Change is coming. The Federal Reserve, various agencies and market participants are engaged in extensive efforts to transition the market away from U.S. Dollar ICE LIBOR (“LIBOR”) to an alternative rate. With over trillions of global financial instruments tied to LIBOR, across both derivative and funding markets, will not be an easy task.
The Run-Up to Change
In the U.S., LIBOR has been in operation since the late 1980s, and its construction has changed and adapted over the years. Currently, 16 banks contribute their estimate of wholesale funding rates to the ICE Benchmark Administration (BA) for the calculation of USD LIBOR. ICE BA calculates a trimmed mean from the submissions and publishes daily rates across different maturities, including for one-, three- and six-month rates.
However, the wholesale unsecured funding markets underpinning the LIBOR submissions have declined substantially over the past decade, making the submissions less transaction-based and more subjective. This poses structural risks and the opportunity for manipulation of LIBOR.
The Alternative Reference Rates Committee (ARRC) was formed in 2014 in response to these growing concerns. The AARC began to identify reference rates that were more firmly based on transactions from the underlying market and that also complied with international financial benchmark standards. The ARRC eventually selected the Secured Overnight Financing Rate (SOFR) in March 2018 as its recommended alternative to USD LIBOR.
In July 2017, the primary regulator of LIBOR announced that it would not compel panelist banks to submit to the LIBOR panel indefinitely. Instead, they announced a voluntary plan to sustain LIBOR until the end of calendar 2021.
This deadline accelerated market participants’ work on the transition away from LIBOR to SOFR. However, while progress has been made, there is not enough clarity about how the financial services industry will transition to SOFR, and exactly how that new index will be calculated.
Fifth Third, along with other major market participants, have been analyzing potential impacts of the transition on its clients and for itself. Internal preparations for non-financial corporates seem less robust.
Partly, this inactivity by corporate CFOs and Treasurers is understandable, as attempting to plan a course of action would only be setting themselves up for frustration by the lack of detail available on the new SOFR index and the transition mechanics. However, as we approach 2020, corporate finance teams are certain to have more questions for lenders.
The Knowns and Unknowns
First—and most simply—companies know that USD LIBOR-based contracts that expire before the end of 2021 will likely not be impacted because LIBOR is expected to be published until that point. However, Fifth Third has been active with corporates who wish to borrow or make trades today with contracts that go beyond the end of 2021.
For example, many U.S. corporates are keen to take advantage of the shape of today’s yield curve and to manage their company’s debt maturity profile. Understandably, treasurers at companies with such outstanding loans want to know what the possible implications will be if—and when—LIBOR ceases to exist or be recognized as a benchmark interest rate. So what will happen?
The honest answer is that no one really knows yet with any precision, and it will also depend, in part, on the specific language of the underlying contracts. For example, some existing contracts will rely on fallback agreements, which will replace the LIBOR rate with a different replacement rate. Meanwhile other contracts will need to be renegotiated or amended by an agreement between the borrower and the lender.
Since LIBOR is still the largest and most widely utilized U.S.-based index, there is a working trust in the industry that regulators, financial services firms and market participants will be able to resolve any required transition in a fair and equitable way that works for everybody.
Fifth Third is talking with affected clients to begin to understand their concerns and develop a plan to work together to transition in a way that minimizes any disruption.
But as we get closer to the deadline some companies will want a firmer strategy that helps minimize transition risk.
There are some ways to minimize risk in advance of the current-end-of-2021 deadline.
One simple approach is to avoid financial instruments that expire past this deadline. However, this is not a particularly practical solution for companies requiring longer-term funding and risk management strategies.
Another is to use the Prime rate as the underlying reference interest rate in financial contracts. Fifth Third is able to offer instruments referenced to Prime for risk-averse clients for several of its products in certain segments of the market.
However, given the Prime market is not as liquid or as large as existing LIBOR-based markets, this is not a practical solution for larger entities that fund in the syndicated bank market.
Last, but not least, treasurers can continue to monitor the developments of alternative rates like SOFR and consider implementation of the new rate or upgrading the existing contract language to embed the use of the new rate at the appropriate time.
SOFR So Good?
SOFR is a broad measure of the cost of borrowing cash overnight secured by U.S. Treasury securities. SOFR has been published on a daily basis since April 2018 by the Federal Reserve Bank of New York and the underlying transaction volume for the index is well in excess of $1 trillion daily. This extensive transaction volume is the primary reason why the ARRC prefers the new index rate over LIBOR.
In addition to the vast difference in trading activities underlying the two indices, there are other key differences between LIBOR and SOFR. LIBOR is unsecured and is term based, typically 30 or 90 days. SOFR is secured and is only an overnight rate (so far). Generally speaking, secured facilities with a shorter duration should result in a lower rate (e.g., SOFR should be lower than LIBOR), but SOFR may not be as reflective of the actual funding costs that a bank incurs to extend credit to borrowers. As such, work is underway to determine a translation methodology between these two rates.
One methodology to create a term structure to SOFR includes calculating SOFR as a compounded average of the overnight rate for a specified length of time. The potential for a compounded backward-looking reference rate would add some complexity for treasurers, as they might not know the interest costs until the end of a payment period. This could require updates to systems, including accounting and reporting systems.
Additionally, there are other market dynamics that affect both reference rates in different ways, such as typical quarter- and year-end liquidity needs, which typically have pushed overnight repo rates higher. The potential for higher volatility in the new SOFR index rate has some market participants concerned about its implementation.
As an example of this volatility, SOFR spiked from 2.43% on September 16, 2019 to 5.25% on September 17, 2019 as a result of liquidity issues in the overnight funding market. SOFR reverted back to 2.55% on the following day, but clearly the additional volatility in a short rate like this creates other concerns that may need to be addressed ahead of broader industry adoption.
Progress is being made on SOFR but there is more work to be done. To date, there have been very few actual debt issuances utilizing SOFR as the rate index. The few instances of SOFR based notes have been issued by government related entities, such as the Federal Home Loan Bank. Most domestic U.S. banks and corporates have not embraced adoption yet.
The Impacts on Risk
LIBOR is also currently used as the major reference rate for interest rate derivatives contracts. Companies that enter into derivatives contracts to manage financial risk will similarly be affected by the transition away from LIBOR. The same broad dynamics apply here, too: The market expects reasonable transitions to be broadly agreed upon to minimize basis risk that could appear between hedges and their underlying debt instruments to the extent possible.
As the end of 2021 deadline approaches, all these issues will become more pressing for banks and corporates alike. For the time being, banks are naturally taking the lead on managing the issue given their role as underwriters and counterparties. For now, corporate treasurers should be cognizant of the key dates and market developments.
Banks like Fifth Third will continue to work with clients to help them better understand and manage the expected LIBOR transition issue as the details become clear. Fifth Third's team of expert corporate banking partners will be ready to help clients through the LIBOR to SOFR transition if and when it occurs.
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