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Market conventions for the use of alternative risk-free reference rates have not been synchronised across asset classes.
As you transition both the loan exposure and the derivatives hedge from USD LIBOR to SOFR, you should carefully consider the contractual features across both asset classes and the actual execution of the transition.
As we had noted in our previous communications, given limitations on its usage in the derivatives market, you may find that the execution costs of Term SOFR hedging differ from those of hedging a compounded SOFR exposure.
If your loan contract is amended to reference SOFR instead of USD LIBOR, and that is the only amendment in the contract, you will find that a ‘credit adjustment spread’ or CAS is likely to be added to the margin. That is done to limit net present value transfer, given that SOFR is typically a lower rate than LIBOR which encompasses bank funding costs. Commonly used methods to determine the CAS are to use the CAS that ISDA uses in its IBOR fallback protocol (‘ISDA CAS’), or to base it on the forward pricing of the difference between LIBOR and SOFR: the so-called ‘basis’.
Synthetic JPY LIBOR will cease after 31 December 2022. Synthetic Sterling 1 and 6 months LIBOR will continue until 31 March 2023. Synthetic Sterling 3 months LIBOR may continue beyond that date but that is yet to be confirmed. All remaining panel-based USD LIBOR tenors will cease after 30 June 2023.
LIBOR’s supervisor, the Financial Conduct Authority (FCA), has stated that
‘for US dollar LIBOR, in due course we will need to assess whether the remaining settings can be wound down in an orderly fashion when the panel ends on 30 June 2023, and if not, whether a synthetic US dollar LIBOR rate might be appropriate for certain contracts’.
In the US, Federal legislation (the Adjustable Interest Rate (LIBOR) Act) passed earlier this year provides a replacement rate for certain US law-governed financial contracts (including derivatives) that mature after the cessation of LIBOR in June 2023 and do not have appropriate fallbacks or otherwise an agreement to transition to an alternative benchmark. As a result, contracts governed by US law are likely to be either within the scope of that legislation, which provides a clear mechanism to transition to alternative rates at end-June 2023, or are beyond its scope because they contain robust fallbacks that provide for LIBOR’s cessation as a representative rate.
Therefore if a temporary synthetic USD LIBOR, which would not be a representative rate, becomes available, it could provide an orderly transition for contracts and transactions falling outside of the scope of the Adjustable Interest Rate (LIBOR) Act which do not contain robust fallbacks or have not otherwise been transitioned.
We emphasise that supervisory bodies have made it clear that the possible publication of synthetic USD LIBOR is not a reason to delay the transition of contracts from USD LIBOR to SOFR.
As nothing in this document should be taken to be advice, we encourage you to seek independent advice on these matters and you should reach your own conclusions and decisions, in consultation with your own advisors. The information in this document might change and we do not undertake to update it.
This information is published solely for information purposes. It is not to be construed as a solicitation, an offer or recommendation by the Commonwealth Bank of Australia (CommBank). As this information has been prepared without considering your objectives, financial situation or needs, you should before acting on the information, consider its appropriateness to your circumstances. It must not be relied upon as investment research. CommBank believes that the information is correct and any opinions, conclusions or recommendations are reasonably held or made, based on the information available at the time of its compilation, but no representation or warranty, either expressed or implied, is made or provided as to accuracy, reliability or completeness of any statement made. Commonwealth Bank of Australia ABN 48 123 123 124. AFSL and Australian Credit Licence 234945.