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April 17, 2023
The Secured Overnight Financing Rate (SOFR) will soon replace the U.S. dollar LIBOR (London Interbank Offered Rate), which will cease on a representative basis on June 30, 2023. This will mark the culmination of close to a decade’s work by the Alternate Reference Rate Committee (ARRC), the Official Sector and market participants globally.
SOFR Is Well Established Across Markets
SOFR markets continued to develop throughout 2022. On average, SOFR swaps now account for more than 85% of daily volumes of interest rate risk traded in the outright linear swaps market. In 2023 alone, the total volume of trades referencing SOFR (by notional) currently stands at over $14 trillion, including $1.4 trillion of basis swaps.1 In exchange-traded derivatives, the average daily trading volume of SOFR futures is now roughly three times that of Eurodollar futures — up from less than a quarter at the start of 2022.2 In recent months, J.P. Morgan has seen a significant increase in clients seeking to transition legacy U.S. dollar LIBOR portfolios to SOFR in order to take advantage of this market liquidity.
Adoption of the new reference rate has been pretty spectacular … picking up pace in the last nine months or so.
Ben Kinney, Global Co-Head of Interest Rates Sales
In cash markets, the use of SOFR is now prevalent, comprising over 95% of all new floating rate notes (FRN) issuance and the vast majority of agency-issued adjustable rate mortgages.3 In the loans market, Term SOFR is the predominant rate used in new lending — especially across multi-lender facilities, middle market and trade finance loans. In addition, since the beginning of 2023, the pace of borrowers choosing to proactively restructure to SOFR ahead of cessation has increased.
Multiple deals each week are converting to SOFR from LIBOR.
Patricia Devine, North America Head of Global Corporate Banking
Legislative Initiatives
In December 2022, statutory fallback rates for U.S.-governed law contracts in scope of the LIBOR Act were confirmed by the Federal Reserve Board (FRB).4 The announcement specified fallback rates that will be applied to non-remediated contracts after cessation. For derivatives, statutory fallbacks will follow the International Swaps and Derivatives Association’s (ISDA) IBOR fallback methodology. For the majority of cash products, fallback will be consistent with the Alternative Reference Rates Committee’s (ARRC) hardwired approach.
The LIBOR Act reduces the potential for market disruption or disputes at cessation. It provides statutory replacement rates for in-scope products at cessation based on industry-agreed fallbacks.
Greg Geffen, Head of North America Corporate Interest Rate Derivatives
Outside of the U.S., the Financial Conduct Authority (FCA) in the U.K. has confirmed that one-, three- and six-month tenors of U.S. dollar LIBOR will continue to be published based on a non-representative “synthetic” methodology until the end of September 2024.5 This is similar to the approach taken following the cessation of sterling and yen LIBOR at the end of 2021, and will be available for use in all contracts where fallbacks do not contain so-called “non-representative” triggers. This rate is not for use in new products, but it provides time for non-remediated contracts to mature or for parties to agree terms to restructure to SOFR.
Given our experience in both the U.K. and Japan, we would expect that [synthetic rates] will lead to much better outcomes for contracts where there’s still some ambiguity around what should happen at cessation.
Ben Kinney, Global Co-Head of Interest Rates Sales
Entering the Final Quarter
As we enter the final three months prior to cessation, operational work across the industry has intensified. Over two weekends in April and May, over $60 trillion of cleared derivative contracts will convert to SOFR contracts in a process orchestrated by central counterparty clearing houses. Firms are also preparing to conduct the rebooking of products to fallback rates, which will take place at the first fixing post-cessation. These two activities will represent major milestones in firms’ book of work for 2023.
As discussed above, legislative initiatives will apply to all non-remediated contracts and are dependent upon product, governing law and existing contractual provisions. Counterparties should not consider remediation complete with the confirmation of these initiatives. In fact, where clients have non-remediated contracts in their portfolios, it places further emphasis on the need for a comprehensive analysis of fallbacks to ensure they are correctly applied at cessation.
With differing fallback methodologies due to be applied to products at cessation, firms should be prepared to manage basis across fallen-back products in their portfolio. This is especially important for firms that are accounting-sensitive, and presents new challenges where basis risk management was not previously an issue.
Proactive restructuring of portfolios ahead of cessation provides benefits to clients who seek to reduce the operational burden of transition, and who wish to avoid basis risk across fallen-back products post-cessation. Transitioning products to take advantage of SOFR liquidity now removes the risk of potentially dealing in illiquid legacy contracts that may be difficult to unwind over time.
[We are] strongly recommending that clients consider proactively restructuring ahead of cessation because there are some benefits, including removing the need for operational work at fallback and providing more certainty around it.
Patricia Devine, North America Head of Global Corporate Banking
We note that proactive restructuring of U.S. dollar LIBOR portfolios ahead of cessation remains the Official Sector’s recommended course of action. We continue to urge market participants to assess their remaining U.S. dollar LIBOR referencing portfolios and ensure they have a strategy in place. As always, J.P. Morgan stands ready to support and guide our clients through the transition process.
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1.ARRC Meeting readout - March
2.FSB Progress Report on LIBOR and Other Benchmarks Transition Issues
3.ARRC Meeting - March
4. Federal Reserve Press Release
5.https://www.fca.org.uk/news/news-stories/fca-announces-decision-synthetic-us-dollar-libor
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