Crunch Time for LIBOR Transition

We believe that banks, generally, are making good progress in transitioning their loan and swap portfolios away from LIBOR, but much work remains to be done before the June 30^th deadline. Only a third of our clients have fully transitioned their portfolios from LIBOR, and 54% of the outstanding trades on our DerivativeEDGE platform are still indexed to LIBOR, with the bulk of these trades being concentrated among larger regional banks.

Many banks may be overwhelmed by the task of transitioning their legacy portfolios of LIBOR-based loans and swaps to their new preferred lending benchmark. Some banks, with large portfolios of swapped loans, have concluded that it is too burdensome from an operational perspective or too costly to proactively amend their swaps and the associated underlying loans. As a result, they are planning to rely on fallback provisions in their contracts. However, lenders should understand the implications before relying on these provisions to transition their loan and swap portfolios.

The Potential Drawbacks of Fallbacks

The loan market and the derivatives market have adopted different protocols for transitioning legacy LIBOR contracts. The differences in the fallback protocols between these two markets can create challenges for a bank’s loan operations team and may expose the bank or its borrowers to potential mismatches. Differences in LIBOR fallback provisions for loans and swaps can result in unintended consequences for banks and their borrowers.

Differences in LIBOR fallback provisions for loans and swaps can result in unintended consequences for banks and their borrowers.

Under the Alternative Reference Rate Committee’s recommended fallback protocol for bilateral business loans, LIBOR-based loans will convert to one-month term SOFR plus a spread adjustment factor, whereas under the ISDA fallback protocol, swaps will convert to the daily compounded SOFR rate plus the spread adjustment factor. Hence, the floating rate on the loan and the floating rate on the swap will track different indices after fallback. Given that 1m term SOFR and daily compounded SOFR are highly correlated, the mismatch between the two is not likely to be considered material by most market participants over the life of the swap. However, it does mean that the monthly swap and loan payments will no longer match exactly.

Additionally, since the floating rate on the swap will be determined based upon the compounded average of daily SOFR observations during the interest period, the bank must wait until the end of the interest period to generate a reset notice for the borrower, potentially creating a compressed timeframe for billing and collecting monthly swap settlements.

Cleared Swaps: Different Rules & Accelerated Timeline

Banks that centrally clear their derivatives trades may face additional considerations and an accelerated timetable for transitioning their cleared LIBOR trades to SOFR. On April 21st, the CME will split each cleared LIBOR trade into a short-dated LIBOR trade and a forward-starting daily compounded SOFR trade. The LCH will undertake a similar process for amortizing swaps on April 22.

It is important to note that the Clearinghouse’s payment and reset conventions under the fallback protocol differ from those of ISDA. Under the ISDA protocol, a LIBOR trade converts to daily compounded SOFR with a two-day lookback, whereas under the Clearinghouse methodology, the LIBOR trade would convert to daily compounded SOFR with a zero-day lookback and a two-day payment lag. For banks running back-to-back customer swap programs, this means there will be payment date and reset date mismatches between their bilateral customer trade which falls back under the ISDA protocol and their dealer trade which falls back under the Clearinghouse protocol. Banks will also have twice as many dealer trades for all cleared LIBOR trades (i.e., one borrower trade will match two dealer trades). They will also no longer have a flat customer book since the dealer trade will now have a forward SOFR trade, whereas the borrower trade will remain tied to LIBOR.

Avoiding Mismatches through Proactive Amendments

Banks wishing to avoid mismatches between their loan and swap books may want to consider proactively amending their trades rather than relying on fallback, but time is growing short to do so-especially for banks that are looking to amend their cleared trades before the Clearinghouse fallback process begins next month. Given the large number of trades that still need be transitioned, dealers may have limited capacity to accommodate the volume of amendment requests they will receive in the run-up to the June 30^th deadline.

Working with an experienced derivatives advisor with the expertise and technology to expedite the amendment process can help promote a smooth transition for your bank and your borrowers. For more information on LIBOR transition, please contact sales@derivativepath.com.