On 27 May 2020 the Alternative Reference Rates Committee (ARRC) published best practices for completing the financial industry's transition away from the US dollar London Interbank Offered Rate (USD LIBOR).(1) With 19 months remaining before the anticipated cessation of USD LIBOR at the end of 2021, the ARRC's recommendations should provide market participants with further guidance as they continue to prepare for the transition.
Since 2016,(2) the ARRC has been conducting research and analysis in an effort to prepare the financial industry for the likely cessation of USD LIBOR. In doing so, the ARRC has, among other things:
- published a paced transition plan(3) which outlines a number of key steps that should be taken to restructure cash products that reference USD LIBOR;
- recommended the Secured Overnight Financing Rate (SOFR)(4) as the alternative reference rate to USD LIBOR;
- proposed a New York state legislative solution(5) for amending legacy contracts that reference USD LIBOR but lack fallback language; and
- recommended a spread-adjustment methodology(6) to minimise changes in value that result from switching reference rates.
Because USD LIBOR's cessation will affect a wide array of cash products, the ARRC has also established working groups to obtain input on how best to transition those products away from USD LIBOR. After issuing several consultations and releasing its 2020 objectives(7) to set product-specific transition priorities, the ARRC finalised the best practices discussed below.
As recommendations, the guidelines are not considered binding rules or regulatory guidance. It is up to market participants to determine to what extent they wish to adopt and apply the recommendations, taking into consideration the size and complexity of their activities and institutions, their engagement in relevant transactions and applicable supervisory and regulatory policy.
USD LIBOR transition best practices: timing, internal programmes and awareness
The ARRC's best practices are based on four transition preparation goals:
- New cash products that reference USD LIBOR should include ARRC-recommended, or substantially similar, fallback language as soon as possible.
- Third-party technology and operations vendors should complete all necessary enhancements to their systems to support SOFR by the end of 2020.
- New use of USD LIBOR should stop, with specific timing dependent on the circumstances of a particular cash market.
- Contracts specifying that a party will have discretion to select a replacement rate for USD LIBOR should require that party to disclose its selected replacement rate to relevant parties no later than six months before its implementation date.
Accordingly, the ARRC has recommended three best practices to achieve these goals:
- taking active steps to meet the ARRC's recommended transition milestones set out below;
- instituting clear internal programmes to prepare for the transition and assess USD LIBOR exposure; and
- incorporating further ARRC recommendations and maintaining an ongoing dialogue with key stakeholders to promote awareness of the transition and preparedness.
The first best practice is to adhere to ARRC-recommended transition milestones. As illustrated, the ARRC has recommended transition milestones for floating rate notes (FRNs), business loans, consumer loans, securitisations and derivatives with respect to fallback language implementation, operational readiness, cessation of the continued use of USD LIBOR in new contracts and selection of anticipated fallback rates.
|
Product type |
Hardwired fallbacks should be implemented by |
Technology and operational vendors should be ready to publish SOFR by |
Market participants should fully cease USD LIBOR in new products by |
Anticipated fallback rates should be selected by |
|
FRNs (with maturities after 31 December 2021) |
No later than 30 June 2020 |
No later than 30 June 2020 |
No later than 31 December 2020 |
No later than six months prior to reset after USD LIBOR's end |
|
Business loans (with maturities after 31 December 2021) |
No later than 30 September 2020 |
No later than 30 September 2020 |
No later than 30 June 2021 |
No later than six months prior to reset after USD LIBOR's end |
|
Consumer loans |
Mortgages: no later than 30 June 2020 Student loans: no later than 30 September 2020 |
Mortgages: no later than 30 September 2020 |
Mortgages: no later than 30 September 2020(8) |
In accordance with relevant consumer regulations |
|
Securitisations |
No later than 30 June 2020 |
No later than 31 December 2020 |
CLOs: no later than 30 September 2021 Others: no later than 30 June 2021 |
No later than six months prior to reset after USD LIBOR's end |
|
Derivatives |
No later than four months after the amendments to the 2006 ISDA definitions are published |
No later than when dealers take steps to provide liquid SOFR derivatives markets to clients |
No later than 30 June 2021 |
Not addressed |
Internal risk management and assessment programmes
The second best practice is to create internal risk management and assessment programmes that manage and reduce exposure to risks that the transition may pose. These programmes should, among other things:
- provide a governance framework with accountable senior executives to oversee a firm's enterprise-wide USD LIBOR-transition plans;
- evaluate and mitigate risks and give heightened consideration to unique product and client exposures;
- develop a strategy for redesigning or reorganising portfolios that contain USD LIBOR-based products;
- identify and address financial and non-financial risks arising from a transition to SOFR via the implementation of fallbacks; and
- determine accounting, regulatory and tax reporting considerations.
The third and final best practice is to stay aware of material updates to ARRC recommendations and product-specific conventions. In doing so, market participants should engage with their constituents and other key stakeholders to foster mutual awareness and preparedness. The ARRC has also provided a number of tools, conventions and principles to assist with this.
The ARRC's best practices should provide guidance as the industry continues to prepare to transition away from USD LIBOR to SOFR. The ARRC will continue to publish information relevant to the USD LIBOR transition as the transition progresses.
Endnotes
(1) ARRC Best Practices (Full Report), 27 May 2020; ARRC Best Practices (Fact Sheet), 27 May 2020.
(2) Timeline of ARRC contributions to LIBOR transition, last updated 27 May 2020.
(3) ARRC Paced Transition Plan.
(5) ARRC Executive Summary of Proposed Legislative Solution to LIBOR Transition, 6 March 2020. For a detailed analysis, see: ARRC Releases NY Law Proposal to Amend Transactions Referencing USD LIBOR.
(6) ARRC Spread-Adjustment Methodology Press Release, 8 April 2020. For a detailed analysis of the spread-adjustment methodology, see: ARRC Recommends a Five-Year Median Spread-Adjustment Methodology for Cash Products Referencing USD LIBOR.
(7) ARRC 2020 Objectives for LIBOR Transition, 17 April 2020. For a detailed analysis of the ARRC's objectives, see: "ARRC announces 2020 objectives for facilitating USD LIBOR transition".
(8) This date refers to new applications for closed-end residential mortgages using USD LIBOR and maturing after 2021. For further information on the impact of the LIBOR transition on the mortgage and consumer loans markets, see: "LIBOR transition: Fannie Mae and Freddie Mac to stop accepting LIBOR and begin accepting SOFR".
