As the countdown to the LIBOR sunset enters its final six months, the CFTC staff is trying to help the market transition.
By Yvette D. Valdez and Deric Behar
With less than six months to go before the London Interbank Offered Rate (LIBOR) expires on December 31, 2021, regulators around the world have been amplifying already loud calls for market participants to switch to alternative reference rates. In many cases, those calls have been accompanied by significant regulatory efforts and policy shifts to ween the market off reliance on LIBOR. In particular, the US Commodity Futures Trading Commission (CFTC) has been focused on helping the trillion-dollar USD LIBOR interest rate swap market navigate the transition.
Along with other regulatory authorities such as the Federal Reserve Board, the Financial Stability Board, the International Organization of Securities Commissions, the Alternative Reference Rates Committee (ARRC), and the International Swaps and Derivatives Association, the CFTC has been working to steer the derivatives market to safety before the LIBOR clock runs down. On July 13, 2021, the CFTC’s Market Risk Advisory Committee (MRAC) adopted SOFR First, a market best practice recommendation developed by MRAC’s Interest Rate Benchmark Reform Subcommittee. The Subcommittee previously recommended SOFR First on June 8, 2021, and provided an informative set of frequently asked questions.
Over the past few years, the Secured Overnight Financing Rate (SOFR) has emerged as the alternative reference rate to USD LIBOR with the most regulatory and market confidence and support. The SOFR First initiative is a recommended prioritization of derivatives markets trading in SOFR over LIBOR. Specifically, it proposes a phased transition for switching trading conventions for the interdealer market from USD LIBOR to SOFR for USD linear interest rate swaps, cross-currency swaps, non-linear derivatives, and exchange-traded derivatives.
MRAC intends for the implementation of SOFR First for trading activity among swap dealers to take place in four phases:
1. Linear Swaps: From July 26, 2021, interdealer brokers would replace trading of LIBOR linear swaps with trading of SOFR linear swaps.
- Impacted products would include outright swaps, swap spreads, and curve trades, while excluding LIBOR/SOFR basis, LIBOR/LIBOR basis, Forward Rate Agreements, and Single Period Swaps.
- Interdealer brokers’ screens for LIBOR linear swaps would be available for informational purposes until October 22, 2021, but not for trading activity. Thereafter, the screens should be turned off.
- Because SOFR First is designed for the interdealer market only, dealers could still execute USD LIBOR linear swaps with clients after July 26, 2021, and after October 22, 2021.
2. Cross-Currency Swaps: From September 21, 2021, interdealer brokers would replace trading of LIBOR cross-currency swaps with trading of SOFR cross-currency swaps.
- Impacted products would include cross-currency swaps with legs involving USD LIBOR, the Swiss franc, the British pound, and the Japanese yen. Other currencies will be transitioned at a later date.
3. Non-Linear Derivatives: At a date to be determined, interdealer brokers would replace trading of LIBOR non-linear derivatives with trading of SOFR non-linear derivatives.
- Impacted products would include swaptions, caps, floors, and other non-linear products.
4. Exchange-Traded Derivatives: At a date to be determined, exchanges would replace trading of LIBOR exchange-traded derivatives with trading of SOFR exchange-traded derivatives.
- Impacted products would include certain futures contracts and other exchange-traded products, such as cross-currency swaps for currencies not covered in Phase 2, above.
The CFTC’s Market Participants Division and Division of Market Oversight followed the SOFR First announcement with a statement of their own, reminding market participants and swap execution facilities (SEFs) of the importance of a timely and orderly transition away from LIBOR. The risks are manifold. Continued reliance on a discontinued benchmark threatens the stability and integrity of the derivatives markets, as well as consumers who are knowingly or unknowingly exposed to such benchmarks. Furthermore, the statement noted that “[m]arket participants and SEFs themselves may also face financial, conduct, litigation, operational, and reputational risks associated with inadequate preparation.” To achieve an orderly transition, the CFTC staff reiterated what has long been part of the regulatory call to action to market participants:
- Cease issuance of new derivatives linked to LIBOR as soon as practicable, but no later than December 31, 2021
- Remediate legacy contracts referencing USD LIBOR
- Build liquidity in alternative reference rates in the various markets
CFTC Acting Chairman Rostin Behnam indicated in his opening statement at the MRAC meeting at which SOFR First was recommended that the CFTC has been digesting feedback from market participants on the impact of SOFR First on mandatory clearing requirements and related “made available to trade” determinations for SOFR swaps under the Commodity Exchange Act and CFTC regulations. To address the issue, he envisions a rule proposal addressing mandatory clearing of SOFR swaps, with the expectation of finalization in 2022.
In anticipation of such rulemaking, Acting Chairman Behnam stated that the CFTC expects that SEFs will treat SOFR swaps as mandatorily cleared or intended to be cleared in the interim, for purposes of the CFTC’s post-trade name give-up rule (CFTC Rule 37.9(d)).
The potential rulemaking on mandatory clearing for SOFR-linked derivatives was supported by CFTC Commissioner Dawn DeBerry Stump in a related statement. However, Commissioner Stump did raise the lingering issue that CFTC restrictions still prevent US clients from accessing non-US-registered clearinghouses and central counterparties, even if they are subject to comparably robust regulatory regimes.
SOFR First does not create any enforceable obligations on market participants. The initiative should, however, help reduce LIBOR-linked transactions and deepen SOFR-linked liquidity. The ARRC has issued a statement commending MRAC’s adoption of SOFR First in general, and has specifically endorsed phase 2 of SOFR First (the September 21, 2021, target for SOFR cross-currency swaps). The initiative is expected to expedite any formal recommendation by the ARRC to market participants to replace LIBOR with Term SOFR in cash products.
MRAC’s recommendation will now progress to the CFTC Commissioners for final consideration.
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