The “SOFR First” initiative takes off | Latham & Watkins LLP
As the countdown to the extinction of LIBOR enters its final six months, CFTC staff are trying to help the market transition.
With less than six months of the London Interbank Offered Rate (LIBOR) expiration on December 31, 2021, regulators around the world have stepped up already strong calls for market participants to switch to alternative benchmarks. In many cases, these calls have been accompanied by significant regulatory efforts and policy changes to prevent the market from becoming dependent on LIBOR. In particular, the US Commodity Futures Trading Commission (CFTC) has worked to help the trillion 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 s’ is endeavored to guide derivative products. walked to safety before the LIBOR clock ran out. On July 13, 2021, the CFTC’s Market Risk Advisory Committee (MRAC) adopted SOFR First, a good market practice recommendation developed by the MRAC’s Interest Rate Reform Sub-Committee. 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 Guaranteed Overnight Funding Rate (SOFR) has become the alternative benchmark rate to USD LIBOR with the most regulatory and market confidence and support. The SOFR First initiative is a recommended prioritization of derivatives markets traded in SOFR over LIBOR. More specifically, it proposes a gradual transition for the transition of trading conventions for the inter-professional market from USD LIBOR to SOFR for linear USD interest rate swaps, currency swaps, non-linear derivatives and derivatives traded in USD. stock Exchange.
MRAC anticipates that the implementation of SOFR First for trading activity between swap brokers will take place in four phases:
1. Linear exchanges: From July 26, 2021, inter-professional brokers would replace trading in LIBOR linear swaps with trading in SOFR linear swaps.
- The affected products would include firm swaps, swap spreads and curve transactions, while excluding the LIBOR / SOFR basis, the LIBOR / LIBOR basis, forward rate agreements and single period swaps.
- Interprofessional broker screens for LIBOR linear swaps would be available for informational purposes until October 22, 2021, but not for trading activity. Subsequently, the screens should be turned off.
- Since SOFR First is designed for the inter-industry market only, dealers could still execute LIBOR USD linear swaps with clients after July 26, 2021 and after October 22, 2021.
2. Currency swaps: From September 21, 2021, inter-professional brokers would replace trading of LIBOR currency swaps with trading of SOFR currency swaps.
- The affected products would include currency swaps with legs involving USD LIBOR, Swiss Franc, British Pound and Japanese Yen. Other currencies will be transferred at a later date.
3. Nonlinear derivatives: On a date to be determined, the inter-professional brokers would replace the trading of non-linear LIBOR derivatives by the trading of non-linear SOFR derivatives.
- The affected products would include swaptions, ceilings, floors and other non-linear products.
4. Derivatives traded on an exchange: On a date to be determined, the stock exchanges would replace the trading of derivatives traded on the LIBOR stock exchange with the trading of derivatives traded on the SOFR stock exchange.
- The affected products would include certain futures and other exchange traded products, such as currency swaps against currencies not hedged in phase 2 above.
The CFTC’s Market Participants Division and Market Surveillance Division followed SOFR First’s announcement with a statement from them, reminding market participants and swap execution facilities (SEFs) of the importance of a swift and orderly transition from LIBOR. The risks are manifold. The continued use of a discontinued benchmark threatens the stability and integrity of derivative markets, as well as consumers who are knowingly or unknowingly exposed to such benchmarks. Further, the statement noted that “[m]Market participants and FLS themselves may also face financial, conduct, litigation, operational and reputational risks associated with inadequate preparation. To achieve an orderly transition, CFTC staff reiterated what has long been part of the call for regulatory action to market participants:
- Stop issuing new LIBOR-linked derivatives as soon as possible, but no later than December 31, 2021
- Correct old contracts referencing USD LIBOR
- Build the liquidity of alternative benchmark rates on the different markets
CFTC Acting President Rostin Behnam indicated in his opening statement at the MRAC meeting at which SOFR First was recommended that the CFTC digest market participants’ comments on the impact of SOFR First on Mandatory Clearing Requirements and Related “Make Available to Trade” Determinations for SOFR Swaps under the Commodity Exchange Act and CFTC Regulations. To solve this problem, it is considering a proposal for a rule concerning the compulsory clearing of SOFR swaps, with the expectation of a finalization in 2022.
In anticipation of such regulation, Acting Chairman Behnam said the CFTC expects SEFs to treat SOFR swaps as either mandatorily cleared or intended to be cleared in the interim, for the purposes of the Clearing Rule. CFTC on trade name abandonment (CFTC Rule 37.9 (re)).
The potential regulation on mandatory clearing of SOFR-related derivatives was supported by CFTC Commissioner Dawn DeBerry Stump in a related statement. However, Commissioner Stump raised the persistent issue that CFTC restrictions still prevent US clients from accessing clearing houses and CCPs not registered in the US, even though they are subject to comparable regulatory regimes. .
SOFR First does not create any binding obligation for market players. However, the initiative is expected to help reduce LIBOR transactions and deepen SOFR liquidity. The ARRC issued a statement welcoming the adoption by the RMCA of SOFR First in general, and specifically approved Phase 2 of SOFR First (September 21, 2021, target for SOFR currency swaps). The initiative is expected to expedite any formal recommendation from the ARRC to market participants to replace LIBOR with the term SOFR in cash products.
The RMCA recommendation will now be forwarded to the CFTC commissioners for final review.