LIBOR Transition: Navigating the World of Synthetic LIBOR

Once a cornerstone of the financial industry, the financial world recently bid farewell to the London Interbank Offered Rate (commonly referred to as “LIBOR”). As of June 30, 2023, overnight and 12-month LIBOR officially ceased to exist. Significant efforts have been made globally to transition all LIBOR-based financial contracts, but there is still a long way to go. While LIBOR as we know it may be dead, the concept of “synthetic LIBOR” is living on as an interim solution for contracts that have yet to make a switch.

The Challenge of Transition

The expectation from regulatory bodies was that institutions needed to have replacement alternative rates negotiated and in place for all LIBOR-referencing contracts before June 30, 2023. This included investments, derivatives, and loans. But the reality is that many institutions have not been able to meet this deadline, with the Financial Times recently reporting that over USD700 billion of loans remain tied to LIBOR. Several foreseen and unforeseen factors have contributed to the slower-than-expected transition. Current economic conditions and rising interest rates have played a role in creating an environment where borrowers are now hesitant to refinance further stalling the process.

The Role of the US LIBOR Act

The US LIBOR Act, signed into law in March 2022, plays a crucial role in this transition landscape. Financial contracts governed by US law that lack viable fallback provisions to USD LIBOR fall under the purview of the LIBOR Act. This legislation empowers the Federal Reserve Board to select a replacement rate for contracts meeting specific criteria, including those with inadequate fallback provisions or none at all. The chosen replacement rate is typically CME Term SOFR plus the relevant ISDA fixed credit spread adjustment.

Synthetic LIBOR to the Rescue

With overnight and 12-month LIBOR gone, “synthetic LIBOR” has emerged as a stopgap solution to address the challenges presented by contracts tied to the outdated benchmark rate. In this context, synthetic LIBOR refers to the use of the Term SOFR rate published by ICE for USD LIBOR contracts until September 30, 2024. This measure aims to provide more time for institutions with finance contracts not governed by US law to actively transition away from LIBOR while maintaining some semblance of continuity in the interim.

Navigating the Future

With LIBOR officially in the rearview mirror, the focus now turns to the utilization of synthetic LIBOR and the LIBOR Act. Legacy contracts that fall outside the scope of the LIBOR Act, due to the presence of fallback provisions, can continue to rely on synthetic LIBOR until September 30, 2024, provided that their fallback language allows for such usage. For contracts that automatically shift to a replacement rate upon LIBOR’s discontinuation, synthetic LIBOR may not be used and another benchmark must be chosen instead. No newly originated loans governed by US law and the LIBOR Act may utilize the synthetic LIBOR rate.

While the road ahead might be challenging, the financial industry has shown resilience and adaptability throughout this transition. As we navigate the nuances of synthetic LIBOR and the LIBOR Act, the ultimate goal remains unchanged: to establish a new foundation for benchmark rates that is robust, reliable, and reflective of the modern financial landscape.