Shearman And Sterling

Derivatives, Stock Data

Feb 17, 2020

CFTC Staff Issues Three Letters Providing LIBOR Transition Relief to Market Participants

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Introduction

The Commodity Futures Trading Commission (CFTC) has issued three no-action letters providing relief for swap transactions (and amendments to swap transactions) in connection with the expected market transition from using the London Interbank Offered Rate (LIBOR) and other interbank offered rates (collectively with LIBOR, IBORs). Letter 19-26 from the CFTC Division of Swap Dealers and Intermediary Oversight (DSIO) provides relief to swap dealers (SDs) from certain requirements under the de minimis registration exemption, uncleared swap margin rules, business conduct requirements, confirmation and documentation and reconciliation requirements. Letter 19-27 from the Division of Market Oversight (DMO) provides time-limited relief from the trade execution requirement. Letter 19-28 from the Division of Clearing and Risk (DCR) provides time-limited relief from the swap clearing requirement.

Division of Swap Dealers and Intermediary Oversight Letter 19-26—No-Action Positions to Facilitate an Orderly Transition of Swaps from Inter-Bank Offered Rates to Alternative Benchmarks[1]

Background

This letter was drafted in response to a request from the Alternative Reference Rates Committee (ARRC) requesting no-action relief for non-compliance with certain CFTC regulations in connection with amending uncleared swaps referencing (i) IBORs,[2] (ii) any other interest rate that the parties to a swap reasonably expect to be discontinued or reasonably determine has lost its relevance as a reliable benchmark due to a significant impairment, or (iii) any other reference rate that succeeds any of the rates described in (i) or (ii) (collectively, Impaired Reference Rates or IRRs).

To address the possibility of IRRs, market participants are expected to amend existing IRR-linked uncleared swaps to include new fallbacks to alternative reference rates (including so-called risk-free rates, or RFRs) that will be triggered when an IRR is discontinued or determined to be non-representative (Fallback Amendments). Some market participants may also choose to voluntarily make such conversion prior to a permanent cessation of the applicable IRR or determination that it is non-representative (Replacement Rate Amendments). Market participants have been concerned that such amendments, without relief, could cause a loss of legacy status resulting in a swap becoming subject to regulatory requirements to which it was previously not subject. As a result, the ARRC requested, the DSIO was willing to provide relief to facilitate an orderly market-wide transition without causing amended swaps to become subject to additional requirements.

DSIO No-Action Positions

For purposes of the DSIO no-action positions described below, the amendment of an uncleared swap that references an IRR solely to: (i) include new fallbacks to alternative reference rates triggered only by the permanent discontinuation of an IRR or determination that an IRR is non-representative by the benchmark administrator or the relevant authority in a jurisdiction; or (ii) accommodate the replacement of an IRR, is referred to as a “Qualifying Amendment.” This does not include any amendment that extends the maximum maturity of a swap or a portfolio of swaps or increases the total effective notional amount of a swap or the aggregate total effective notional amount of a portfolio of swaps beyond what is necessary to address the differences in conventions relating to an IRR and its replacement.

De Minimis Exception to the Swap Dealer Definition

To address ARRC concerns that entities that rely on the de minimis exemption from swap dealer registration may be reluctant to transition from IRRs, DSIO provided relief from the requirement to count toward the de minimis threshold a swap that references an IRR solely to the extent such swap would be required to be counted as a consequence of a Qualifying Amendment to such swap.

Uncleared Swaps Margin Requirements

Legacy Swaps

Because SDs and their counterparties will be amending uncleared swaps that were entered into prior to the CFTC Margin Rule[3] compliance date (CFTC Margin Rule Legacy Swaps), concerns have been raised that such legacy swaps would become subject to the margin rule. In response, the DSIO stated in the no-action relief that it will not recommend that the Commission take enforcement action against an SD for non-compliance with the CFTC Margin Rule to the extent such non-compliance is due to a Qualifying Amendment to a CFTC Margin Rule Legacy Swap.

Basis Swap Method Relief

Some market participants may wish to transition swap portfolios reference rates to alternative reference rates through one or more new basis swaps that would swap the IRR basis of a portfolio with an alternative reference rate basis without amendments to any of the swaps referencing IRRs (the Basis Swap Method). The DSIO was willing to provide a no-action position under such circumstances. Accordingly, DSIO will not recommend that the Commission take enforcement action against an SD for failure to comply with the CFTC Margin Rule with respect to a basis swap that meets the following conditions:

  • it references only one or more CFTC Margin Rule Legacy Swaps;
  • it is entered into solely to achieve substantially the same effect as would be obtained by an amendment to the referenced CFTC Margin Rule Legacy Swap(s) to accommodate the replacement of an IRR; and
  • it does not have the effect of extending the maximum maturity or increasing the aggregate total effective notional amount of the referenced CFTC Margin Rule Legacy Swap(s).

SD Business Conduct Requirements

The ARRC requested no-action relief with respect to SD non-compliance with the CFTC business conduct requirements[4] (the Counterparty BCS) when entering into a Fallback Amendment or Replacement Rate Amendment to a legacy swap executed before the effective date of the Counterparty BCS final rules.

DSIO accepted that such no-action relief is warranted and will not recommend that the Commission take an enforcement action against an SD for a failure to comply with the Counterparty BCS (other than CFTC regulation 23.431(a)) solely to the extent such compliance would be required as a consequence of a Qualifying Amendment to an uncleared swap. Relief from CFTC regulation 23.431(a), which requires disclosure of material information concerning a swap, however, was viewed as inappropriate because pursuant to the IR transaction, counterparties will be transitioning from familiar reference rates to new rates, DSIO believes it appropriate that SD provide material information about such new rate to facilitate counterparty understanding of the new rates.

CFTC Documentation and Swap Processing Requirements—Confirmations, Swap Trading Relationship Documentation and Reconciliation

DSIO granted no-action relief with respect to the requirement to provide a confirmation in compliance with CFTC regulation 23.501 to the extent compliance with such requirement would be required as a consequence of a Qualifying Amendment to an uncleared swap, provided such amendment is accomplished pursuant to a multilateral protocol.

For the same reason, and relating to the same circumstances, DSIO granted further no-action relief with respect to compliance with CFTC regulation 23.504(a)(2) requiring SDs to enter into swap trading relationship documentation for swaps solely as a result of a Qualifying Amendment. 

DSIO also will not recommend that the CFTC take an enforcement action against an SD for a failure to comply with the discrepancy resolution timing requirements of CFTC regulation 23.502(a)(4) and (b)(4) relating to portfolio reconciliation solely to the extent such compliance would be required as a consequence of a Qualifying Amendment to a legacy uncleared swap.

Relief Requested Related to End Users—CFTC Margin Rule, Eligible Contract Participants and End-User Documentation

With respect to Fallback Amendments and Replacement Rate Amendments, DSIO recognizes that a temporary mismatch in the interest rates referenced in commercial arrangements and the swaps used to hedge the risk of such arrangements may lead certain counterparties to question whether one or more swaps still qualify as instruments used to hedge or mitigate commercial risk. To address this concern, DSIO will not recommend the Commission commence an enforcement action against an SD for failure to comply with the CFTC Margin Rule with respect to a swap entered into with an entity electing an exception or exemption pursuant to the requirements of CFTC regulations 50.50(c) or 50.51(b)(2) (relating to commercial end-users and cooperatives), if:

  • It is an uncleared swap referencing an IRR that qualified as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulation 50.50(c) or 50.51(b)(2) at the time of execution;
  • CFTC Margin Rule compliance would be required solely due to a Qualifying Amendment to such swap, or, with respect to the commercial arrangement for which such swap qualified as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulations, solely due to an amendment to such commercial arrangement solely for the purpose of (a) including new fallbacks to alternative reference rates triggered only by permanent discontinuation of an IRR or determination that an IRR is non-representative by the benchmark administrator or the relevant authority or (b) accommodating the replacement of an IRR; and
  • Such swap or the commercial arrangement which the swap served to hedge or mitigate commercial risk pursuant to CFTC regulations is amended prior to December 31, 2021, such that the swap again qualifies as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulation 50.50(c) or 50.51(b)(2).

DSIO also will not recommend that the Commission commence an enforcement action against any person for failure to qualify as an eligible contract participant pursuant to section 1a(18)(A)(xi) of the Commodity Exchange Act (CEA) solely to the extent such status would otherwise become relevant as a consequence of a Qualifying Amendment to an uncleared swap.

DSIO also will not recommend enforcement against an SD for failure to obtain documentation meeting the requirements of CFTC regulation 23.505(a)(4) (as to the counterparty’s reliance on exemption based on hedging or mitigating commercial risk) from a counterparty for which it has previously obtained such documentation solely to the extent such documentation would be required to be obtained as a consequence of a Qualifying Amendment to an uncleared swap.

Division of Market Oversight Letter 19-27[5]

 The ARRC requested that the DMO provide clarity regarding the application of the trade execution requirement under section 2(h)(8) of the CEA when market participants use certain mechanisms to transition swaps and swap portfolios from IBORs to risk-free rates (RFRs). As this transition may take different forms, “depending on the needs of counterparties, the nature of the particular swap or swap portfolio being transitioned, and the liquidity and availability of products referencing new RFRs,”[6] the ARRC asked Commission staff to consider the need for flexibility to implement transition mechanisms that take into account individual facts and circumstances.

In order to promote regulatory certainty and to support a smooth and orderly IBOR transition, until December 31, 2021, DMO will not recommend enforcement against any person for failure to comply with the trade execution requirement under section 2(h)(8) of the CEA, with respect to an IBOR-linked swap that is amended or created by the execution of a new swap, a Fallback Amendment or a Replacement Rate Amendment, for the sole purpose of accommodating the replacement of the applicable IBOR with an RFR.

Division of Clearing and Risk Letter 19-28—No-Action Relief from the Swap Clearing Requirement for Amendments to Legacy Uncleared Swaps to Facilitate Orderly Transition from Inter-Bank Offered Rates to Alternative Risk-Free Rates[7]

No Action Position for Uncleared Legacy IRS

ARRC requested that DCR confirm that an amendment of fallback provisions (or addition of contractual terms) regarding selection of the new floating rate because the rate is unavailable, permanently discontinued or determined non-representative (an IRS Fallback Amendment) with respect to a swap that was executed prior to the compliance date on which swap counterparties were required to begin centrally clearing interest rate swaps (Uncleared Legacy IRS) would not result in a requirement to clear such swap pursuant to section 2(h)(1) of the CEA, as implemented in Part 50 of the Commission’s regulations. 

To help facilitate an orderly market-wide transition away from the use of IBOR floating rates to alternatives RFRs, until December 31, 2021, DCR will not recommend that the CFTC commence an enforcement action for a failure to comply with the swap clearing requirement with respect to an Uncleared Legacy IRS that references USD LIBOR, JPY LIBOR, GBP LIBOR, CHF LIBOR or SGD SOR that is amended by adding a Fallback Amendment for the sole purpose of changing the existing floating rate to an applicable RFR in the event the existing floating rate is unavailable, permanently discontinued or has been determined non-representative by the benchmark administrator or the relevant authority in a jurisdiction, provided that the following conditions are met:

  • The swap is an uncleared swap that would have been subject to clearing under CFTC Rule 50.4(a), but for the fact it was entered into before the 2012 application of the CFTC Rule 50.5 clearing requirement and has not been voluntarily submitted for clearing to a derivatives clearing organization; and
  • Each amended swap must:
    • have the same counterparties as the original swap;
    • have the same maximum maturity, the same average weighted maturity and the same total effective notional amount of the original swap; and
    • be amended solely to change the floating rate fallback provisions.

This relief does not apply to the Commission’s trade execution requirement, although separate time-limited relief has been granted relating to the trade execution requirement as noted above. 

No-Action Relief for End Users

DCR also provided no-action relief similar to that described above for end-users under the CFTC margin rules for uncleared swaps. As in that case, commercial end-users have noted that they may need to amend swaps referencing IBORs that are subject to the clearing requirements, but may not yet be made corresponding amendments to the related IBOR-linked credit agreements or vice versa, and raised concerns as to whether the resulting rate mismatch could create uncertainty as to whether a swap still qualifies for the clearing exception or exemption for instruments used to hedge or mitigate commercial risk pursuant to CFTC regulations 50.50(c) and 50.51(b)(2). In response, DCR has provided time-limited no-action relief that until December 31, 2021, it will not recommend the CFTC commence an enforcement action against an eligible entity electing such exception or exemption for failure to submit a swap that is required to be cleared to a derivatives clearing organization (DCO) for clearing pursuant to CFTC regulation 50.2, if:

  • Such swap is an uncleared swap referencing a floating rate that qualified as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulation 50.50(c) or 50.51(b)(2) at the time of execution;
  • One or more of the following occurs: (a) such swap or relevant commercial agreement is amended by execution of an IRS Fallback Amendment (or similar contractual provision in a commercial agreement); (b) an existing fallback provision in a commercial agreement is activated because the floating rate is unavailable, permanently discontinued or determined non-representative by the benchmark administrator or the relevant authority in a jurisdiction or (c) a commercial agreement is amended solely to change the existing floating rate to an applicable RFR; and
  • Prior to December 31, 2021, the commercial arrangement documentation and/or the uncleared swap documentation is amended such that the uncleared swap again qualifies as a swap used to hedge or mitigate commercial risk of such an entity pursuant to CFTC regulation 50.50(c) or 50.51(b)(2), though DCR noted that counterparties should plan to align the reference rate provisions in both swap documentation and commercial documentation as soon as practicable, but no later than December 31, 2021, to maintain their eligibility to elect an exception or exemption from the clearing requirement.

Looking Forward

Overall, the no-action letters remove a number of potential hurdles and legal uncertainties that had been identified as market participants continue to prepare for the broader task of converting their existing derivative contracts from referencing IBORs to alternative rates over the coming year. The approach is consistent with an increasing focus at the CFTC and other regulators on facilitating an orderly transition to alternative rates.

Footnotes

[1]  View Division of Swap Dealers and Intermediary Oversight Letter 19-26.

[2]  Including, but not limited to, LIBOR, the Tokyo Interbank Offered Rate (TIBOR), the Bank Bill Swap Rate (BBSW), the Singapore Interbank Offered Rate (SIBOR), the Canadian Dollar Offered Rate (CDOR), the Euro Interbank Offered Rate (EURIBOR) and the Hong Kong Interbank Offered Rate (HIBOR).

[3]  Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 FR 636 (Jan. 6, 2016). The CFTC Margin Rule, which became effective April 1, 2016, is codified in part 23 of the Commission’s regulations. See §§23.150-159, 161.

[4]  See CFTC Regulations, Part 23, Subpart H.

[5]  View Division of Market Oversight Letter 19-27.

[6]  The ARRC, Treatment of Swaps Amended or Otherwise Transitioned from IBOR to Alternative Risk Free Rates under the Commodity Exchange Act, (November 5, 2019) (“ARRC November 2019 Letter”).

[7]  View Division of Clearing and Risk Letter 19-28.

Authors and Contributors

Donna Parisi

Partner

Derivatives & Structured Products

+1 212 848 7367

+1 212 848 7367

New York

Geoffrey Goldman

Partner

Derivatives & Structured Products

+1 212 848 4867

+1 212 848 4867

New York

Azam Aziz

Partner

Derivatives & Structured Products

+1 212 848 8154

+1 212 848 8154

New York

Jennifer Oosterbaan

Associate

Derivatives & Structured Products

+1 212 848 7111

+1 212 848 7111

New York