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SOFR Takes Over
by TPG Software on Mar 30, 2022
The end of 2021 brought to a close the first major phase of LIBOR cessation with 24 of the 35 LIBOR tenors ceasing.
The transition from non-USD LIBOR has proved successful, with the vast majority of transactions shifting to alternative reference rates before or at cessation. Synthetic LIBOR rates have been created for the residual tough legacy products referencing 1M, 3M and 6M tenors of GBP, and JPY LIBOR for a one-year period with no guarantee of extensions. However, while parties should work towards remediating these residual non-USD LIBOR transactions before 2023, industry focus has turned toward remediation of the more significant portfolio of USD LIBOR referencing transactions ahead of cessation on June 30, 2023.
The Successful Adoption of SOFR
SOFR is now the dominant index used for new transactions in trading and lending markets, having replaced LIBOR in 2021.
U.S. regulators and national working groups have been clear on the necessity to transition away from USD LIBOR. They facilitated this move by supporting initiatives to improve liquidity in SOFR, and introducing measures to limit adoption of new USD LIBOR-referencing transactions.
The Commodity Futures Trading Commission’s (CFTC) phased “SOFR First” initiatives for switching trading conventions from USD LIBOR to SOFR across derivatives products, implemented in the second half of 2021, has led to a significant shift in liquidity towards SOFR. In the interbank markets, dealers have shifted the vast majority of their volumes from LIBOR to SOFR. Furthermore, between 90% and 100% of flow OTC markets across products and more than 50% of exchange traded interest rate futures contracts are now referencing SOFR.
"In early March, the notional of SOFR swaps traded in the market was higher than that of LIBOR swaps for the first time." -Ben Kinney, Global Co-Head of Interest Rate Sales
An upward trend in SOFR liquidity is further attributed to the November 30, 2020 interagency statement notifying market participants of restrictions to dealing in new USD LIBOR transactions after 2021. In 2022, new USD LIBOR derivatives should only be executed for risk management purposes and should not be entered into if it results in increased market exposure to the benchmark. In the derivatives markets, unwinding trades, compressing portfolios of trades, hedging LIBOR or fixing risks are all permitted use cases in risk reduction of USD LIBOR portfolios.
The message from the U.S. regulators is clear: no more new use of USD LIBOR.
Conventions for SOFR
Conventions across products are now widely understood. Derivatives products have led the transition to a new normal after LIBOR following the publication of SOFR in 2018. Compounding in arrears is the preferred standard for tenors longer than overnight, with the exception of hedges to products referencing Term SOFR Rates. This convention has similarly been adopted as the preferred standard for securitizations.
Other variations in overnight methodologies have been observed in non-loan cash products, including the SOFR-in-advance methodology used in U.S. adjustable-rate mortgages. The publication of an ARRC-endorsed forward-looking term rate in the CME Term SOFR Rates bridged the gap for those products where transition to an overnight rate has been difficult. This particularly applies to multi-lender facilities, middle market and trade finance loans, where forward-looking term rates have been accepted as appropriate use cases. CME Term SOFR has been the preferred convention globally for these U.S. dollar loans which is quoted in one month, three, six, and 12 month tenors.
Credit Spread Adjustments (CSAs) have been recommended by national working groups as part of pricing to SOFR, in order to try to maintain economic equivalence. However, with the rising rate environment and volatile global markets, the adoption of CSAs has varied, particularly in the loans market.
Federal Legislation Around LIBOR
On March 15, 2022 U.S. President Biden signed into law the Consolidated Appropriations Act, 2022. It contains federal legislation to significantly reduce market disruption and outstanding risks associated with USD onventions across products are now widely understood. Derivatives products have led the transition LIBOR transition. Originally developed by the ARRC, the legislation will allow U.S. Law-based financial contracts unable to transition to adopt SOFR upon USD LIBOR cessation. Additionally, any agent with the discretion of selecting a successor rate will benefit from safe harbor provisions if they select SOFR.
The enactment of federal legislation is a big step forward for tough legacy products, particularly bonds and securitizations, as well as consumer products such as adjustable-rate mortgages that typically are governed by state laws. However, while federal legislation will be effective in U.S.-law financial contracts, market participants who carry contracts governed by other jurisdictional laws must be aware that there is currently no equivalent legislation on the international front.
Next Steps in the LIBOR to SOFR Transition
The tools and conventions for remediation of legacy USD LIBOR are available today. Transaction volumes referencing USD LIBOR continue to decline and benchmark liquidity will only reduce going forward. The continued adoption and liquidity of SOFR in derivatives and cash markets, and the announcement of federal legislation to aid the transition of tough legacy products means that there has never been a better time to consider transition.
We urge market participants to assess their remaining USD LIBOR referencing portfolios and have a strategy in place for transition as soon as possible. As always, J.P. Morgan stands ready to support and guide our clients through the transition process.
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