The London interbank offered rate is coming to an end. New U.S. dollar Libor issuance will come to a halt at the end of this year, and critically for legacy contracts, USD Libor rates will cease to be published after June 2023. At present, Libor is embedded in over $220 trillion of these legacy contracts, including mortgages, consumer loans, bonds, business loans, swaps and more. The terms of most of these contracts do not consider Libor’s permanent cessation — and thus fail to provide effective outcomes once USD Libor ceases publication after mid-2023.
This narrow set of legacy contracts creates one of the most critical remaining uncertainties stemming from the transition away from Libor and, if left unresolved, could threaten to severely disrupt capital markets and burden courts, private entities and consumers with costly litigation and a wide-ranging span of possible outcomes.
While the issue could be addressed by passing state legislation along the lines of the legislation first proposed by the Alternative Reference Rates Committee and recently enacted in New York State, given Libor’s pervasive use and its reach across all 50 states, it is critical that Congress pass legislation now to ensure the stability of nationwide markets.
For such a bill to minimize uncertainty, litigation risk and market disruption, it is critical that it establish a single interest rate benchmark to which legacy contracts will migrate, or “fall back,” upon Libor’s cessation.
This is the only way to provide a clear, fair and effective solution to transition legacy contracts away from Libor and eliminate uncertainty and wide-ranging outcomes. Offering parties to these contracts a choice of rates would only introduce further uncertainty for markets and create disputes between parties — precisely the kind of outcome that federal Libor legislation is designed to prevent. The most suitable candidate for this fallback rate is the Secured Overnight Financing Rate, or SOFR, the ARRC’s recommended replacement for USD Libor.
It is a robust solution that was chosen from a comprehensive list of alternatives through a rigorous, multiyear selection process and public comment period, and is based on around $1 trillion of daily transactions in the overnight U.S. Treasurys market involving a wide range of market participants. SOFR is by far the strongest solution for the set of legacy contracts that this legislation was designed to protect, and when combined with historically based spread adjustments, it is the most demonstrably neutral Libor replacement, fair to both sides of legacy transactions. The International Swaps and Derivatives Association’s IBOR protocol, which was likewise extensively vetted and has been widely adopted across the market, will move U.S. dollar derivatives — of which there are almost $200 trillion — to SOFR for the same reasons.
It is important to emphasize, however, that this legislation is narrowly targeted. It has no impact whatsoever on any contract that points to a non-Libor floating rate, as is the case for most legacy business loans. It does not prohibit parties from agreeing ahead of Libor’s cessation to use any suitable rate they wish in their contracts, legacy or otherwise. Nor is a contract subject to the legislation if parties mutually agree to opt out of its application, either before or after Libor’s cessation. The legislation is intended only as a fail-safe remedy for contracts with no other practical means of addressing Libor’s demise. It is designed for application precisely when amendment to improve the current fallback is an insurmountable challenge — as such, it must impose a single fallback rate to decisively settle the issue.
The legislation also addresses existing contracts that give one party the right to unilaterally select a replacement for Libor by providing a liability safe harbor for those who choose the recommended SOFR-based replacement. The legislation does not limit that party’s right to choose any other rate it finds appropriate, but most contracts with this feature are mortgages and other consumer loans, and extending the liability shield to rates that haven’t gone through SOFR’s extensive vetting would leave these consumers and other borrowers helpless against lenders who substitute rates that may be manifestly unfair to consumers and borrowers. Here again, the only reasonable exercise of this legal authority is to specify the one rate that is clearly fair to both sides. Consumer protection groups supported the ARRC’s legislative proposal in New York for this very reason.
Narrowly targeted federal legislation that falls back to SOFR-only is needed to safely, fairly and effectively transition the trillions of dollars in financial contracts that otherwise will have no workable fallbacks and cannot practicably be changed away from Libor. Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell have recently attested their support for this solution. It will furnish certainty not only to a diverse array of corporate borrowers and lenders, but to everyday retail bondholders and consumers, whose student loans, mortgages and investment accounts the legislation will protect from disruption and value degradation. Most critically, it can only be viable if it identifies a single fallback rate for the affected legacy contracts — and only SOFR has gone through the careful public feedback process and has the robustness and reliability that legislation of this importance requires.
