Are we ready for LIBOR transition? What is the best alternative?

By Iresha Jayakodi

Transitioning from LIBOR is not an activity to be taken lightly. LIBOR is the world’s most widely used benchmark for short-term rates, but its era of influence is slated to end by 2022. We have almost two to three weeks to go. The endgame of the LIBOR transition is imminent, if not already upon us. 

In 2017 the Financial Conduct Authority (FCA) in the UK announced the benchmark LIBOR will cease for all currencies other than USD on 31 December 2021. We hardly had seen communication and discussions on LIBOR transition in Sri Lanka. Ready or not, loan market participants need to deal with it. 

LIBOR currently underpins approximately $ 400 trillion in financial contracts for derivatives, bonds, mortgages, commercial and retail loans, representing an enormous challenge. 

The London Interbank Offered Rate (LIBOR) is a well-known name in financial markets which measures the average rate at which banks are willing to borrow wholesale unsecured funds. It is estimated that current outstanding contracts referencing USD LIBOR, including corporate loans, adjustable-rate mortgages, floating rate notes (FRNs), securitised products and a wide range of derivatives products, total nearly $ 200 trillion, roughly equivalent to 10 times US Gross Domestic Product. While financial providers may show a lack of urgency in their transition plans, hence we should be prepared and take steps to accelerate transition efforts. 

Business entities and financial institutions should assess the risks and costs of servicing remaining LIBOR products in a shrinking market. This scenario is akin to a business wind-down, in which continuing operations may be prohibitive. Any upside to keeping LIBOR products on the books would be offset by the possible costs of maintaining a segregated operating model, the higher capital charges to LIBOR products with limited price points, and interest rate gaps and mismatches. In short, the risks of an untimely transition from LIBOR outweigh potential benefit.

1. Most USD LIBOR tenors will continue until 30 June 2023, but this longer period is intended solely to allow legacy USD LIBOR transactions to roll off. US banks are restricted from originating new USD LIBOR loans after 31 December 2021. Other regulators, including in the UK, are similarly encouraging the entities they supervise to meet this same deadline.
2. Risk-free rates (RFRs) have been adopted in the jurisdiction of each LIBOR currency. These rates are overnight rates. For loan transactions, RFRs may be applied in arrears using compounding.
3. Forward term rates based on an RFR have been recommended for loan transactions in the US (Term SOFR) and in Japan (TORF). In no other LIBOR jurisdiction has a similar forward term rate based on an RFR been recommended for general use in loan transactions. Although the UK has two versions of a forward term rate (Term SONIA), it has been recommended for use only in specific limited circumstances. While there are a number of reference rates that could take USD LIBOR’s place.

There are five major globally accepted Risk free Alternative Reference (ARRs) which have been proposed to replace the respective LIBOR rates for each major currency (i.e. Sterling, US dollars, Japanese Yen, Swiss Franc, and Euro). Secured Overnight Funding Rate (SOFR) for US dollars and Sterling Overnight Index Average (SONIA) for Sterling have emerged as frontrunners. In the context of Sri Lanka, SOFR will be the main ARR of interest due to the dominance of US$ denominated instruments. The main difference between SOFR and LIBOR is how the rates are produced. 

While LIBOR is based on panel bank input, SOFR is a broad measure of the cost of borrowing cash overnight collateralised by US. It is worth noting that other countries are introducing their own local-currency-denominated alternative reference rates for short-term lending, but SOFR is expected to supplant USD LIBOR as the dominant global benchmark rate.

• The Sri Lankan market should probably have huge exposure LIBOR based pricing; it is very important to get an understanding that would be impacted. Corporate, bank, end-users hedging risk with LIBOR-based derivatives, investment banks underwriting, issuing and making markets in LIBOR-based instruments, investors managing portfolios of swaps, bonds and loans tied to LIBOR, syndication loans, bilateral/multilateral loans, etc.
• The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rate Committee (ARRC) in 2014 recommended Secured Overnight Financing Rate (SOFR)—as its recommended alternative to USD LIBOR. Organisations need to make significant changes in order to reduce their risk exposure. Ideally, these contracts should be renegotiated to reference SOFR, but that won’t be possible in all cases. When they can’t be renegotiated, contracts should be amended to include robust fallback language that clearly lays out how and when the benchmark rate will transition to SOFR.

Is your bank ready to transition? 8 steps to transition away from LIBOR (Source: Crowe 2020).

The multiphase process to transition away from LIBOR will involve different stakeholders across each bank. The necessary steps require time and thoughtful deliberations to minimise risk to customer satisfaction, net interest margin, and interest rate sensitivity, among other considerations. Institutions should continue working their plans (or establish one if they haven’t already!) to get themselves well-positioned for the end of LIBOR in its current form at the end of 2021. 

For banks to make the transition from LIBOR to SOFR, especially for contracts already referencing LIBOR, they need to calculate a spread component that measures the difference in risk between the two rates. 

This spread calculation will have a large impact on a financial firm’s risk profile, and its impact will be felt in asset liability mismatch, hedging strategies, risk modelling, valuation tools, product design and customer communication. 

The wide-reaching impact stresses the importance of the LIBOR-SOFR spread calculation for financial institutions.

The most widely suggested approach for calculating the LIBOR-SOFR spread is the five-year median. It is recommended by ARRC and the International Swaps and Derivatives Association (ISDA) and appears to be the leading market preference. Utilising a median has the advantage of avoiding market fluctuations. However, depending on the market conditions at the time of determining the spread, a median could be artificially low or high and be subject to higher variance during times of economic stress. In addition, official SOFR rates have been published since 2018, although the Federal Reserve (the Fed) has released pre-production SOFR estimates from August 2014 using the same underlying methodology and data, which results in a shorter than five-year median in the near term. Financial firms can also consider a point-in-time spread in moving from LIBOR to SOFR. Static spreads are the easiest in terms of communication and implementation in existing contracts. 

In this situation, customers will have a clear understanding of how the transition affects their existing contracts. However, financial institutions that choose to utilise a static spread will not be able to accurately reflect market conditions prevailing at the time, especially during times of volatility and stress, and are at risk of not pricing instruments properly.

The transition away from LIBOR involves at least eight key steps:

1. Establishing a transition plan with an appropriately robust governance structure. 
2. Identifying all affected contracts, this could include loans, securities, debt agreements, derivatives, leases, and more.
3. Adding fallback language to new contracts denominated in LIBOR to allow for a smooth transition once a replacement rate has been selected.
4. Selecting a replacement rate and determining appropriate changes to credit spreads. 
5. While the Secured Overnight Financing Rate (SOFR) has been designated as the recommended alternative to LIBOR by the Alternative Reference Rates Committee, each institution should evaluate what alternative rate(s) would best fit their business and their borrowers. It is important to understand several differences between LIBOR and SOFR and other alternative reference rates in order to make an informed decision and minimise negative impacts on profitability, net interest margin, and interest rate sensitivity.  
6. Ceasing entering into new LIBOR-based contracts.
7. Programming changes into models and systems to support the change.
8. Modifying existing contracts and managing the customer experience.

Assessing the accounting, tax, and financial reporting implications of the transition.

The writer is an ex-banker by profession and covers areas in economics, banking, current affairs and is involved as a research assistant mainly on socio-economic research studies.