The U.K. Financial Conduct Authority’s confirmation earlier this month that Dec. 31 would mark the end date for the London Interbank Offered Rate (LIBOR) should not have been breaking news for anyone. For years, it has been known the benchmark interest rate would cease to be available at the end of 2021.
And yet, use of LIBOR has seemingly grown over that period. The Alternative Reference Rates Committee (ARRC), a group including major banks, asset managers, and other financial institutions formed by the Federal Reserve to help ensure transition away from LIBOR to a new reference rate, estimated in a progress report earlier this month that there are $223 trillion in outstanding exposures to LIBOR—an increase from $199 trillion at the end of 2016.
“The ARRC [previously] estimated that more than 80 percent of these exposures would roll off by the end of 2021 if market participants stopped new use of USD LIBOR,” the group stated. “However, despite warnings from the official sector that LIBOR would end, use of LIBOR has continued and actually increased.”
The ARRC noted the increase largely relates to derivatives exposures, “but the estimated amount of business loans referencing USD LIBOR has also increased.” Roughly two-thirds of respondents in an ARRC survey of U.S. firms conducted in March 2020 said they were not being offered alternatives to LIBOR in communications with lenders, the progress report continued.
The Fed has recognized signs the transition from LIBOR is not being treated with proper urgency. Michael Gibson, director of the Division of Supervision and Regulation, signed off on a note on March 9 that encourages examiners to “consider issuing supervisory findings and other supervisory actions if a firm is not ready to stop issuing LIBOR-based contracts by December 31, 2021.”
“Supervised firms that are not making adequate progress in transitioning away from LIBOR could create safety and soundness risks for themselves and for the financial system,” Gibson’s note reads. The Fed is focusing on six key aspects of transition efforts: planning, financial exposure measurement and risk assessment, operational preparedness and controls, legal contract preparedness, communication, and oversight.
The ARRC’s preference to replace LIBOR in the United States is the Secured Overnight Financing Rate (SOFR). SOFR is a measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities.
Despite pushing SOFR as the top alternative, the ARRC announced last week that a forward-looking SOFR term rate will not be available by mid-2021 and maybe not even this year altogether. The group had previously suggested it would have such a rate available ahead of the end of LIBOR.
“While trading activity in SOFR derivatives is growing, at this time, the ARRC believes that it is not yet in a position to recommend a term rate with confidence based on the current level of liquidity in SOFR derivatives markets,” the group stated. “In addition, the ARRC is still evaluating the limited set of cases in which it believes a term rate could be used. Robust underlying activity and a limited scope of use over time are important conditions to help ensure that a recommended term rate does not reintroduce the vulnerabilities that first prompted the transition away from LIBOR.”
The ARRC urges market participants not to wait for a forward-looking term rate and continue with transition efforts using the tools available now.