LIBOR has been referred to as the plumbing buried in many financial contracts, and the end of LIBOR will cause a seismic shift in the financial markets.
I had the privilege of speaking about LIBOR in a podcast and a live-stream session at the Association for Finance Professionals (AFP) annual conference in Boston last week. LIBOR replacement is a hot topic because mandatory reporting of Inter-Bank Borrowing Rates (IBORS, including LIBOR) continue only through December of 2021. Following are some of the questions that my colleagues and I received at the sessions:
1. Is LIBOR really going away?
The consensus among practitioners is that yes, it will go away and it may not last until the end of 2021. If the market becomes too thin (not enough liquidity), it may degrade to the point where it is no longer seen as a benchmark rate.
We recommend that you review your exposure to LIBOR (and any other “IBORS”) now to ensure that you are ready when replacement products become available. The SEC and the Federal Reserve Board have both made pointed comments about starting now and how it’s part of a prudent risk management strategy.
2. Do you see a cliff-edge or a catastrophic end?
We don’t see either of these. The International Swaps and Derivatives Association (ISDA) has drafted fall-back language that will kick in when LIBOR ends. The fall-back language includes triggers for both LIBOR cessation and pre-cessation triggers based on LIBOR no longer being representative of a benchmark interest rate and includes replacement rates. We believe that derivatives, even if you are not proactive, will be taken care of by this universal fall-back language.
We expect that the LIBOR cash products (loans, bonds, etc.) will take more time and attention to switch over. The Alternative Reference Rate Committee (ARCC) has published recommendations for fall-back provisions on newly issued syndicated loans and floating rate notes. Existing contracts may need to be individually negotiated, depending on who is on the other side of the transaction.
3. Will SOFR replace LIBOR?
The Secured Overnight Financing Rate (SOFR) is being touted as the LIBOR replacement in the US. That being said, there are some other rates out there that are also being considered.
One that we heard quite a bit about was Ameribor. Ameribor, like SOFR, is compliant with the International Organization of Securities Commissions (IOSCO) benchmark standards; however, unlike SOFR, Ameribor is not currently approved as a benchmark interest rate by the FASB.
The consensus at the conference was that for most corporate clients, SOFR will emerge as the replacement index. For financial institutions, insurance companies, GSE’s, REITs and other interest rate sensitive businesses, there may be more than one rate to contemplate.
Keep in mind that the Overnight Index Swap (OIS) rate is already a benchmark interest rate and there is a derivatives market for this rate. In fact, many of our larger Financial Institutions are already trading OIS derivatives and some have moved out of LIBOR completely.
4. What about the recent SOFR volatility? There was quite a spike in the rates in September. How will this impact corporate use of the rate?
Yes, there was a spike on September 17th – SOFR surged over 280 basis points. In contrast, 3M LIBOR jumped less than 2 basis points. This makes great headlines, but what you need to remember is that SOFR is a daily rate, and SOFR contracts work on a daily average, so the spike, while large, only applied to a single day.
By September 18th, the rate dropped by 270 bps. If September 17th was your 3M LIBOR reset date, you were stuck with the increased rate for the entire three months.
As the range of SOFR participants in the market expands beyond the large interest rate sensitive entities, many expect that the SOFR spikes seen at most quarter-ends will become a thing of the past. While we don’t expect the SOFR spikes to cause many headaches for swap users, we do expect that the set-in arrears, daily averaging will require changes to many internal processes including interest expense accruals.
What is happening internationally? Below is a quick summary of some of the major currencies. These new rates are transaction based, overnight and some are secured while others are unsecured.
- UK: SONIA (Sterling Overnight Index Average) — currently trading, replacing GBP LIBOR
- EUR: ESTER (Euro Short Term Rate) — debuted recently, replacing EURIBOR & EUR LIBOR
- JPY: TONAR (Tokyo Overnight Average Rate) — pre-existing rate, replacing JPY LIBOR
- CHF: SARON (Swiss Average Rate Overnight) — pre-existing rate, replacing CHF LIBOR
There are also some existing rates that are expected to continue into the future (some are being reformed to bring them up to IOSCO standards) as follows:
- USD: OIS (Overnight Indexed Swap)
- AUD: BBSW (Bank Bill Swap Rate)
- CAD: CDOR (Canadian Dollar Offered Rate)
- JPY: TIBOR (Tokyo Interbank Offered Rate)
Preparing for Risk-Free Rates
Here’s what you can do now to prepare your entity for the transition to risk free rates:
- Educate yourself and your colleagues in legal, purchasing, treasury, accounting and other parts of your organization
- Start making a list of all contracts, systems and processes that will be impacted by LIBOR cessation. Don’t forget contracts with contingency/penalty language, intercompany loans, transfer pricing, etc.
- Look at the fall-back language in existing contracts and evaluate the impact
- Examine your infrastructure for LIBOR dependencies
- Start talking to your LIBOR partners (counterparties, etc.) about what they expect
In summary, the LIBOR replacement picture is becoming clearer as time marches on; however, there is still a lot of work to be done. Many LIBOR users at the conference are hopeful that SOFR will develop a term structure that allows for a set-in advance rate similar to 1M, 3M and 6M LIBOR. Others are taking a less optimistic view and noting that if that market develops, it’s unlikely to develop in time to manage the transition in a thoughtful way.
Whether you have LIBOR based derivatives, or you just have LIBOR embedded into your processes, everyone is recommending that you don’t wait to start the transition process.
If you have any questions or concerns about the services Hedge Trackers performs for organizations related to this change, please contact us.