SEC's OCIE to Begin LIBOR Preparedness Exams

On June 18, 2020, the Office of Compliance, Inspections and Examinations ("OCIE") of the US Securities and Exchange Commission ("SEC") announced in a risk alert (the "Risk Alert") that it will conduct examinations of SEC-registered investment advisers, broker-dealers and investment companies ("registrants"), among others, to assess their preparedness for LIBOR's expected discontinuation. In a clear warning to registrants regarding LIBOR preparedness, OCIE stated the following in the Risk Alert:

Preparation for the transition away from LIBOR is essential for minimizing any potential adverse effects associated with LIBOR discontinuation. The risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate is not completed in a timely manner (emphasis added).

OCIE commented in the Risk Alert that LIBOR is used extensively in the United States and globally as a "benchmark" or "reference rate" for various commercial and financial contracts (such as bonds and loans, floating rate mortgages, asset-backed securities, and interest rate swaps and other derivatives). OCIE expressed its view that LIBOR's discontinuation, currently expected to occur after 2021, could have a significant impact on the financial markets and may present a material risk for registrants (emphasis added).

The Risk Alert publication follows through on the OCIE's earlier announcement that LIBOR preparedness would be an examination priority for 2020.

LIBOR Generally

LIBOR is the interest rate at which banks offer to lend funds to one another in the international interbank market. It was designed to reflect how much it costs banks to borrow from each other in specified currencies for specified periods of time (tenors). LIBOR is the benchmark reference for determining interest rates for a variety of debt and derivative instruments and other commercial transactions, such as mortgages, corporate loans, government bonds, structured finance products.

LIBOR is a fixed rate that is quoted for a specified tenor (typically one, three, or six months) and for a specific currency. At the end of that time period, the rate can be re-set based on then-current rate quotations. According to Bloomberg, LIBOR underpins over $350 trillion of mortgages, loans and derivatives globally. The combined exposure for various asset classes that are priced based on USD LIBOR exceeds $200 trillion. Derivatives account for approximately 90 percent of this exposure.

In the United States, the Alternative Reference Rates Committee ("ARRC") was convened by the Federal Reserve Board and New York Federal Reserve Bank in 20171 and charged with determining a preferred alternative to LIBOR for US Dollars. In 2017, ARRC selected the Secured Overnight Financing Rate ("SOFR") as the preferred rate to replace LIBOR.2 SOFR is a combination of three overnight Treasury repurchase rates. Some key differences between LIBOR and SOFR include:

  • SOFR is a backward-looking historic rate, not a forward rate like LIBOR.
  • SOFR is an overnight rate, not a term rate like LIBOR.
  • SOFR is a secured, risk-free rate, not an unsecured cost of funds rate like LIBOR.
  • The SOFR market is liquid, deep, and transparent, unlike current LIBOR.
  • SOFR does not track like LIBOR. For example, SOFR is more volatile at quarter- and year-ends and tends to move down in a distressed market while LIBOR moves up.

The ARRC has said that it will attempt to develop a SOFR term rate, but meanwhile favors SOFR compounded in arrears (Compound SOFR). In March 2020 the NY Fed began to publish 30-, 90-, and 180-day Compound SOFR. Other global regulators have indicated that they favor compounded overnight rates to term rates.

Prior SEC and Staff Statements Regarding the LIBOR Transition

The SEC and its staff have issued a number of statements regarding the LIBOR transition. For example, in a December 2018 speech, SEC Chairman Jay Clayton discussed the market risks associated with the LIBOR transition.3 In July 2019, the SEC's Division of Corporation Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant published a joint statement regarding the LIBOR transition and registrant preparedness (the "Joint Statement").4

The Joint Statement provides general commentary regarding LIBOR preparedness, but also includes division-specific guidance and commentary, which registrants may find particularly helpful in preparing for upcoming OCIE examinations and interpreting the Risk Alert.

Further, as mentioned above, in January 2020, OCIE identified registrant preparedness for the LIBOR transition as an examination program priority for 2020:5

. . . OCIE will be reviewing firms' preparations and disclosures regarding their readiness particularly in relation to the transition's effects on investors. Some registrants have already begun this effort and OCIE encourages each registrant to evaluate its organization's and clients' exposure to LIBOR, not just in the context of fallback language in contracts, but its use in benchmarks and indices; accounting systems; risk models; and client reporting, among other areas. Insufficient preparation could cause harm to retail investors and significant legal and compliance, economic and operational risks for registrants.

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Originally published 24 June, 2020

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