At this point, LIBOR’s phasing out by Britain’s Financial Conduct Authority (FCA) may be old news. Although the topic has been a constant presence in headlines, there’s still lingering questions about what this means and what organizations should do in its wake.
To figure out the best possible next step for your organization, let’s dive a little deeper into the issues.
The London Interbank Offered Rate (LIBOR) has historically been an important figure, serving as the foundation of interest on many loans across the world. That’s why, when the FCA announced it will support LIBOR only until 2021, the markets become unstable. It’s been a contentious topic ever since.
Why is LIBOR going away?
Most sources point to the notorious LIBOR collusion that was revealed in 2008. Despite attempts in regulation to salvage the trustworthiness of the rates, credibility continued to be questioned.
While this situation is damaging in its own right, it’s not the true root of LIBOR’s ineffectiveness as a benchmark.
The real threat lies in the fact that the market for LIBOR is already thin – and it just keeps getting thinner. Banks aren’t borrowing at LIBOR anymore; they’ve already replaced it at that level. This illiquid market is a negative feedback loop: as the number of LIBOR-based transactions decrease, the market continues to shrink, making it even more illiquid, reducing transactions, and so on.
This is why LIBOR is headed out. Sooner rather than later, it will become near impossible to do an accurate valuation for contracts based on LIBOR.
The problem? The market for LIBOR may be very illiquid, but the pure volume of existing transactions based on LIBOR is massive. So, it’s going to take some time for corporations to make the switch to a new rate.
Interestingly enough, as people start switching to replacement rates, the market will become more liquid. People will take positions and make profits. But at some point, once everyone has made the switch, the market will dry up.
Check Your Fallback Provisions
As organizations begin to look at how to transition away from LIBOR, many are focusing exclusively on derivatives. But LIBOR is referenced in leases, accounts receivables, transfer pricing contracts and more. We need to go deeper into the impact beyond the more obvious issues.
Fallback provisions have been overlooked thus far. Any contract that has interest penalties – interest that kicks in on a trigger event, such as a missed payment – will be impacted by the LIBOR switch.
This is because the LIBOR rate only kicks in if something happens. If you have a contract written with LIBOR after the 2021 deadline and then default, you will be charged interest. The interest rate would be LIBOR, but since LIBOR will no longer exist, you will actually be paying at a different rate: the fallback rate.
So, are your fallback provisions reasonable?
For example, back in 2008 when LIBOR was first having issues, fallback provisions on mortgage-backed securities were trigged. Some of these fallback interest rates could be highly inflated – say, 15%. Nobody thought they’d use them … until they had to use them. Start negotiating them now before this happens again. It takes time.
Will You Need to Do a De-Designation?
When you start to consider your fallback provisions and the process for adjusting those rates, you may wonder: do I need to do a de-designation for my hedge programs?
The answer is most likely no.
Luckily, most economists agree that to replace LIBOR with a new rate, you won’t have to de-designate your contracts.
Though we are still waiting on official guidance from FASB, we can say that as long as you show that your contracts are still effective, you shouldn’t need to do a de-designation. Conducting one would be even more disruptive and make the transition more complicated.
If all you’re doing is changing a rate because LIBOR is being phased out, that shouldn’t be cause for a de-designation.
We’re expecting rules to make this transition clearer. While we can’t say anything for certain now, we can look at past situations and how they were handled.
Back when Dodd-Frank required banks to consolidate their activities, a lot of financial institutions got out of hedging or moved their hedging into another branch. In doing this, they had to novate trades from one entity to another. Many audit firms thought this was critical enough that they’d need a de-designation. However, because this was widespread and a mandated situation, the FASB eventually released guidance to say that a novation, when no other terms have changed, does not trigger an automatic de-designation.
We hope and can assume that the FASB will release similar guidance to ease the transition away from LIBOR.
LIBOR’s Impact on Hedging
As you prepare to switch the interest rates from LIBOR, it’s important to be aware of the fundamental economics of hedging and how these switches may impact your hedge effectiveness.
It will take time to figure things out, which means people may be referencing many different rates until we land on the right one.
Be careful. If your debt falls into one rate and your derivative into another, the economics may not work, and you may lose hedge accounting
For example, take a company that has entered into a swap to fix their variable rate loan. In this case, they pay out LIBOR on their loan, and receive LIBOR on their swap. This cancels out so they only pay the fixed rate on the swap plus the spread on the loan.
But in this transition, if you elect one rate on your loan to be paid on index X but on the chosen swap, you’re receiving index Y, you may no longer qualify for hedge accounting – depending on whether or not the changes in the two rates track each other over time.
Keep this in mind as you make your negotiations. If you’re too late re-working your contracts, your counter parties may stall, and this could cost you a lot in the long run.
The New Normal
While several details are still being worked out in terms of official guidance, there are still some things you can do to make sure your organization is as prepared as possible.
- Identify all contracts with LIBOR mention
- Identify the fallback provisions
- If they are horrible, start re-negotiating now if possible
- Educate yourself and your organization
There’s not a whole lot you can do right now. SOFR is out there as a replacement option in the U.S., but trading is still pretty thin. Before corporations can start trading SOFR derivatives, a term structure needs to be created – but this isn’t due to come out until 2020, according to some experts.
The best thing you can do now is to educate yourself and be aware and vigilant.
If you’re writing new contracts, make sure you have good fallback provisions.
Not everyone will do it the same way in the beginning. This means the road will be bumpy as details are hammered out. The key is to be proactive and look out for the guidance and term structures released by regulatory bodies.
It may be difficult to price options for a while. There may be more volatility on cross-currencies. Market data will continue to drop off for LIBOR, valuing will become more difficult and disclosures will have to be much more in depth.
But over time, we will move into a new normal.