A series co-authored by Lara Rhame, Chief U.S. Economist at FS Investments, and Tal Reback, Principal at KKR
For over a decade global markets have been preparing for the shift away from LIBOR, a Herculean task given the rate’s reach into every corner of the financial system. At times, the transition has felt like an interactive Rubik’s cube where the colors on the squares keep changing—every time market participants thought they were inching closer, the colors switched, pushing the market and global regulators to continuously adapt with actionable solutions. As the year-end 2021 deadline approaches, LIBOR’s sunset is finally imminent. In our final note in this series, we address what items remain outstanding and how the shift will look for markets.
- Activity in global LIBOR replacement rates has accelerated ahead of the year-end 2021 deadline, a positive sign that markets have internalized the transition.
- The CFTC ‘SOFR First’ initiative has boosted liquidity in the SOFR derivatives market, a crucial development that led to the official adoption of Term SOFR rates.
- The first SOFR-linked leveraged loans have finally hit the market. Market conventions will continue to be worked out as more issuance hits the pipeline.
- The task remains tall for CLOs, which carry LIBOR exposure on both their assets and liabilities. This is where much of the focus will be in 2022.
First, let’s set the stage for what is to come December 31, 2021. On this date, LIBOR settings for all currencies other than the U.S. dollar (GBP, JPY, CHF, and EUR) will cease to be published. So, what does that mean? Officially all non-USD LIBORs can no longer be referenced as a benchmark in existing facilities. For the last three quarters we have seen a significant uptick in the use of alternative reference rates globally in order to prepare for the year-end sunset date. These markets have largely seen derivative volumes in replacement rates increase significantly, a sign of improving liquidity ahead of the year-end deadline. In the U.K., the Sterling Overnight Index Average (SONIA) accounted for 65% of total notional in GBP interest rate derivatives in September, while Japan’s Tokyo Overnight Average (TONA) saw a spike up to 54% as new LIBOR derivatives were set to end after Q3.1
In the U.K., regulators directed firms to stop issuing GBP LIBOR-referenced debt beginning in April, and SONIA issuance has grown significantly since then. While these cash and derivative markets are much smaller compared to those in the U.S., the uptick in liquidity is significant. In addition to the importance for their domestic markets, it has also been a positive development for U.S. market participants who have multi-currency debt facilities and/or cross-currency swaps. Broadly speaking, the adoption of global LIBOR replacements has accelerated, which should create a virtuous cycle of market liquidity heading into year-end.
Integration of global LIBOR replacement rates is accelerating
Further, starting January 1, 2022, there can be no new origination in any LIBOR currency, including USD, despite the longer expiry date for the USD LIBOR rate itself. As we discussed in our previous notes, in the U.S., regulators announced last November that settings for 1-, 3-, 6-, and 12-month USD LIBOR would continue to be published through June 2023 to ensure an orderly transition and winddown LIBOR exposure with ample time to remediate the tail of contracts.
However, this should not be mistaken for an extension allowing markets to continue utilizing LIBOR in new contracts. The June 30, 2023, date was architected to allow enough runway for the loan market to work off the rate from a legacy perspective and afford time for potential federal legislation on tough legacy contracts. Overall, there is no net change to the timeline: market participants should be ready to move off LIBOR by year-end 2021 and look towards the new future. We anticipate the first half of 2022 to be a busy one as the market works through legacy LIBOR facilities in conjunction with new SOFR issuance. Ultimately, we believe balancing the multiple moving parts will be manageable, though it will require proactivity and continued education in the evolving market.
This schedule sets the market up for two remaining phases of the LIBOR transition in the U.S.: first, the period from today until the end of 2021 marks the crescendo of the transition, during which the focus will be on building up further activity and liquidity in SOFR markets ahead of year-end. Second, the period from January 1, 2022, through June 30, 2023, may feel comparatively diminuendo, but will be no less important, as SOFR origination will continue to build and all legacy LIBOR contacts must choose their fate: lean into the new successor rate earlier through a reprice and or refinancing or rely on contractual fallbacks to maneuver the automatic rate switch on June 30, 2023. We will lay out how we believe those two phases will look.