What is LIBOR?
LIBOR is a series of benchmark interest rates that are used for pricing loans, debt and derivatives. Due to LIBOR being based to a large part on expert judgement rather than actual transaction volumes its regulator the Financial Conduct Authority (FCA) based in the United Kingdom has stated that they will no longer require firms to provide LIBOR indications after 12/31/2021.
Benchmark regulation was passed by the European Union (conforming to recommendations from BCBS/IOSCO) regarding the requirement that the benchmark index be representative of the market. Should the FCA issue a statement that LIBOR is no longer representative of the market, many foreign counterparties and contributors to LIBOR setting would no longer be able to utilize LIBOR and it is assumed that LIBOR would cease to exist in its current form.
Per the NY Fed, at the end of 2016 USD LIBOR transactions were $200 trillion, roughly 10 times U.S. GDP. ISDA estimates that there are about $370 trillion in financial contracts tied to LIBOR around the world.
Why begin the transition?
The LIBOR cessation will impact a vast array of areas within your institution. Analysis of the impact should be started early to allow for changes that may be necessary to products, systems, processes, transactions or contracts that the institution has already entered into. As an example, LIBOR may be imbedded in a business loan in a penalty calculation while it is not the primary rate on the loan. Also, regulators are now moving towards including LIBOR transition in their examination work plans, as stated by the Federal Reserve.
When will LIBOR go away?
Panel banks which contribute to the LIBOR setting process will no longer be required to provide LIBOR indications after 12/31/21. The FCA could declare LIBOR to be non-representative of the market at any time which could cause the index to cease. The administrator of LIBOR (ICE) has indicated that they may be able to develop a LIBOR type substitute to be able to keep LIBOR quotations for a period of time or that dealers may still wish to contribute indications after 2021 to keep LIBOR in place. It is unknown at this point if LIBOR will exist after 2021.
Who should be transitioning away from LIBOR?
Both you and your counterparties will need to move away from LIBOR. The key is to understand your exposure and working with your counterparty to replace LIBOR with a mutually agreeable alternative. The goal is to minimize the value transfer.
How do I transition away from LIBOR?
Inventory your LIBOR exposure. Monitor and understand the alternative reference rates choices such as SOFR. Create a plan to stop utilizing LIBOR and to transfer your legacy LIBOR exposure to a replacement index. This may require renegotiation of existing contracts and changes to systems. Incorporate recommended fallback and trigger language in your contracts. Both ISDA and the ARRC have recommended language available for different instrument types.
Do Secured Overnight Financing Rate (SOFR) swaps clear?
Yes, they clear at both The Chicago Mercantile Exchange (CME) and the London Clearing House (LCH). To see the volume of SOFR swaps if you have access to a Bloomberg terminal, type SDR [go], choose “rates”, and choose “SOFR”. (You can see the Overnight Index Swaps (OIS) in the same way on the same screen).
I have a cleared LIBOR swap hedging a fixed rate Advance, how do I limit my exposure to LIBOR?
There are a couple of ways to limit your LIBOR exposure:
1) enter into a LIBOR swap with the same terms as your existing swap except in the opposite direction and clear this swap at the same clearinghouse, have the swaps compressed by the clearinghouse and enter into a new SOFR or OIS swap.
2) enter into a LIBOR swap with the same terms as your existing swap except in the opposite direct and clear this swap at the same clearinghouse and have the swaps compressed, prepay or allow your fixed rate Advance to mature and enter into a SOFR Advance with no swap.
I have looked at documentation in my business loans and it says that I can change the index. Is this all I have to do to be ready for LIBOR transition?
No. The language in your business contracts may be ambiguous and open to interpretation based on how LIBOR may be brought to cessation. It is unknown how LIBOR will cease to exist. Some of the alternatives are:
- The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market and LIBOR is no longer published
- The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market with a future date for cessation of LIBOR
- The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market but ICE (the LIBOR Administrator) may continue to publish LIBOR because Dealers continue to contribute their estimates of LIBOR and LIBOR continues to be published
- ICE may stop publishing LIBOR without a statement from the Financial Conduct Authority
- ICE may come up with an alternative estimation model/framework and continue to publish an index calling it LIBOR
- LIBOR ceases to be updated and the LIBOR rate remains at the same level and is published daily – essentially a fixed rate
Also, it is not just the index that needs to be changed but the spread to the index or the margin on the index. SOFR unlike LIBOR does not have a term component (there is no term SOFR at this time, although it is envisioned). There is also no credit component as SOFR is based on Secured Treasury Repurchase transactions. LIBOR include both of these components. ISDA has announced that they have decided on contracting with Bloomberg to provide data on the spread adjustment when moving from LIBOR to SOFR. This is a process that is evolving and we are still unsure as to the exact methodology for this calculation. We would suggesting watching developments in this area at ISDA to how to determine the adjustment to equate your contracts when moving from LIBOR to SOFR and where to obtain an industry standard data point for the adjustment.
We believe you should contact your legal counsel for specific guidance regarding the language in your business loans and be watching for developments from the Alternative Reference Rate Committee (ARRC) regarding LIBOR fallbacks and triggers in business loans and ISDA as they move forward with providing LIBOR SOFR spread adjustment data.