective number for each tenor will be even less. (See Figures 3, 4, & 5 of the ICE Bank Yield Index Update, here.) Are these numbers sufficient for a benchmark designed to replace the flawed LIBOR? If not, what are the minimum thresholds?

As a result, it is likely that the US regulators will eventually need to establish a set of protocols and procedures to control and manage the quality of the private benchmarks, similar to the EU Benchmark Regulations. The Congress, however, will first have to enact legislations authorizing the regulators to establish the regulations. The legislative and regulatory processes may be time-consuming and the outcome uncertain, adding to the uncertainties already embedded in the LIBOR-replacement undertaking!

It has been widely reported that the Federal Reserve (via a group of public & private organizations, ARRC) has identified SOFR (Secured Overnight Financing Rate) to replace LIBOR. SOFR, however, is a risk-free (or nearly risk-free) rate and does not include risk premia such as the credit risk premium. Therefore, SOFR cannot fully replace LIBOR for many stakeholders, particularly those in the cash markets.

Need for a rate with credit risk

In 2014, the FSB (Financial Stability Board) issued a report titled “Reforming Major Interest Rate Benchmarks”. (Available here.) In the report, the FSB pointed out that LIBOR, which is based on unsecured interbank markets, included two main components, a “risk-free or nearly risk-free rate” and a group of other “risk premia, including a term premium, a liquidity premium, a credit risk premium as well as potentially a premium for obtaining term funding”. The FSB report observed that it might be feasible for many derivative transactions to replace LIBOR with a risk-free rate, such as SOFR. However, the FSB report also pointed out that there would be continued need for a “reference rate with bank credit risk”, such as in the markets for bank loans, and other “bank-provided credit products”. In general, there is a greater need for such types of risk premium in the cash markets, such as bank loans, FRN bonds & securities, mortgages, structured products, capital market products, etc.

Nonexistence of a market-based rate with credit risk

Unfortunately, the need for a market-based rate with bank credit risk to replace LIBOR cannot be readily and satisfactorily met in any existing markets. In a speech presented on 7/12/2018, Andrew Baily, the head of the British financial regulator, put it bluntly: “It is difficult […] to see how the term credit premium that LIBOR seeks to measure […] can be obtained from other sources. We have not seen a compelling answer to how one-month, three-month, six-month and twelve-month term bank credit spread can be reliably measured on a dynamic and daily basis.” (See here.)

The quagmire for cash market participants

In 2014, the FSB envisioned a post-LIBOR new world, where multiple rates would provide the flexibility to meet the needs of multiple market sectors. A few years later, the reality has sunken in that the existing market liquidity can only support a risk-free rate, SOFR, but not a rate with credit risk. Therefore, for cash market participants, the new post-LIBOR reality is not a world of multiple rates to choose from, but one in which no single existing rate is satisfactory for their needs.

No satisfactory options

Given such a quagmire, cash market participants face enormous difficulties in planning for the anticipated changes in LIBOR. No options currently available paint a clear path.

• Continue to use LIBOR: And face the liability and legal risks that LIBOR may be held inadequate or even illegal, particularly with the prospect of new bench mark regulations such as the EU Benchmark Regulations.
• Adopt SOFR plus a fixed spread: And face the risks of mismatch between assets and liability due to large fluctuations in the credit spread (in addition to the lack of term structure and other deficiencies of SOFR).
• Use other rates having a credit component, such as PRIME, FHLB rates (eg, 11th District Cost of Fund), commercial paper rates, CD rates, AMERIBOR (here), ICE Bank Yield Index (here), new auction-based rates (here), Investment Grade SOFR (here), etc: And face the reality that all these markets have low liquidity and other deficiencies such as data transparency & sufficiency, and may not be acceptable as a benchmark rate.

The risks

For cash market participants who are regulated, such as banks or insurance companies, the question is how the regulators will approach this quagmire. Will they establish a safe harbor or other rules? Or will they leave it to the regulated entities to establish their own safety and soundness policies & procedures? Considering the costs and uncertainties, it is most likely these regulated entities will not make any major decisions and take major actions until the regulators provide a clear guidance. The risk is high, however, that those decisions & actions may be too late.