The Global Transition Away from Libor Industry and Market Sentiment

R E P O R T

The Global Transition away from libor Industry and market sentiment

July 2021 0 0

sia-partners.com 0 0

Table of Contents. 4 • Introduction 5 • Transition Progress 8 • Infrastructure 11 • Contracts 14 • Regulatory 17 • Alternative Reference Rates Replacing LIBOR 31 • Project Summary 32 • Contact Us 0 0

Introduction.

METHODOLOGY AND ACKNOWLEDGEMENTS

This report represents an update on a series of studies we issued in 2019 and 2020 on the industry progress made in meeting the transition deadlines for the Global Transition away from LIBOR. Our prior document, issued in December/Ja- nuary focused on the year end results for the participants and at the time, initial feedback on the consultative document issued on November 30th, 2020, by the FCA. After the update and final consultative document was distributed in early March of this year, we reached out to participants to ask for their input on the impact of that guidance crossing a myriad of the same topics that we had covered in previous studies. However, in this report there was substantially greater focus on several topics: the different public and private sector approaches used in the US vs other geographies and the detailed debate on the role of SOFR and alternative reference rates being proposed in the USD market. We are immensely grateful to the participation of all our clients in these efforts which we believe will be helpful in providing a synopsis in detail on the state of the transition with approximately six months to go before the cessation of the use of LIBOR.

The methodology we followed in this report mirrored what we have utilized in previous efforts. In brief:

● We conducted approximately 50 interviews with US and Non-US G-SIB’s, foreign banks, US Regional Banks, asset and fund managers, insurance companies, corporations, specialty lending firms, clearing and settlement houses as well as software & technology firms, research companies and law firms. Those interviews were conducted from mid-April through the end of May this year.

● As a result of a series of releases by the ARRC, FCA and other bodies, we did a meaningful set of follow-up discussions with ~30 firms in June to review specific topics surrounding Term SOFR and various Credit Sensitive Rates, several of which were released during that time frame.

● Immediately prior to releasing this paper there were some additional announ- cements, at an FSOC Meeting on June 11th relating to the transition in the US. As a result, we completed a very small outreach to firms to garner their feedback on those discussions.

● We were especially pleased that over 90% of our participants in this project were involved in most of our studies the past two years allowing comparisons of their progress and changing views.

These efforts would not be possible without the contributions of many of our managers and consultants who have worked long hours to support them. This was a particularly challenging effort given the number of discussions required to keep up with the quick policy pronouncements. In specific, to all our Sia colleagues who have assisted with these projects while working on their engagements full time; thank you for devoting your time and energy to our industry efforts. Finally, our profound appreciation to all our participants for their patience in working with us on this initiative and assisting us in completing this work successfully. 0 0

Transition Progress.

Our study results identified consistent progress by major financial and corporate they almost exclusively use derivatives entities to meet the cessation deadlines including risk assessments, contract re- for hedging purposes. Regional banks, view, systems updates and reference rate transitions from LIBOR to other reference largely are dominated by a wide variant rates. There is less progress across the US among mid-size and smaller market of lending businesses—commercial, participants that will require redress for a successful transition for USD Libor. corporate, retail, etc. Hence, their focus is near 100% on the transition Global Banks tized; loans in SONIA for example get- of USD LIBOR. Fourth, most of these ting attention and looking to remove institutions (with some exceptions) Our study reflected that Globally Sys- those from the backlog with other have never had the ability to invest temically Important Banks (G-SIBs) tenors delayed for redress until 2022.” the same resources (human or finan- continue to be on track to hit the ces- cial), nor have they had the backing sation triggers identified throughout As other alternative rates are being of management for an aggressive ti- 2021. Almost without exception, these considered by the official sector, we metable for the transition away from institutions started very early in the noted that most G-SIB’s had begun USD LIBOR. Finally, unlike some of process by setting up the necessary preparation for a varied multi-rate their colleagues. These institutions governance and transition infrastruc- environment across necessary opera- have almost exclusively seen this tran- ture, establishing working groups/ tional and infrastructure efforts. Lar- sition as a rather ‘collegial’ industry workstreams to implement the transi- ger banks noted that “SOFR was not based, non-competitive effort. These tion and constructing the necessary the only rate they were working on” firms have seen their efforts as a major support steps for contract review & and that “they had established deci- infrastructure ‘lift’ and an ability to drive extraction, conducting risk assessment sion-making and approval frameworks client businesses with an acceptable across their business lines for LIBOR to assess other rates and understand RFR replacement by year end. exposures, identifying key operational, their characteristics and risk.” Others The most pressing challenge for regio- system and technological upgrades described plodding “week by week nal banks is the on-going discussions that would be required and a rapid in- progress” reviewing new reference regarding RFR options that are being clusion and integration of their second rate alternatives. They also commented reviewed by the ARRC and the official and third lines of defense in that effort. on the critical role Term SOFR imple- sector. A number of these institutions In the UK and elsewhere in Europe, mentation will play in the months ahead would either like a Term rate for SOFR firms rapidly prepared for regulatory to assist in resolving some of these or possibly a Credit Sensitive Rate. oversight and in the U.S., even without challenges across the U.S. market. While we are late in the process to specifically identified safety and soun- garner liquidity for the market, many dness criterion in place, banks were Regional Banks of these institutions would like the of- ready for anticipated official sector ficial sector to opine on what are the oversight. Regional Banks have made meaningful possible and acceptable alternatives progress towards meeting their transi- However, larger G-SIBs noted that to SOFR compounded in arrears. Many tion goals. Though unquantified, broad the pace of their “lending businesses, have executed trades with ‘simple sentiment existed among participants both consumer and institutional rea- SOFR’ and would not anticipate push- that while many US-based community diness” have been impacted by the back from their regulators if that is the banks, corporations, and various types postponement of certain tenors until best option available. of fund management firms likely have June 2023.” Banks recognized that considerable work to do to meet transi- on the retail side that the origination tion deadlines and could pose broader End-users of SOFR based ‘arms’ had begun and operational challenges to the market. there were initiated conversion ef- Assessing the state of ‘end-user’ forts and that they were finding ‘fewer First, the vast majority of U.S. regio- preparation for the transition is un- market headwinds on the retail side.’ nal banks do not have meaningfully derstandably difficult given the broad Institutions often noted that they had large over-the-counter derivative bu- range of defining who that populous established a two tier process, “tenors sinesses; most of them are not market is. The end-user participants in this going away by year-end being priori- makers except in rare instances, and study, which were generally more so- 0 0

phisticated, have been preparing for a have been cajoled into signing the crucial to initial efforts and at the time reasonably lengthy period of time and ISDA Protocol or are holding out. In se- institutions identified approaches have communicated their general rea- parate presentations Sia Partners had for a business line by business line diness.” Many noted that the consulta- during this study, we found that less breakdown of their exposures and tive paper took some pressure off and than 50% of ‘smaller-mid-sized’ cor- separated them by client type. These enabled a readiness for a new RFR by porates felt that they had made some contracts were categorized by product year end.” Another layer of our end- progress towards the transition. There group and client group. Firms often users, both financial and otherwise are segments of the financial end-user used either an outside automation pro- (including some insurance companies), community who clearly see some ad- vider to complete this work (if the num- have already started processing SOFR vantage in identifying the potential in- ber of contracts were 1000 or more) or derivatives; initiated SOFR linked fun- troduction of basis risk from additional used an in-house capability to achieve ding agreements; and built-up changes reference rates and determining how the same result, along with manual in their systems to prepare for that their portfolio’s will align with those human resource contributions. Efforts product transition. Most advanced/ possible changes. Progress among larger entities are well prepared and this sector will vary greatly over the on operational and system upgrades have traded/issued in SOFR limitedly next 3-6 months as we get closer to the varied. Participants noted early on or are ready to do so once issues on cessation date as firms decide steps, that the complexities of transitioning alternative reference rates once they they need to take to meet deadlines. from LIBOR to SOFR compounded in are sorted out. Participants thought it was plausible arrears would pose meaningful challen- that there would be a big Q4 push as ges and require extensive resources. In fairness, this tends to represent the impending deadlines drew closer. Vendor assistance for both cash and more advanced portion of the end-user derivative systems (common to most market. Our bank participants agreed that the percentage of their counter- firms but not all) were typically still cur- Contributing Steps rent at the time of our study and will parts who have made truly measurable towards the Transition transition progress could be on the hi- continue through year end. Overall, our gher end 15-20% but more likely closer Most banking institutions began their study concluded that there was limited to 5%. These figures vary depending transition process with a risk assess- change in progress from Q4 2020 (our on whether these firms have a mea- ment at least 18 months ago, if not prior study) through nearly the conclu- ningful derivatives portfolio and would earlier in 2018 or 2019. This step was sion of Q2 2021. 0 0

Challenges of Transition Implementation for Global Banks

Throughout our study work, larger clients have identified numerous issues which have arisen as they have worked to finalize their transition plans worldwide. The issues that have arisen are varied and get covered in several other segments of our paper. Core to most institutions concerns were the different functionalities of their home regulators in their approach to the transition; the introduction of variant RFRs in the U.S. market; and the broader messaging around those issues. An enforcement of the Status of other currencies transitions vs USD the dates from the various guidance Sensitive Rates) so are likely to have LIBOR-SOFR. We will look to tackle bodies (PRA & Bank of England in the taken a slightly different approach to these below. UK and the ARRC in the U.S.) often client outreach to date while those de- differed, creating further misunders- cisions are being reviewed by the offi- Consistent with our prior studies, tandings. Participants added that the cial sector. One of our regional banks participating firms echoed that their UK approach was “milestone driven commented that “we have set up nu- European counterparts, and often with a consistent pace and honest and merous calls beginning in 2020 and a even their European branches/subsi- proper project goals and less of a “talk diaries/affiliates, had moved ahead on hub on our website to educate our rela- shop” which mirrored other efforts. the transition in a more rapid manner. tionship managers on a real time basis.” Institutions commonly referenced that Regional Banks, alike all others, specifi- there was more explicit direction from Client Relations cally created websites have been use- the outset from their home regulator; ful for both internal and external about Most of the largest banks globally an earlier start in the UK/EC than the building out communications to clients have completed their initial client U.S., clearer deadlines that did not wai- via the RM’s to better understand SOFR outreach and initiated contacts with ver and importantly, a smaller volume and other alternatives.” some specific client groups. They market in other parts of the world. have very finished and complete inter- Client outreach efforts at some junc- European institutions in the study nal capacities ranging from websites, tures need to morph from websites noted that they have not seen near- educational sharing with clients, direc- and dialogue to substantial remedia- ly the same pace of the SOFR based tion and background on the various tion. Others believed that their clients transition as they have with SONIA reference rate options, and regulatory would not dictate the pace and at some and UK progress. and even other input on timing. A larger U.S. based point, the market would embrace one reference rates which has included bank commented that “we have tar- or several rates and clients will adopt building out some of the look back pe- geted communications and allow us those. Foreign banks agreed their le- riods into their methodologies. Others to inform them about readiness, what gacy contracts and the roll-off -from noted that they have already spent time they need to do with their vendors certain tenors ensure that this will not with leading clearers (LCH); had com- and consideration of investment deci- be a burning issue for them to resolve. pleted work on their European stack sions.” One regional bank commented Firms agreed that customers wanted an and were picking up other currencies that “there has been meaningful client answer to the simple question which is like Yen/Sterling/Swiss. outreach and our relationship mana- “we used LBIOR last year, what’s next? gers have been educated on the topics Some sentiment was shared that the We are starting to drive our training mo- to raise in conversations.” US approach of “recommendations” dules to our bankers so they will know did not instill sufficient motivation for The pace of US regional banks was how to handle those discussions.” For their peers to evaluate their risk appe- somewhat different given that the those where there are a larger number tite and determine next steps. Others pace of the U.S. adoption of a final of contracts which expire by June 2023 referred to both the UK and Swiss ap- reference rate is different than that of firms noted that the revisions would proaches as “definitive, achieving re- the UK and other parts of the world. need to take place sooner vs. later and sults vs. the U.S. being in a “no man’s U.S. Regional banks are also among be part of their broader discussions land” for too long. Others noted that the largest proponents of CSRs (Credit with customers. 0 0

Infrastructure.

Study participants along with help from their vendors were on target in Q3/Q4 to firms felt, barring new major changes meet specific cash and derivative system updates. Smaller firms who have yet that they would require investment or to land on SOFR as an alternative reference rate due to its complexity or want a severe changes in regulatory or indus- credit sensitive rate instead are likely going to be more last-minute adherents. Risk try requirements or practices, that they and capital issues were getting more extensive review at larger firms in the US as would be fully operational by the Fall. regulatory oversight increased. Technological Capabilities Systems, Operations and rency exposures and that they had for Credit Sensitive Rates Risk Capital and Modeling already built-in approaches for SOFR for the Transition in arrears and systems had functio- As we noted at the outset, there was nalities for doing lookbacks. Others substantive feedback on this ques- Firms noted that their systems were who also had expressed support for tion and the broad consensus was ready to handle the transition. Some BSBY or other Credit Sensitive Rates that firms could handle the additions noted that that their “mortgage servi- This noted that a tight timeline to handle without significant challenge. cing platforms were mostly in-house, institution like many others noted that all the RFR’s could be achieved. While and their internal capabilities had “in addition they had been preparing some degree of segmentation aligns been supported by a series of vendor for a multi-rate environment in compari- to Cash and Derivatives, most key mortgage updates and scheduled for son to a relatively LIBOR vendors expressed those institutions homogenous readiness by the end of Q2 in advance environment. are ready for the Rates transition with of the cessation and allowing time for primed modules, patches, and code We raised with firms their capacity to doing sample trades. It was common which offer the enhanced functionality handle accrual and accounting issues for the regional banks to have focused necessary for future implementation. within the ambit of the upgrades. The on accruals early on and some com- International banks, also of good size, feedback was divergent. An invest- mented that they “were a mix of in- noted that they would have manual ment entity noted that their systems ternal and external systems and have workarounds for risk processes and is already support SOFR for securitized built out a timeline that should have us finalizing their cash and derivatives ef- products, but upgrades were required ready by September 2021.” Generally, forts. Some had not completed their re- for compounding in arrears for ac- they agreed it was not a big concern to ference rate mapping but those will be counting issues. A firm with more of a get to the finish line. ready by September of this year, and lending focus noted that their efforts A few of the regional banks noted that they all seem to have patches for cash were dependent on accounting SOFR they were not burdened with multi-cur- or derivatives. In summary, most of the approvals by the FASB as part of the hedging accounting index. They would then need to await developments for CSRs to finalize their work on accrual issues.

One of the larger G-SIBs had completed a high-level assessment and felt that they would be ready for BSBY or any other CSRs. They noted that the investment would be “less complex and require significantly less effort in comparison to the effort that was required to become operationally ready for SOFR.” This institution, like many others, noted that “in addition, they had been preparing for a multi-rate environment in comparison to a relatively homogenous LIBOR environment. 0 0

We raised with firms their capacity to as part of the hedging accounting in- tures. Many firms will have to rely on handle accrual and accounting issues dex. They would then need to await tactical solutions while the industry within the ambit of the upgrades. The developments for CSRs to finalize their waits for a strategic upgrade in 2023. feedback was divergent. One of the work on accrual issues. G-SIBs commented that they had ad- Capital Issues, Model ditional analysis to complete but anti- Operational Issues Validation and Regulatory cipated being able to provide a more Related to Electronic Initiatives “detailed response, specific to accounting, accrual issues, pricing and other The timing associated with updating First, soliciting information was dif- challenges in a timely manner.” A firm message structure provides additional ficult. However, this information was with more of a lending focus noted that challenges as the SWIFT organization almost exclusively in the domain of the their efforts were dependent on ac- has a rigid timeline for providing new risk specialists and not with those who counting SOFR approvals by the FASB requirements to update message struc- had broader transition remits. 1 1

Second, the focus of the participants beneficial with SOFR. Our product was not on regulatory capital but pricing and those liquidity impacts on rather on either the ‘cost of funding’, sensitivity in a stressed environment ‘asset liability management’, or the and how you price that into your basis implications of ‘economic capital’ by risk management is a challenge. How the transition from LIBOR to SOFR. do you think about a natural hedge in a stressed environment—how do you Third, participants agreed that as think about unfunded commitments ensuring their risk models met both when you have negative correlations market/industry and eventually regu- on the rates while being realistic about latory best practice, the issue was less the pricing.” than pressing. Firms noted that unlike other portions of their transition effort, this initiative rarely had dedicated re- Regulatory Capital sources to purely the LIBOR transition, Add On and consequently other regulatory de- Some firms hypothesized it was pos- mands took precedence. sible that if the uptick in SOFR was not Fourth, there were a minimal num- as both LIBOR and SOFR stabilize and sufficient, the Fed and other regula- ber of firms who had engaged their there is limited volatility in the markets.” tors ‘could’ consider changing the risk regulatory on this topic; the group was essentially comprised of only the weighted assets to spur that growth. Admittedly this exchange occurred largest institutions. Regional banks Potential Capital Impacts for example, had less dialogue on this on the Introduction prior to the meaningful efforts to intro- issue but were focusing on their own of a Credit Sensitive Rate duce ‘Term SOFR’ to the market which internal efforts to determine what im- has changed some thoughts among The feedback on the capital implica- plications this might have for the bank. our participants. However, there was a tions of an introduction of a CSR likely dialogue regarding the use of capital as As we noted above, there was subs- depended on whether the respondent a ‘stick’ without the carrot. tantial discussion throughout our was an advocate of the rate (and felt reference rate replacement segment it was nonexistent or limited) or had One major investment entity who had about the impact that the transition not studied it yet and thought the dialogued with banking firms noted from LIBOR to SOFR would have on question might be open to further that “risk weighted assets could get the lending environment. Respon- consideration. interesting as the Fed could pressure dents from these regional banks see firms with new requirements. The Fed One trader noted that “I question the impact of the transition impacting could also create new non-SOFR capi- whether moving to CSRs would have their ability to cost-effectively manage tal requirements with less flexibility on a material impact on capital/stress test their net interest margin. One of the SOFR amendments which could raise results. I expect CSRs to move in line large global banks explained, “the other issues.” with any assumed moves in LIBOR regional banks feel that they cannot To summarize, there was very limited models. SOFR in stress may have an lay off the risk in the back-to-back feedback among participants on impact, but it is not currently expected books, which could reasonably im- whether a capital surcharge was likely to be material. I trust the ARRC which pact what they will face. That creates or advisable and that the Federal Re- has already made recommendations differences between their net interest serve and the ARRC would work in as for better regulatory guidance on this margin (NIM compression) and notional collegial manner as possible to achieve topic.” compression.” the best possible result to avoid impo- One of the larger global banks provi- sing any restrictions on the market on One larger bank summarized this well ded their own perspective on the U.S. what reference rates were acceptable for most of the participants by noting dialogue here. “One of the items we to allow the industry to determine that “as new CCAR stress testing re- worry about the most is not just the ca- what reference rates would achieve quirements flow into other derivative pital impact on earnings but on interest appropriate liquidity and meet broader market shock scenarios, we would in- rates as well. We can envision real mis- criterion. corporate SOFR and LIBOR as part of matches with assets and liabilities crea- our overall risk management design. What is also clear is that many banks are ting meaningful basis risk. We know the We anticipate that rates will converge, doubtful that this sweeping statement transition will introduce real basis risk and the value-at-risk (VAR) numbers can be made for some grouping of their and it will need to be capitalized. should be roughly the same. We would clients who are smaller, have less ex- expect that the volatility and correlation One noted, “how big is our basis risk posure to LIBOR and have started this between the two rates will synchronize or re-balancing that basis risk is not process out later than others. 1 1

Contracts.

Study participants concurred due to exemplary work by the ARRC, ISDA and indus- Larger market participants with grea- try working groups that firms had transitioned across both derivative agreements ter market exposures in the end were (via the ISDA Protocol) and cash instruments. Client remediation continues to lag pleased with their progress in the nu- in the US as many clients are reluctant without demonstration of SOFR liquidity in mber of contracts that had been exe- the market and further public sector clarifications to finalize their RFR transitions cuted the past year that referenced from LIBOR. SOFR and/or and hardwire fallbacks. Participants broadly agreed that hardwire approaches had progressed fur- Progress varied LIBOR cessation requirements ther with derivative instruments since inclusive of all tenors. Most had prio- AARC, ISDA, LSTA and other global they were implicit and addressed via ritized their contracts across business working groups, have worked steadily the ISDA protocol. In summary: strong units and then on maturity dates of the past several years with the mar- progress; still work to do on the lending expiration. Currently many of those kets, ensuring a high level of prepa- side; concerns on the timetable for im- institutions want to interact and reme- ration on contract review, extraction, plementation of language for ARRs if diate with clients using a form of SOFR essential language and readiness for that demand arises. (compounded in arrears or simple remediation across cash and deriva- SOFR) and will consider an alternative The primary deterrent currently for tive instruments. effectively left the reference rate if appropriate. many institutions (inclusive of regional industry participants prepared in terms banks and end-users and small clients) of contracts and legal exposures. Res- Other large firms referenced building is due to the product uncertainty that pondents have noted that there are a portal on their website and had continues to engulf the U.S. market. specific legal shortcomings in state already reached out to their largest Institutions are not concerned that the legislation that was passed in NY that clients in addressing the process. vast majority of their clients doubt the requires redress in the proposed Fe- Firms noted that while this approach cessation date. But they agree that for deral legislation being considered by may well work to mollify clients who the time being the influx of continued the Congress. are still awaiting a more indicative re- dialogues about potential ARRs and ference rate choice by the industry, this Participants have consistently noted the introduction the past several mon- does push forward important steps that over the past two years that the origi- ths formerly of several Credit Sensitive nal framework, feedback structures, we will need to eventually take. Rates has only increased that hesi- and timetables for release have been A few study participants noted that tance to close on finalizing remedia- completed consistent with most time- some institutions had challenges tion efforts. More recently, the added lines with limited exceptions. Second, with specific contract amendments likelihood of a formal endorsement of these efforts have worked efficiently but that was a distinct minority that Term SOFR has only exacerbated the with efforts outside of the U.S. and anticipated their hardwire language wait-and-see approach for some in the most of the initiatives have been iden- to go in place or the runoffs to occur market. tified with meaningful global backing. in advance of June 2023. Firms noted Larger banks shared the view that Third, whereas other areas in the tran- that they have tracked statistics care- the failure for SOFR to take hold es- sition have produced some clear fric- fully for a number of months across pecially in the lending market to date tion among participants and slowed their program managers who have has been a challenge in remediation progress, there has been broad sup- reported back that their clients have progress. Banks noted that “we have port in our interviews with the eventual come around to the amendment pro- already completed our internal work-- outcomes produced by the industry. cess and have structures in place to that’s not the problem--it’s the lack of Initially, we inquired what participants handle the amendment process if that volume in the market that has created thought about the broad progress in is required. Finally, larger global banks our biggest challenge.” These institu- implementing the ARRC hardwire fall- mentioned that with a half dozen plus tions generally shared the view that the back language. The consensus across months to go that they were curious as fallbacks will endorse SOFR as the wi- all groups was that the pace and suc- to the impact of “re-opening the hood” dely accepted replacement for LIBOR cess of those efforts had gone well and for the compounding conventions for along with the hardwire approach and that they were on schedule to meet the ARRs if that was required. the supplemental amendment process 1 1

once market liquidity takes hold. Firms have undertaken sufficient contract re- rates, and we also do not have an auto- noted that they did not “want to get view and extractions (risk assessments) mated fallback on the ISDA side. Firms ahead of themselves” and wanted to to confirm their firm-wide exposure to shared the view that CMS was awaiting focus on the ‘economic piece of the LIBOR in various agreements. next steps from drafting into the ISDA transition--ensuring a well thought protocol and were linked to floating through cost benefit approach to the Non-Linear Derivative rate notes (FRNs). Lawyers we spoke transition.” Solutions with felt that Sterling LIBOR was not that far away from a clearer suggested Separately, the release of the ARRC At the time of our publication the methodology being crystallized. End- fallback language has highlighted industry is still working on various users noted that they believe these some of the issues associated with solutions via ISDA for non-linear de- negotiations are winding down, that legacy contracts and the occasional rivatives. There was limited feedback bumpy path to remediation. Most ins- language surrounding floors and caps broadly on the question, as many res- titutions in our project noted that they are being looked at and that firms are pondents familiar with the challenge were going to address these with ‘BAU managing the convexity risk with those noted that they anticipated additional practices’ but also will require some instruments. ISDA language in the market some- customized remediation efforts. The time in the next several months. Some initial challenge of identifying in each banks noted that they recognized the Federal Legislation business where sufficient fallbacks difficulties with finalizing language on Contract Certainty were not present and evaluating the without a fulsome SOFR market being size of the exposures has been on- Our study focused on both the value created. going for several months. of the recently passed New York State For constant maturity swaps (CMS) legislation on legacy contracts and the Readiness and Outreach participants noted that they have proposed Federal legislation that is at been discussing these at the ARRC its initial stages in the House of Repre- The current pace of re-papering and re- to construct options “best practice” sentatives and received testimony from mediation outreach is slower in the U.S. which have been based on the ICE several industry firms and regulators. than in UK and some other markets glo- swaps market. To date the answer has We also address below the third leg to bally as many banks have not finalized been that the fallback language will this stool which is the corresponding their RFR offerings and clients may not not apply to either ICE or the Euribor UK approaches on legal certainty that 1 1

firms also commented upon. Univer- Most of our participants acknowledged sally, participating firms agreed that that they had reviewed AI/NLP op- the NY State legislation was very tions and those with a meaningful important given the predominance number of contracts engaged provi- of contracts written under NY law. ders. Some of those were third party Firms noted that this allowed the re- consulting firms; others reached out to placement of patch work approaches external law firms and many also found and should provide needed certainty expertise in specialty automation firms for the transition. Firms noted that the who provided high end delivery for a legislation would help with corporate wide variety of use cases. There was a trusts but Federal legislation was still fourth group who leveraged current di- required for structured finance and de- gitization efforts that had already been rivative instruments. Federal legislation employed by the bank for prior initia- is important given the proliferation from tives. After reviewing our data over the a dispersed group of lending statutes past two years, we believe that many and useful to enhance the coverage for of the largest global banks, many of securitized assets and notes that are the U.S. regional banks and numerous not typically covered. foreign banks embraced one of these The lack of Trust Indenture act was four solutions which included automa- a major gap identified in the NY le- tion as a key component of their review gislation and essential to the need and extraction of contracts related to for Federal intervention. Some banks the transition. Some of our largest end- noted that they were interested in in- user study participants followed suit. A cluding it as part of their offering and segment of those institutions we spoke they would like that to be picked up with agreed that some products were in the upcoming Federal legislation if too complex to be captured by their possible. Regional institutions added product including CLO’s or bank loans that the exclusion of community bank as examples. contracts in isolated jurisdictions could We noted in this study that some eventually pose a systemic problem for firms clarified that they had engaged the market. For the larger institutions, a third-party provider who by proxy portfolios often fall under jurisdictions was using AI as part of their review ap- of NY law but underlying documents proach. Finally, others noted that their have a trust indenture which is not third-party vendors were used for only covered. inventory management as opposed to the entire review. Use of Automation The use of digitization was pronounced and NLP as part among many in our study and was be- of their Contract neficial to learn key word tools which Review and Extraction were then handed off to others for legal review. This reduced time to a certain Since our first study in 2019 we have extent but there was still significant asked participants about their use of manual work required. One firm com- AI/NLP or similar tools in their contract mented “we loaded all of our contracts review and extraction process. We to an AI solution; built a script for LIBOR extended that question to include the that used the tool; customized for the possible use of AI/NLP in their reme- library and found a law firm that could diation approaches but there was li- use both and provide external advice.” mited indication that this was favored. A few had engaged outside firms or were using internal technologies to assist with the initial remediation and outreach steps, but most had not considered the technology. Firms regarded these steps to be manual and time consuming and had yet to see tools that would be efficient for those efforts. 1 1

Regulatory.

Regulatory scrutiny has differed markedly from the US vs. other jurisdictions. A tive regulatory effort in the U.S. that larger spring/summer push by US regulatory bodies, joined by the FCA, reflect mirrored what they had encountered to date a singular commitment to SOFR as the transition RFR—promised safety & in the UK. soundness reviews to achieve those goals. Increased oversight is anticipated in Q3 and Q4 as the process evolves. Regulatory Examination Process Official Sector Roles Separately in our discussions, firms and Responsibilities noted that the messaging and the Some firms had very high touch discus- pace associated with the timelines sions with their regulatory bodies and Since we initiated these projects, (which were different) caused unique others something more structured. core to the discussion among the challenges. One of the larger buy side Some noted that they anticipated fur- participants has been at least the firms commented that “we are working ther scrutiny during Q3 and Q4 while perception, and for most the reality, towards our transition for GDP LIBOR others had not received a clear direc- a distinctly different approach under- this year and we are aware that the tion on next steps. taken in the US vs. UK and other geo- pressure from the FCA on UK institu- U.S. firms did not see the efforts as very graphies towards the transition. As a tions also finds its way to our efforts proactive, and one noted that they could result, the feedback from the beginning since they are pushing us to be further not describe what the OCC remit really of our work, has been split along geo- along than their US counterparts.” A was. Another noted that the OCC had graphic lines—differing thoughts about European based fund manager com- been “very hands off and not in lock the appropriate role of regulators to mented that “with two different imple- step with the ARRC. They generally standard set or influence the transition mentation dates items can be proble- seem to favor market autonomy and in their locale and, eventually, whether matic. Many of our counterparties are focus on price transparency. We would the examination process would have European based and we are seeing not mind them trying to produce more the necessary rigor to encourage firms real movement and progress with them rigor and level the playing field with the to meet transition deadlines and meet whereas we are seeing less movement Fed.” Some of the institutions noted that better/best practices. among our US entities.” they took the questionnaire “turned into Those sentiments were re-echoed in this This tone and tenor were mirrored by their own risk assessment and sent it to study as participants noted that, looking banks who noted that the lack of regu- stakeholders who were responsible, backwards, participants did believe that latory pressure is leading to stagnation and we went through a self-assessment the US structure provided a sufficient from their clients. One foreign bank and a good health check.” balance among the largest institutions noted that this was the continuation of and regional/community banks as well “less clarity and less analysis leading to SEC as appropriately engaging the corporate paralysis from our counterparties. The community early in the process. urgency for the transition was reduced; Firms noted that the base responsibi- The opinions on what should have oc- the commitment to SOFR and the ap- lity for the SEC oversight was almost curred were straightforward. One glo- petite to clarify that positioning has not all disclosure-based although firms re- bal bank noted that the “PRA and FCA been helpful especially with ‘new toys’ cognized that this could change under have been very direct in their pers- coming out for institutions to consider.” the direction of Gary Gensler, the new pective including data gathering and SEC Chairman. Finally, we note that only a few firms rigorous oversight guidance and this Large banking institutions commented properly noted the global role of the has not been matched by the Federal that “they did not think that the SEC FCA as the regulator charged with the Reserve to date.” Others noted that the would have impact one way or ano- oversight for the LIBOR transition and “delay the US has agreed to kicks the ther.” Another noted that “more dis- often assumed that the Federal Re- can down the road—the messaging has closure would not change anything.” A serve or others had equivalent power. been in speeches vs. action. FR 21-7 is third bank commented that “we have a step in the right direction—enhanced From the beginning of our studies, not read nor heard or have any indica- scrutiny and consequences for the lack we have found most global banks tion that this is a concern of the SEC. of progress.” reflecting a desire for a more pro-ac- There was no gun or hammer in their 1 1

lidation all at the table with their work plans.

One of our larger regional banks noted what typified a few the bigger banks. They commented that the “second and third lines were engaged from the start; governance meetings; model validation all at the table with their work plans. Our program was audited, and they are part of our ongoing practice approach now.” An international G-SIB said “that all of our proposals and new origination have engaged with compliance and conduct working groups providing consistent market practice. Our second line is imbedded with our controls and close to all new originations.” A large financial end-user said that “our second line groups prepared and were involved with compliance, legal and risk and those representatives are tied to inter- hands, nor do they have authority to tins, were not “freaked out” and were nal audit wholistically throughout the accomplish that.” comfortable with their timelines and firm.” An asset manager commented could demonstrate to their manage- that their IA has called but not audited Institutions were generally skeptical ment that they were in good shape. A the project and we anticipate that they that the breadth of the SEC capa- global bank noted that they had put will wait till the project management is bilities would change the dynamic special attention on their system rea- for financial or corporate end-users done and system changes. Our second diness and joined other banks in noting to hasten the transition process, al- line has been involved all along.” The that there were “no surprises and were though the tone has clearly changed concept of internal audit ‘observing on track for the transition.” as of June and Gensler’s team taking and not having an in-depth review of the reins. There is a bit of “TBD”. We also engaged some firms on their our practices—they have been passive interactions with the New York De- and less engaged’ was voiced by an partment of Financial Services who Federal Reserve end-user who sensed they would want had originally issued their transition to upgrade their efforts. Examinations update request in December 2019, We attempted to probe the role of Over the past six months the Federal which at the time provided meaningful internal audit and the interaction with Reserve have provided significantly concern in the market. Several firms greater guidance to regulated entities noted that they found it unusual that partnering and the role in decision-ma- regarding expectations for the LIBOR they had not heard from the DFS since king with the Steering Committees. A Transition. The Fed was seen as the the 2019. Finally, a group of our Cana- perspective was provided by a larger most engaged regulator for the transi- dian participants commented that they regional bank who commented that tion. Firms in our study had reviewed had engaged OSFI in Canada who have “our internal audit partnered through SR-21 among other documents and had reached out regarding progress on the the whole way—releases governance more likely than not already engaged transition, and they all felt that additio- monitoring and evaluated the work nal activity and an uptick in scrutiny the Fed regarding the transition and we have done; coding on our fallback would be welcomed. had formed a view (however prelimina- language that was also reviewed exter- ry) about the level of scrutiny. nally and regulatory reviews. They have Role of the Second & Third Regional banks felt they were ready used ARRC best practices as a refe- Lines of Defense in the rence but not as a tight benchmark.” An for the Fed’s review and had already Transition answered the initial set of ques- investment entity said that their internal tions and had established quarterly Larger regional banks and GSIB’s audit looked at governance structure touchpoints. Others commented that echoed the same themes: the “second but has not done a full-blown review they had strong confidence that they and third lines were engaged from the and risk sits on the committee along had reviewed the SR letter and bulle- start; governance meetings; model va- with audit which is a stakeholder.” 1 1 1 1

Alternative Reference Rates Replacing LIBOR.

Participants in our study spent considerable time discussing the current poor li- There are very fervent supporters of quidity tick-up in SOFR across both derivatives and cash; the potential role for one or more of the Credit Sensitive Term SOFR to build out those figures and enhanced regulatory approvals for the Rates. One of those firms commented, inter-dealer market to increase investor/end user participation. There was strong “BSBY appears to have some early and divisive dialogue around Credit Sensitive Rates of all types and the potential traction with some G-SIB backing and contributions they could bring to the market which will ensure even a larger global we would support BSBY emerging as ‘multi-rate’ environment. a viable credit sensitive term rate for commercial lending. We anticipate the ARRC recommending Term SOFR this Market Messaging to determine our readiness.” A global year and if the ARRC acts soon then and Competition G-SIB was quite succinct: “we need Term could supplant Daily SOFR as ano- Between Reference Rates a settling of the market. Do we have ther viable rate in the commercial loan a Term SOFR settling on the options Over the past several weeks, we have market. We do expect multiple rates to and different flavors with lookbacks seen commentary from the various replace LIBOR for new issuance and and averaging in arrears (as that will U.S. and UK regulatory bodies aligning we think the two most prevalent refe- be very challenging) which executing support behind “SOFR & SONIA First.” rence rates for new issuance in lending is going to be very challenging? To the Additionally, there has been commen- will be Term SOFR and BSBY. However, extent that there are going to be CSR’s, tary clearly providing support for Term this is just our speculation and many which ones will be selected? What are SOFR with the expectation that its contingencies could derail this. they? Are they of the magnitude that adoption would bring further liquidity One European bank with a small U.S. they can compete with SOFR for liquid into the market once that product is presence said that “it’s important to derivatives, or are they a ‘niche’ that oc- given additional approvals. Interviews understand why markets lead; if a rate cupies a not so widespread portion of in June the content of which align with has demand it is very difficult to turn the market and are actually competing dialogues held several months ago, re- it down, whether it’s AMERIBOR or for market share? Will BSBY be on the flect the desire from the industry for a SOFR or Fed Fund Rates or another set of answers in the U.S. If term SOFR periphery or core to the market?” CSR. They will all come down to changing the tone. If no bank wants to offer can effectively address those ques- Whether this ‘wait and see’ is either a term market, BSBY will gain traction. tions, that would further spur adoption short term perception or reality, we Regulators right now are staking the by institutions and clients. believe respondents believe it will moral high ground, so this is difficult Developments over the past month take a while to play out through year to speculate and we are not writing have included clarification about com- end. They have commented both in about this to our clients.” This view was mitments from a number of individuals past studies, and with passion in this shared by another larger global bank and entities concerning focusing on document, that the fungibility needed when they stated, “it is too soon to say SOFR as the only acceptable RFR that to end and certainty expanded. One of [what product will emerge as a front could be implemented, as well as a our larger end-user participants com- runner]. There has been buzz on BSBY series of statements which included mented, “one of the items we have and it has gained some early traction. very strident commentary from SEC talked about is flexibility and different As there is Term SOFR, as well as five Chairman Gensler regarding CSR’s end-users have different capabilities viable alternatives, it is a bit early to call as being unacceptable alternatives to and products and we will try to be me- that. There has not yet been guidance SOFR although they could or should thodical in our review—but we will wait from the official sector. It took a long have arrived at those options much until we see what our customers want time to build SOFR to meet the needs more quickly. and move where we need to move. of the client. We are surprised by the A regional bank suggested that “we But we are preparing now for multiple Fed’s silence, and we know our clients are doing operational readiness to rates, with CSR’s and other indices and want a term rate. It will be hard to put support other rates like AMERIBOR processes required.” that demand genie back in the bottle.” 1 1

A large asset manager commented syndicated facilities and do at least the necessary changes to adopt SOFR that “with greater fragmentation it will some of them on SOFR which appears compounded in arrears. Respondents be tougher to move the market. More to be the first broad syndicated mul- reported that they are now, or will people are confused and if SOFR mo- ti-billion-dollar US based SOFR loan shortly be, prepared to transition as re- ves forward then some of the choices being originated on an RFR other than quired. However, they also noted that a will create logjams. We think we need LIBOR. The loan would be calculated number of their smaller/mid-size peers to seriously consider narrowing the by ‘Simple SOFR’ and hence not com- in the market are not able to make offerings. The Fed is in an interesting pounded by the outstanding principal. those investments (or would choose position, but the Fed needs to decide not to) as well as that numerous clients how to use BSBY for products like com- SOFR Compounded on the cash & lending side would not mercial real estate where liquidity is not in Arrears: Challenges embrace this approach. that important.” and Complexities A smaller U.S. Regional Bank was more explicit about the challenges SOFR Volumes The largest participants in our project and the Global Pace indicated that they would be prepared when they noted, that “our problems across systems, operations, risk, and include option-based pricing; a tranche The comparison of SOFR and SONIA, other support infrastructure to make in SOFR vs a tranche in prime-pricing, volumes and otherwise, at root, are not comparable. One of the senior traders at a G-SIB noted that “roughly 50% of the client volume had already shifted to SONIA when the UK initiative launched, compared to around 15% on SOFR. How quickly the client piece of the market moves on the back of a “‘SOFR First’’ initiative is something we will need to continue to understand.” Janet Yellen, in her presentation on June 11th at the FSOC group meeting added that “while important progress is being made in some segments of the market, other segments, including business loans, are well behind where they should be”.

There has been strong growth in SOFR futures volumes year-over year from June 2020 to June 2021, but that was on very low volume. Andrew Bailey has enthusiastically supported this effort, noting that new Sterling FRN issuance almost exclusively references SONIA. The share of SONIA referen- cing swaps has exceeded the LIBOR equivalent now for 10 months, and the dealer-to-dealer market has completed a transformation in risk traded with 70% more volume in SONIA as compared to LIBOR across all tenors.

As we referenced in other segments of the document, the UK took a focused and steady approach to the implementation of SONIA as the replacement rate, and the current status of the rate in the market seems to reflect that long planned effort. Most recently, in late June, Ford appeared prepared to refinance $15.4 billion in 1 1

which is forward vs. arrears. How do banks who had interacted with their legal difficulties, we need to face the you deal with those deals and how do clients. One regional bank noted that reality that we have six+ months and we solve for that? We have a lot of head “this is concerning to our customers. the amount of work to get done is a lot. crashing. We can offer simple SOFR The average two-day event you get That is our major concern. A larger glo- and can meet those requirements. noise, which is a natural reaction. bal G-SIB expressed the view of other However, as a lender we are skeptical We have put it into sales and training European-based institutions when they that we can offer a robust compound materials—and they do not know the noted that moving the implementation in arrears—spread differences in pen- SOFR rate so they will have trouble date “has given us more time, but we nies and the challenges for interest and with daily adjusting rates—so billing are not seeing new SOFR transactions lookbacks are more complicated than will be challenging. Another regional on the lending side as a result.” it needs to be.” A larger U.S. regional bank who favors options said, “there is noted, “there are two flavors of SOFR: a demonstrated need for a CSR in the SOFR First Next Steps in arrears and compounded in ad- lending space. SOFR is an option and vance. Borrowers want compounded in will be viable However, mechanically For background, the “‘SOFR First’” ini- advance. Banks would not offer that at clients want to know something before tiative, which was announced on June all. The conversation taking place over the end of the month for planning and 8th, was a cooperative dialogue lead the past month that CSRs could bridge SOFR does not provide that.” by the ARRC and U.S. regulatory bo- that gap by having the term component dies which called on the inter-dealer is something everyone can agree on. brokers to switch U.S. dollar swap Remaining Growth quoting conventions to SOFR, which The client component here cannot Concerns was then more officially articulated be denied. A midsized regional bank by the CFTC’s Market Risk Advisory highlighted that a number of their Almost all institutions we spoke with Committee. peers have identified that “customers said that they felt that the U.S. should would take SOFR until the customer un- be further along and noted issues MRAC noted that the purpose of this ef- derstood compounding and the true up ranging from momentum to opera- fort was to bolster the “disappointing li- period. Then they would take BSBY”. tional hiccups to failure to properly quidity in the Federal Reserve’s prefer- They continued, “with AMERIBOR and message to the competition in the red LIBOR successor (SOFR). A number BSBY they should be relatively easy to industry from CSRs. Others noted of traders spoke out favorably about implement. The calculation methods that “while there are operational and this effort, as one noted that “there with SOFR compounded forward and backward are so much more complex.” This view was shared by a large U.S. G-SIB who noted the juxtaposition of the addition of Term SOFR, saying “the CME announcement changes the game. Derivative markets are comfortable to trade in compounding in arrears. CME solves the issues on the cash side.”

Many of the regional banks in our study noted that their infrastructure upgrades associated with SOFR compounded in arrears were meaningful investments to ensure transition readiness even if they were anticipating additional credit sensitive rates. One of the investor end users has publicly noted their skepticism, stating “SOFR is really designed for large institutions doing a ton of overnight repo as it allows them to hedge their books perfec- tly, but it’s not – in my opinion – a great option for a commercial loan given the daily nature of it, the compounding is- suers and the fact that it’s a risk-free rate.” These views were shared by 2 2

liquidity and recommend that the CME is the Term SOFR provider. We think that clients should follow and, by year end or we move away from LIBOR. It will work well with SONIA—triggers do exist—but they are really into 2023 to get that done.” Participants had reasonably clear views on the value of the term propo- sition and where it would be useful in pumping the growth of the SOFR market. Some, as noted, were concerned with the trade off with CSR products but admitted that this discussion was still in its infancy.

‘SOFR First’ and Term is clear guidance to move away from across almost all types of banks and SOFR LIBOR in the derivatives market by the both corporate and non-bank financial end of the year and reality is that an ini- institutions. Those concerns were aired For several years institutions have tiative like “‘SOFR First’ is probably the quite rapidly and after further consul- been actively advocating the reco- only way to get there.” Another G-SIB tation with the markets there was a gnition of Term SOFR. However, the senior trader succinctly noted that “the complete change of heart announcing linkages implicit or explicit of Term market definitely needs this one-time on April 20th that, when they noted “As SOFR with ‘SOFR First’ and its linkage boost to get out of this chicken and egg we announced in the March statement, was laid bare by ARRC Chairman Tom dynamic.” Most recently the FHFA arti- the ARRC will continue to work quickly Wipf who said, “the linkage between culated a detailed regulatory guidance to communicate what it considers to ‘SOFR First’ and Term SOFR is very related to the LIBOR Transition. The be the necessary conditions to subs- tight and if we can deliver on ‘SOFR letter shared by the ARRC on July 1st tantiate the recommendation of a SOFR First’ with the recommendation of the was issued for the Federal Home Loans term rate, including the development of MRAC subcommittee, I think the ARRC Banks to support a smooth transition sufficient liquidity in SOFR derivatives will be well positioned in days, not away from USD LIBOR. The letter en- markets and recommendations for an weeks, following that July 26th date to courages the continued use of SOFR appropriate scope of use for the term endorse CME Term SOFR.” The ARRC’s and SOFR averages and warns against rate. This feedback was welcomed al- formal endorsement is nearly assured the adoption of rates that have similar though with a few reservations. at that meeting providing an additional shortcomings as those associated with level of assurance for industry partici- One G-SIB commented that “the vo- LIBOR. supervisory letter) pants who find the offering attractive. lume for SOFR is in the overnight rate. That needs to be greater than Term Our study participants noted that if Term SOFR SOFR for this to succeed.” A regional one reviews the progress made based Initially in March, the ARRC an- bank suggested “once derivatives are on SONIA adoption the success for nounced that they did not believe they green lighted on the CME/Term SOFR, SOFR could be rapid. One trader noted would be in a position to recommend this interplay will be sufficient volume that “if we look at the UK experience, a forward looking Secured Overnight for SOFR futures. Conventions will help and you get 30-50% volume on SOFR Financing Rate (SOFR) term rate by and increase volume. However, we are in the first couple of months is possible. mid-2021, and encouraged market not sure about the timing on the ARRC That is a meaningful chunk of the mar- participants to continue to transition and we would like to use it with cash ket when it has been hovering around from LIBOR using the tools available products and derivatives together by single digits for a long time. This should now. This feedback was exceptio- Q4.” A stronger advocate of CSR’s was be an orderly move and not a shock at nally troublesome to the industry leery when they noted “we don’t see the end of the year.” That jump in vo- and indeed we picked this up at the a lot of interest in CME Term SOFR lume would be considerable as some very outset of this project with our without the ARRC seal of approval as of our charts point to. “There’s no doubt initial interviews. Institutions felt I was participants don’t want to be offsides that the pace of SOFR adoption has important to secure sufficient SOFR of the eventual recommendation.” A been disappointing. Given that there’s wide liquidity that a term structure be separate G-SIB reflection in late June less than seven months to go until the included. And it was one of a group offered that the “CFTC announcement business has to be off LIBOR, and we of topics that broadly was supported on the inter-dealer market, will drive are only at about 7% of the derivatives 2 2

markets, it is concerning, as one senior trader noted.

Traders seemed keen to move this along as noted by one senior trader who commented “Market participants are keen to follow these best practices because getting SOFR indoctrinated into our market is in everyone’s best interests and I think everyone will do their best to make this happen.” Switching the pricing curve for interbank markets could also entice more client activity by reducing friction costs on SOFR trades some of our study participants noted. By cementing SOFR as the primary rate on broker screens, dealers will begin using the risk-free rate as the base curve for viewing and hedging risk, meaning they would no longer need to hedge a client SOFR trade with a basis swap. These cost savings could be passed to the client in the form of tighter pricing.

There are caution flags on the appli- cability of TERM SOFR. First, at the release of our paper there are no current plans to offer derivatives to their own CME Term Rate until June 2023, leaving it far more applicable to legacy agreements although the hope is that evolves. Second, there are separate hedging concerns on the use of Term SOFR which is built on the derivative itself. Market participants noted that this could create hedging challenges and basis risk.

We sensed checked this several times the past few weeks in June was sent to the participants. One noted that the outcome of the FSOC meeting included a series of reactions. Client feedback for this institution suggested that clients/ sponsors had put a hold on discussions on CSRs including BSBY and AMERIBOR. They emphasized that the long-held view that most of the larger corporate and financial end-users ‘just want this over with” was confirmed after the FSOC feedback. The debate surrounding the future of ‘SOFR First’ and the role of other alternative rates is likely far from over with protagonists on both sides who want further dialogue both within the industry and with the official sector globally especially in the U.S. 2 2

Discounting credit component). So, to offer a Term Consequently, we ran a small set of SOFR, product lenders will likely need ‘third interviews’ the week of June 14th The issue for discounting and its ap- to determine a credit spread to the mar- and June 21st before issuing the paper plicability for banks trade finance bu- gin which increases the complexity of to ensure some balance in our feed- sinesses was flagged often throughout using Term SOFR.” back. The discussions at the June 11th the study and by foreign banking orga- FSOC Meeting crystallized the desire The long-term viability if there is a nizations who, in particular had large of U.S. Regulatory bodies, joined by trade-off between the emergence of global businesses impacted by the many in the UK, to support the ‘‘SOFR Term SOFR and the discussion around transition. First’’ initiative and, as a result, either CSRs was highlighted by one of our implicitly or explicitly (SEC Chairman One larger international G-SIB sug- participating regional banks after the Gary Gensler) call into question the gested that “we answered the consul- June FSOC meetings when they sug- validity of CSR’s. As one would have tative document last year and noted gested, “we think in the long term, expected, that produced a response that a term rate for discounting is im- assuming CSRs survive, that pricing from the markets, who at least in part, portant for trade finance products for becomes the differentiator rather than are quite supportive of these efforts to the primary and secondary markets term structure. Credit sensitivity can provide alternatives. for discounting and term is absolutely either exist in the benchmark or in the necessary. All the asset classes with credit margin where credit is priced Historically, both the U.S. and UK values gradient such as mortgages much higher in stress with CSR’s or less regulators have argued either in pri- and FRN’s that we are buying and high through the cycle with SOFR. As a vate and occasionally in the public issuing and in between loans securi- result, CSRs could wither on the vine arena that they would strongly prefer tization structures and major chunks before that pricing differential beco- to have a commitment to all things of activities in trade are crucial to get mes apparent. Currently, we do not see SOFR (and SONIA). In early May, John fair pricing and discounting. We would good credit pricing of SOFR but that Williams, President of the FBNY, noted need another solution if we did not get will eventually be a necessity, even if it that regulators would be comfortable term.” An insurance investment ma- takes until the next fiscal stress cycle. with a multi-rate environment, provi- nager commented that “discounting The systemic issues surrounding ding it was built on a solid SOFR foun- for derivatives went to a SOFR curve these various rates are still being dation. Andrew Bailey from the Bank of and nothing happened. Legacy paper vetted but it was top of mind for many England had separately warned that in produced no volume. Term Structure is of the participants. One of our regio- the UK firms regulated by the PRA who what people are waiting for. Term SOFR nal banks questioned, “what happens might be guilty of “lazy” behaviors in has always been in the cards in the US in the case of a crisis? Markets are so unnecessarily sustaining LIBOR linked and until that happens you will not see thin and there are smaller data sets contracts will be treated in the same volume.” that change the behavior. If there is, way as firms demonstrating any other What was broadly clear in all our dis- for example, a decent amount of BSBY risk management or governance fai- cussions is that Term SOFR however Commercial Paper that feeds into the lings. Similar ‘safety and soundness’ will not solve all ills and would often market there is not much margin for er- commentary had been echoed by be directed at the lenders market ror underpinning that product. Howe- others in the U.S. though slightly less who also want CSRs considered. An ver, for the SOFR futures market, that explicitly. At the June 11th meeting of investment entity commented that is the basis for the derivatives market FSOC there was commentary reflecting “Term SOFR hypothetically is linked to and that is a much bigger base and, the likely supplementation of an official- lender banks and those big banks sell conceptually, around to stay.” Ano- ly recognized Term SOFR to assist with futures on a re-set date. Which makes ther regional player commented that the anticipated boon of liquidity and, them vulnerable. The regulators are not “CSR’s will evolve and co-exist with for good measure, a speech directed at enthused about that since they do not various forms of SOFR, but it feels like the shortcomings of BSBY in the eyes of know what will happen when things get the inertia is towards SOFR without a SEC Chairman Gary Gensler. Both the bumpy, or the markets are jumping all doubt for legacy portfolios.” Bank of England and FCA have issued over the place which is what we care statements encouraging liquidity pro- about. This index cannot be approved Recent Regulatory viders and other market participants until robustness is determined or the Commentary on CSR’s to switch from USD LIBOR to SOFR in Fed owns Term SOFR like the way and Term SOFR the USD interest rate markets by late they are managing SOFR in arrears July. Those views were corroborated and the Fed could produce the rate One of the challenges in drafting and by the CFTC’s EMRAC subcommittee themselves.” One of our regional bank completing this paper has been the recommending interdealers brokers participants clarified that “Term SOFR steady drumbeat of updated news change their USD linear swaps trading solves one but not both problems with from the official sector and the corres- conventions by July 26th. And the SOFR (overnight vs term and lack of ponding feedback from the industry. FCA noted that engagement with UK 2 2

market participants in the USD market that “ARRC’s involvement in Term SOFR to the market. We felt that the ARRC found strong support for that change makes it more challenging to front run and Fed occasionally had their own si- in the interdealer trading conventions, an official recommendation. If you pick los themselves and were disjointed. It a conclusion we felt that was shared by up on the CME Term SOFR recom- will be utilized—the market just wants our European participants. mended, and you started issuing in a revised LIBOR, and the Fed cannot Term SOFR you could be in trouble. You allow us to fail.” At a recent Bloomberg The strength of this conviction of the are doing it without a recommendation program on June 29th numerous firms official sector carried into July when vs. a blank sheet of paper which is a were unanimous decrying the “11th the FCA weighed in on the lack of state of play.” A global G-SIB in the last hour discussions when we should be appropriate fit for this product. Edwin week shared that “effectively the CFTC transitioning away from LIBOR.” Others Schooling Latter commented at a July announcement will drive liquidity and reiterated the views cast in our study 5th conference that, “we don’t want to be assisted by the recommendation that we will be in a multi-rate environ- see transition to new so-called ‘credit that the CME is the Term SOFR provi- ment which will have components of sensitive’ rates such as Bloomberg’s der. By year end or early next year, as credit sensitive rates existing along- Short Term Bank Yield index – known we move away from LIBOR except for side SOFR.” A poll at that event found as BSBY – that some have suggested risk reducing trades, we would antici- that roughly a third of the respondents as a possible successor to Libor in pate seeing that momentum.” thought SOFR compounded in arrears some contracts.” He continued in his would be used in derivatives and lower presentation, these CSR’s share many A G-SIB noted that “overall the aims in cash products; Term SOFR would of the same flaws as Libor. That’s be- of the U.S. regulatory bodies and the be used for cash products and only cause they are derived largely from FCA with enforcing market guidance a slightly smaller percentage thought transactions in Commercial Paper (CP) are not very different. The FCA and the SOFR compounded in arrears would and Certificate of Deposit markets. Yet PRA have actively imbedded into the very rarely be used. Market leaders liquidity in those markets has not pro- process and the Fed is singing on the from the UK noted as they did in our ved robust to stress, as we saw vividly same hymn sheet. The initial reluctance study that the transition should have in March last year, when liquidity in CP of the Fed to endorse a forward rate been market lead for a customized so- markets dried up, and yields spiked.” was frustrating to some as one of the lutions but the lack of liquidity on SOFR Of greatest importance is that the UK G-SIB’s commented, “everyone belie- has created a vacuum. clearly intends to monitor the use of ves we need a forward rate and appa- future utilization of CSR’s as Schoo- rently there will be one according to the Numerous institutions conveyed si- ling noted “We ask that any regulated ARRC. The CME Strip is IOSCO com- milar convictions across the Global UK market participants looking to use pliant and gives you a forward point out banks: please step up the superviso- these so-called ‘credit sensitive’ rates to a year. This would be a viable option ry prescriptive measures and try to in UK-based business consider the risks carefully, and raise with their FCA supervisors before doing so “We ask that any regulated UK market participants looking to use these so-called ‘credit sensitive’ rates in UK-based business consider the risks carefully, and raise with their FCA supervisors before doing so.” To date this is a meaningful departure from the US regulatory stance on CSR’s who have yet to provide any formal comment on the approval for any of these offerings let alone an indication of how bank exa- miners would treat an institution who has a meaningful percentage of any alternative rate in their transition outside of SOFR.

It is worth noting that the industry is in near total agreement on the cessation dates—the movement away from LIBOR—but less agreement on moving to what replacement rate in the USD market. One regional bank commented 2 2

get the most influential actors in the volume when the UK initiative took noted that the five-day average daily transition and move it as quickly as effect, meaning the U.S. has a bigger volume for the SONIA futures contract possible without market disruption. mountain to climb and only a short is now above 175,000 lots, also a re- “Other banks noted that while they window for participants to kick their cord, equivalent to a notional value of anticipated a multi-rate U.S. rate envi- LIBOR habit. Several bankers noted £175 million. ronment to replace LIBOR they were that the success of the ‘SONIA first’ The ISDA Monthly charts provided concerned about the “preparation initiative was at least due partly to the some useful comparisons in work they operationally to distribute those. What Sterling market’s ability to build activity do with Clarus and their IFR Adaptor challenges are you encountering from in the risk-free rate while maintaining Figures out in June: treasury to the trading desks? We will liquidity in the legacy LIBOR rate. Ins- not want to endorse optimally until the titutions and regulators did express a The percentage of trading activity in markets have chosen. Traders at some few concerns about the process. One SOFR was 6.9% of total USD IRD DV01 of the banks shared the view that the larger global G-SIB commented that transacted in May, down from 7.5% the regulators’ comments in the past have “we do not have live transactions to prior month. only served to inject more confusion test ourselves at a scale working on and uncertainty into the market while operational readiness for systems for • GBP saw the largest percentage of the business needs to be off LIBOR.” loans and derivatives lack of volume RFR-linked IRD trading activity, totaling executed on Sterling LIBOR in the UK. 54.9% of total GBP IRD DV01. We are further ahead with SONIA de- SONIA Background rivatives and certainly term SONIA is • EUR had the highest percentage of In October 2020, ‘SONIA first’ saw further ahead as a way that could move RFR-linked IRD DV01 executed as tran- quoting conventions for Sterling linear forward.” They continued, that “there sactions with tenors longer than two swaps switch from LIBOR to the Ster- are not that many items for us to ma- years. ling overnight index average. Three nage with the transition moving date. For the week ended June 25, 2021, months after operationalizing, the mon- Our challenge is that we have not seen SOFR had traded 11,417 times, including thly share of Sterling swaps notional re- new SOFR transactions on the lending 3,923 basis swaps, for a total notional ferencing the SONIA RFR jumped from side, but we have already done our in- amount of $1.7 trillion year-to-date. 33% to 44%. Within five months, SONIA ternal work.” Comparatively, SONIA had traded had become the dominant benchmark 33,868 times, including 701 basis for trades expiring after 2021 - when Comparative SONIA and swaps, for a total notional amount of Sterling LIBOR will cease alongside Other RFR Market Usage $7.1 trillion over the same time. SARON, three other currency settings. On Thursday, June 17th, the ICE Fu- TONA, and €STR traded 224 times, 457 The SONIA First initiative saw the in- tures Europe, the largest UK interest times, and 695 times, for total notional terdealer swap conventions flip from rates market, had a record day for tra- values of $17.3 billion, $143.7 billion, LIBOR to the Sterling overnight index ding contracts based on the new UK and $131.4 billion over the same time, average, or SONIA, last October. This alternative to LIBOR as firms switched respectively. China’s Depository-insti- cemented the RFR as the dominant to SONIA for pricing their derivatives at tutions repo rate has seen a daily tra- Sterling swaps benchmark within just the request of the British regulator and ding base exceeding 1.8 trillion-yuan, three months. However, SONIA repre- central bank. That single day volume accounting for 48% of the interbank sented around 30% of Sterling swap topped 473,000 lots. The ICE release repo market in the country. 2 2

Term Sonia sions in our interviews that occurred during the release of those alternative Consistent with commentary from our RFR’s to SOFR. global banks the focus/enthusiasm on Term SONIA was substantially more For the past two years our studies have muted than Term SOFR. The UK pro- included a vigorous debate relating visioning on conduct risk and related to the efficacy of SOFR (simple, com- matters will ensure a scrutiny that will pounded in arrears or Term) in meeting at least short-moderate term temper the specific concerns of several parti- substantive use of the product were cipants related to properly reflecting there demand. There was as we sug- the costs of unsecured borrowing, that gested at the outset a general level of reflects their funding costs, especially comfort very early on in the UK mar- in volatile markets. The strongest pro- ket with the use of SONIA as currently ponents for a CSR have been institu- structured which has both minimized tions with large commercial and retail the interest in a Term Structure or other lending portfolios and included both alternatives. G-SIB’s (U.S. and global) and many Firms also voiced that in the local UK U.S. regional banks. This debate was markets there was not much of an ap- less contentious when we began these petite to add additional system/opera- efforts in 2019 and gained traction in tional investments. The feedback that 2020 with the ARRC and Federal Re- was prompted did not suggest nume- serve level discussions within their rous alternative threads to share. CSG Working Group. The impasse coming from those exchanges left those in the industry who were CSR advo- Credit Sensitive Rates: cates without a reference rate with an Possible Alternatives appropriate level of endorsement from to SOFR the ARRC or the Federal Reserve and In deference to the discussions occur- focused their attention on working with ring in the industry we wanted to de- providers in the market to produce a vote a meaningful portion of our final suitable RFR that would provide those summary and document to the alterna- protections and would meet market tive reference rates. Two of those recei- guidelines. ving a greater level of focus that were Participants noted that the reason ‘first to market’ were AMERIBOR and CSR’s have been explored is that Bloomberg’s BSBY. Hence the greatest SOFR, as constructed, currently lacks level of feedback we have received an appropriate reflection/response to revolved around those two offerings. volatile markets especially for under- Two additional rates to the market were lying credit exposure to their counter- IHS Markit’s CRITR and CRITS and AXI, parts. In their view, as a result, SOFR which is the Across the Curve Credit does not properly reflect the costs Spread Index. There was limited feed- of unsecured borrowing which ap- back on the last two unfortunately, but proximates their funding costs. This we have still attempted to cover them in concern has been voiced by institu- our final paper. We emphasize that this tions, but primarily those with larger paper takes no view on any of these commercial lending portfolios as we alternatives nor whether they should have noted above. supplement the currently preferred rates articulated by the ARRC which we Given this baseline, we explored discuss as the core of the LIBOR Tran- which groups of institutions were most sition response. We should also note concerned about the potential for mar- that there was considerable material ket volatility combined with investor shared related to BSBY and, more li- demand that will result in a lower yield mitedly also, AMERIBOR, so there is and a compression for the institutions a disproportional amount of feedback cost of funding. Not surprisingly, U.S. on those alternative rates and hence, regional banks and global lenders felt only reflect the balance of the discus- the strongest. One institution noted 2 2

that their memories of the issues sur- side.” Some noted that eventually the rounding the Covid Pandemic and len- “first question asked is how do you get ding ring true. “We believe that there out of this transaction and where is my is a risk given our experiences with the hedge, how do I hold on to it, sell with Pandemic. If there is a line of credit that liquidity and currently with SOFR—that is open, we saw negative convexity; does not exist.” Alternatively, they com- clients will draw and our exposure for mented that “even if tomorrow I had to incremental originations under stress use BSBY I could do it with Eurodollar become meaningful exposures and futures and get close. If the market has we could not hedge against it. This has numerous BSBY notes hit the market been clear from the beginning as we in the next few months even with some considered our LIBOR options and our Term SOFR the Fed will have to listen.” ability to manage our funding vs. len- One bank noted as a purchaser that ding spreads and the gaps we will need they would not want to buy a SOFR lin- to fill and why we want a CSR.” One of ked note given inefficient pricing and it the banks expanded on this thinking is not reflected in the market nor where by noting that “regional banks do not the Fed is setting the floor or a ceiling. borrow in the repo market and during I would prefer the market to set those a crisis like COVID their cost of funds rates and keep the government out. goes to zero and they have meaningful One of our third parties was succinct: risk. Larger banks have it much easier. “SOFR does not currently represent the Regional banks need to focus on their borrowing costs and the funding costs function and remember what happens for the banks.” with excess liquidity and the marginal Another G-SIB was equally blunt, “you cost of funds. They need to reconcile are seeing developers of CSR’s see supply and demand and how that trans- the delay in the development and ap- lates into product pricing.” proval of Term SOFR and gain momen- There was a meaningful set of insti- tum building for CSR’s to ‘solve both tutions who highlighted the need to problems.’ This is not due to demand include CSR’s as part of their multi-fa- from clients, just the opening allowed.” ceted approach to managing counter- Another bank said, “without Term party credit risk, especially in volatile SOFR CSR’s will grow rapidly and we markets. One of the larger G-SIB’s who will have to support it. We need Term.” did not necessarily favor this approach The challenge banks explained is that commented, “in the commercial len- “the absence of a SOFR forward rate ding space, we know regional banks ensured that institutions would turn are not satisfied with SOFR. Many of elsewhere. BSBY ticks that box. From their concerns focus on times of finan- an Asset Liability Management pers- cial crisis and the impact of borrowers pective, it has a feel like LIBOR and keeps the current ALM paradigm with drawing down and the conundrum on a credit sensitive index.” funding in a time of crisis. We are not surprised that a regional bank would A larger regional bank had a different not be all-in on SOFR since credit sensi- take when they noted that it was unclear tivity allows them to offset that risk and what factors institutions were given to the SOFR world will not allow them to assess CSR’s relative desirability, noting do that. It is a divergence our business that the markets have the plan and ca- models.” Some foreign banks spoke in pital to carry out that model and get to detail about the implications of a SOFR the ‘right outcome’ and where to push in arrears going awry. The implications or not to push. Regulators, they noted, they note were that “the adjustment originally ignored CSR’s which created credit cost for the borrowers will go a problem. “What are the factors that up and some will pass that on; some institutions are using to assess CSRs’ complain in public and do a review and relative desirability? I do not see the pricing will change. You will eventually need or value for regulators to get in get pushback from the clients using the middle; we have plan and capital to SOFR or from the index borrower carry this through; we will get to the right 2 2

outcome; they need to push or needed overnight unsecured loan market. It is ex- banks. Smaller institutions who have to push is a better place from the market pressed in an actual/360 interest calcu- correspondent banking relationships perspective. They ignored CSR and that lated method and rounded to the fifth de- are funding off AFX their cost of funds is a problem which was a missed oppor- cimal place—calculated and published at in AMERIBOR and align with its index tunity for proper estimates for SOFR and the end of the day. It is verified by a third and then they can match up cost of now they don’t need to tell us what to party—IOSCO compliant—published in funds across instruments.” One of the do.” Others noted that CSR’s could be real-time via an API. Market participants largest G-SIB’s noted that as a result, a bridge who’s gap with SOFR is filled noted that key to this is that the transac- “AMERIBOR will be there since tra- by having the term component which tion volume is weighted, meaning that if ding desks will try to trade it next year is something everyone can agree on.” the transactions have a high rate, then whether its big enough to get involved, Our data would not suggest that “eve- the rate and the volumes will skew that we fully expect it to hang around.” ryone” would agree on that—although way. AMERIBOR was launched in 2015, many would. based on overnight lending conducted IHS Markit by 170 regional banks over AFX with an We do believe that some segment of exchange trades on average of $2 billion Post our interviews being completed, the corporate client base would like per day. the IHS Markit Index (CRITR & CRITS) to have a forward-looking term rate was introduced into the industry. These where they could project their inte- two rates were introduced in June of this rest expenses which can reflect some Interest and Demand year and are inclusive term rate and cre- of the pricing demand for CSR’s right for AMERIBOR dit inclusive term spread. CRITR is an all- now. One larger bank commented that We inquired about the interest in the “pricing for BSBY is easier for lending in rate and CRITS is the add on spread. use of AMERIBOR and received a rea- and more like LIBOR credit spreads and The plan is that they will be available in sonably consistent response. There is easier for loans. The correlation is not the overnight, one, three, six and twelve a steady expression of interest, some perfect but close. The client feedback month markets. How CRITR differen- of it quite public in AMERIBOR and is that they are happy.” An insurance tiates itself is that Markit views this both Zions and Signature Bank have company commented that “clients as leveraging only transactions using been among those public about that want a rate that is a competitive mar- the Certificates of Deposits and Bond interest. One of the regional banks ket rate—forecasts cash flows—no Transactions. The DTTC and FINRA use in our study noted that “lots of those operational expenses and they also their data set for commercial paper as community banks currently fund in want to trust someone. We would like well—pools of data, no quotes, or sub- AMERIBOR and they are familiar with to see momentum in that direction. We missions. They do not limit to the LIBOR it and are not terribly engaged in the know that this is “not a quality of market panel banks. The data is utilization of discussions around the transition. opinion.” Several large banks make the bonds used in financial markets---so One of the larger regionals noted that market; they make the loans; we would G-SIB’s, foreign branches, and regional “smaller banks with more of a voice in buy them. However, we cannot have banks in the US. this space who are below $100 or $50 six infrastructures to accommodate all billion are looking for easier solutions.” Second, as several of our participants these rates. Right now, we still see too Another noted that, “community banks noted who discussed CRITR with us little action and too much speculation know from ‘down the street’ are using as part of our very brief third round of and agreement. Operational costs are AMERIBOR and there is trust here that discussions, this index can be used as significant. CSR costs are meaningful.” this is easier that they can scale, and an add-on to SOFR or as a standalone it won’t be jammed down your throat.” rate. Markit believes that it could be AMERIBOR Another regional agreed that “their used by firms who are potentially strug- funding comes from the AFX exchange, gling with lending products and can be For background, AMERIBOR (American so they are more comfortable.” They used with any type of product. Markit Interbank Offered Rate) is described as also as one commented “do not hedge see’s that adoption is driven through a ‘transparent benchmark interest rate meaningfully. There are deposit takers those benchmarks but there is a need based on the overnight unsecured and excess liquidity and depending on for an ecosystem where cash products loans transacted on the American position and they are not ready for size, and easy for those banks to access this. Financial Exchange (AFX) which is a and they do not manage a rate position self-regulated electronic exchange. and these guys do not need all that.” An CBOE Global Markets hosts the AFX Across the Curve Credit important distinction was raised by one exchange in its services.’ Spread Index (AXI) participant who articulated that “AME- As market participants are aware, AME- RIBOR is different qualitatively than Like the IHS Markit reference rate dis- RIBOR is calculated as the transaction other CSR’s in that the transactions are cussed above, this paper did not have volume weighted average interest rate of from the AFX exchanges. BSBY is from any appreciable time for our paper the daily transactions in the AMERIBOR the G-SIB’s and ICE is off BYI and Panel to garner client feedback at all about 2 2

AXI. So, we are sharing what was out SOFR Academy notes that the AXI marginal wholesale funding. This index in the public domain including material offering is an approach to credit sen- measures what investors are willing to shared by SOFR Academy. sitivity that factors in the volume of pay based on senior unsecured bank This index was described recently as longer-term bank funding transactions notes at various tenors (Overnight, “a rate that can be used as an add-on which occur further out the yield curve. one, three, six and twelve months). to SOFR”. Unlike LIBOR it is based on We believe that it results in a spread The notes considered in the tracking bank funding transactions across a that is less volatile than LIBOR and is include Commercial Paper, Certificate range of maturities, out to five years. representative of the actual bank fun- of Deposits, and trades of senior unse- On Tuesday, June 22nd the provider ding costs. This representativeness cured corporate bonds of G-SIB banks submitted a paper to the ARRC setting and robustness would be maintained and some additional systemically im- out how AXI would supplement a SOFR over time, automatically adapting to portant banks excluding state owned rate. The provider also is currently in any potential changes in bank debt banks. It is constructed using a 3 day discussions with regulated benchmark maturity profiles.” rolling window of data on those tenors administrators regarding publication of which need to hit a minimum volume the rate. Bloomberg Short Term threshold. If that volume threshold is Bank Yield Index (BSBY) not met, then the process falls to a lon- AXI represents the weighted average ger rolling window. At the date of our cost of wholesale unsecured bank debt For consistent definitional purposes, writing there were several issuances— funding in various maturities. Since we BSBY is a proprietary index calculated most recently a one year basis swap for completed our interviews there have daily and published at 8am EST (on $250 Million with one side tied to BSBY been extended discussions on this a business day). BSBY incorporates and the other SOFR by a joint deal lead approach with global regulators and bank credit spread and defines a by Bank of America and JP Morgan. A policymakers to expand the familiarity forward-term structure. Measures the month prior Bank of America issued with the rate and its potential benefits average yields at which large global a $1 billion six-month FRN using the for the market. banks access USD senior unsecured 1-month BSBY. 2 2

Client Feedback noted that “we want to see an entire methodology is robust since everyone in the Project on BSBY raft of BSBY deals and we do hope they has a Bloomberg Terminal and feeds increase.” into the systems and its portability is Initially, a number of firms who were easier and its components are better There was a segment of the market generally on the fence on its utiliza- reflections of funding costs vs. SOFR. that believed that the relative simila- tion were concerned that BSBY would Most organizations do not believe in rity of BSBY to LIBOR would give them fail to garner enough momentum SOFR for funding costs and regional some market acceptance. A group of to have a meaningful impact on the banks have not bid for SOFR.” transition. One G-SIB noted that “when firms noted that familiarity and simpli- you look at BSBY historically compared city in the transition was critical. And for This analytic and operational support to five years ago, we are concerned a group of those firms a core conviction for BSBY has yet to turn into demand for that the sponsors could be on a ‘bit is that relative operational ease (which the product. Among the challenges for of an island.’ We think you could see we discussed in that section) as well the proponents is clearly being able to a situation where the credit spreads as an ability to calculate, risk manage- leverage the relative ease and comfort are attractive for money markets, but ment, contract transfer, etc., would be in its use. The profligate utilization of not realistic to see that this year. It will primary in their consideration of use of Bloomberg throughout institutions need time to transition and see where alternative RFR’s. and the common interests of big parts of lending institutions throughout the it stands in 2022.” One of the larger end-users noted that U.S. makes this tenable going forward. An international G-SIB noted that “six “BSBY looks like LIBOR and re-sets How that turns out will take months to months ago the only credible solution every two days, and we would have a sort out if not longer. for USD Transition is SOFR. We are process now to drop that into our ap- concerned that they will not be able proach.” A regional bank who supports There was solid, though somewhat to take on options for example, and this effort noted that “this index has the mixed, feedback on the actual de- we are not seeing the interest in the potential to succeed because it is very mand for the product. One internatio- market one of them taking off. There similar and well correlated to LIBOR for nal global G-SIB noted that “we have might be some pocket traction but hard time series. BSBY does not spike as had a good discussion on the issue, but to see one of them taking the whole de- much in volatility and one of its positive we are not seeing demand and having rivatives market, securities and lending intangibles is that it does not look like a the growing pains for an unknown rate, market.” A smaller international bank, LIBOR replacement.” Another regional especially for one that did not exist reflecting their current lack of focus, bank emphasized that “BSBY or BYI are before. For our purposes we have not said “BSBY’s availability is quite new close enough to LIBOR to just slot it in. seen a desire for any CSR rating. Pos- is something what we are hearing from It is much easier for market participants sibly that will arise form a funding pers- others, and we will potentially consi- on their own without quasi-official sec- pective which is where we know the der it.” A larger investment manager tor guidance and standards.” The BSBY noise is coming from.” A regional bank noted that trying to create that demand could be challenging since “we are not sure that the industry knows how the pricing on this works correctly. If they did, we think they would like to be short the CSR or buy the protection. If it is a SOFR loan and it has a premium price, the client likely has no basis for a strong opinion since they might be missing the pricing piece.” An insurance investor commented that right now “we do not see an actual interest in trading a CSR right now, but we suspect there will be more interest. People are clamoring for whatever will get the most comfortable equality of process.”

There were some practical concerns addressed by others. One of the larger trading G-SIB’s noted that “the reason there is no demand is that they are not offering it in term sheets; they are not getting demand because banks are not 3 3

really offering it. And it is hard because the regulators do not want this flexibility. Second tier regional banks just don’t want to get smoked and they need someone to lead.” As a result, this bank continued, “we see no demand at all right now. We know it will come from the money fund complex but that’s it so far.”

At this point, participants did not iden- tify any demand from the corporate sector with a range of opinions. One of the larger international G-SIB’s noted that “we have not seen corporate demand for BSBY. Commercial conversations between the lender and borrower have not yet occurred. AMERIBOR is not seen as an introduction into the multi-rate environment. We just are not seeing demand yet.” One of the regional banks who strongly supports CSR’s and BSBY commented that “we have received very little feedback on BSBY or any other CSR from our commercial clients but there is a bit of ‘anecdotal support’ just emerging.” Another global bank was blunt, saying ‘there are no corporate treasurers buying it; it has not been a competing product yet.” That sentiment was echoed by a large G-SIB who said, “we have not seen customers who want to use it.”

However, as we noted above, Credit Investors in part at minimum like the credit sensitivity element. One of the skeptical G-SIB’s commented that “we do see a buyer base in the money fund community, the yield world. If you can get someone to offer more than one option, then it would happen here. You need something deep and liquid who supports them said “we are doing behaves in an economic cycle and in over time and then it could succeed.” A operational readiness to support other a recession and see the tick up in free larger institutional investor concluded rates.” Another bank commented that rates. We need to see the forward mar- that “there will be demand form mutual “we are moving forward with SOFR but ket as well; need the IRS and FASB to funds who buy bonds that are exposed if one of these CSR’s is more prevalent transition and bless it from a hedge ac- to the direction they want to be ex- than we would use it. But we see that counting perspective.” A foreign G-SIB posed and for them, it will make sense. several years down the road. A forei- summarized some of the hurdles when This is a highly regulated group and all gn bank said to date “we have not put they concluded, “with respect to all the of them are regulated by the SEC. The much thought into it. We are doing CSR’s we are looking at what it would other buyer would be banks who want further analysis and see what the tur- mean for the investment and moneta- the credit convexity.” naround is.” A regional bank who has rily the workload. If we need to build Finally, as we have commented a supported this effort for a conside- it out if there is demand from smaller group of our participants felt that the rable period commented that “we do CSR space is still too ‘new’ and ‘niche’ not have parameters which we are tes- banks than we would do that. It will re- and needs exposure and growth be- ting. We are going to vet wholistically; quire work across operations and tech- fore it takes hold. One regional bank going to need to see how this product nology that we have yet to consider.” 3 3 Project Summary.

We believe that our study provided an interesting vehicle for discussions for the various reference rate options as well as the strength of views on multiple sides of the individual questions. We doubt based upon the data that these topics sort out incredibly quickly though some larger market makers would like to see that happen. The conflicts which used to play out for the most part in bilateral dialogues or group ARRC discussions or webinars/seminars are now finding their way into the public square and hence has increased some of the volume and the inevitable divisiveness. These exchanges in the U.S. are also occurring somewhat late in the game compared to other geographies. Ample consideration of supplemental approaches to the official sector approved rate (SOFR) is just now being vetted though well known to the industry. The alternative reference rate dialogues, which include a handful of different providers, have been ongoing for a year or more and received the attention of the CSG, but no resolutions have been reached. Several of those options have just come onto the market in the past month+ and at least one other has yet to appear. Some institutions wanting to put a stake in the ground (especially for AMERIBOR) got out in front of other discussions in 2020. Most of the industry shares the desire for a hastened resolution and voiced those thoughts throughout our dialogues. Others, while sharing that conviction, want to give the market a chance to consider the options without the imposition of official sector jawboning or less likely, guidelines.

A broad set of U.S. institutions have a global concern that they are implementing massive changes on multiple continents and have tens of thousands of clients to educate, remediate and make meaningful progress towards transition completion. Others, while quite large, are significantly more domestically focused and have heavily biased business in commercial and retail lending. These players are not market makers in derivatives and have very different concerns.

There are also then at least one or two other segments of the U.S. Banking Commu- nity who frankly would wish this would go away. They have far smaller exposures in LIBOR as opposed to other reference rates and find this effort a nuisance at best. The U.S. also has this enormously diverse and complex end-user community ranging from the world’s largest multi-trillion-dollar investment managers with very complex portfolios to global treasuries with numerous business lines to fund all the way down to niche service line companies that need the very simplest solutions to allow them to complete this transition.

If there is one thing we have learned through our hundreds of conversations since 2019 it is the following. There will be more issues to unfold, more debates to be held, extended interactions to resolve and a transition that will have several inter- mittent conclusions extending well past the end of this calendar year. 3 3

Bradley P. Ziff John Gustav Operating Partner Partner Sia Partners [email protected] [email protected] 347-331-265` • Abu Dhabi • Edinburgh • Panama* • Amsterdam • Frankfurt • Paris • Baltimore • Hamburg • Riyadh • Brussels • Hong Kong • Rome • Casablanca • Houston • San • Charlotte • London Francisco • Chicago • Luxembourg • Seattle • Denver • Lyon • Singapore • Doha • Milan • Tokyo • Dubai • Montreal • Toronto • Dublin • New York

* Sia Partners Panama, a Sia Partners member firm

About Sia Partners.

Sia Partners is a next generation management consulting firm and pioneer of Consulting 4.0. We offer a unique blend of AI and design capabilities, augmen- ting traditional consulting to deliver superior value to our clients. Counting 1,800 consultants in 18 countries, we expect to achieve USD 300 million in turnover for the current fiscal year. With a global footprint and expertise in more than 30 sectors and services, we optimize client projects worldwide. Through our Consulting for Good approach, we strive for next-level impact by developing innovative CSR solutions for our clients, making sustainability a lever for pro- fitable transformation.