Firms Must Proactively Protect Their Interests as LIBOR Transition Looms
The announced discontinuation of the London Interbank Offered Rate (LIBOR) at the end of 2021 has the potential to be the “Y2K bug” of the financial sector: for firms that devote proper attention and resources on an ongoing basis, it should be more or less a non-event, while those that fail to address it face serious economic, operational and legal consequences. Firms of all shapes and sizes – large and small, financial and non-financial – should already be acting to protect their interests.
What’s the issue?
In July 2017, Andrew Bailey, chief executive of the Financial Conduct Authority (FCA) in the U.K., which regulates LIBOR, gave a speech that has been widely interpreted as announcing “the end of LIBOR.” Specifically, Bailey said the FCA will not compel the panel banks, which contribute submissions for the determination of LIBOR every day, to continue to support LIBOR after the end of 2021. While there is a possibility that such support could continue voluntarily after that date, there does not seem to be a serious prospect that it will, or that the LIBOR rates that result from voluntary participation will be viewed as sound and useable after that date.
Bailey has since reinforced his call to action with another speech in which he stated, “Firms that we supervise will need to be able to demonstrate to [UK regulators] that they have plans in place to mitigate the risks and to reduce dependencies on Libor.” He also noted that, “The pace of that transition is not yet fast enough.” Meanwhile, some European regulators have indicated they might require firms to discontinue using LIBOR even sooner than Bailey’s end-of-2021 deadline. It also seems likely that some market participants may abandon LIBOR sooner if it is feasible.
What kinds of transactions use LIBOR?
LIBOR represents the average interest rate that a bank would be charged by other banks for an unsecured loan for a particular term in a particular currency. It has been called “the world’s most important number,” and with good reason, as it is the most widely used financial benchmark in the world. It is referenced by an estimated US$350 trillion of financial contracts with maturities ranging from overnight to more than 30 years. As of July 2018, it was reported that financial institutions alone hold about $170 trillion in LIBOR-based swap contracts, a third of which mature after 2021. In addition, some estimates indicate that tens of billions of dollars of adjustable-rate mortgages and other consumer loans currently reference LIBOR in some fashion, and lenders are continuing to use LIBOR notwithstanding its looming discontinuation.
In the derivatives markets, LIBOR is the primary benchmark for over-the-counter interest rate swaps and also serves as the basis for final settlement prices of exchange-traded Eurodollar futures. In the cash markets, LIBOR is used to set borrowing costs on corporate bonds, loans and notes. It also is used in about half of all consumer adjustable-rate mortgages in the U.S. as well as other consumer loans, including many private student loans.
What is being done so far?
Several significant initiatives already are well underway to address the cessation of LIBOR.
In the U.S., the Alternative Reference Rates Committee (ARRC), which was convened in 2014 by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York, has been working to identify and create an implementation plan for risk-free alternative reference rates for USD LIBOR. In early 2018, the ARRC recommended a new reference rate known as the Secured Overnight Financing Rate (SOFR) and is now working to further its widespread adoption. SOFR began regular publication in April 2018, and as of November 2018, approximately $17.2 billion in floating rate instruments tied to SOFR have been issued, and the CME Group also has launched SOFR futures for trading. It is anticipated that SOFR futures eventually will replace LIBOR-based Eurodollar futures. The ARRC also has issued a series of consultation papers soliciting input from market participants and interested parties regarding various aspects of a potential transition from LIBOR to SOFR in the cash markets. Similar efforts are underway in other countries and have led to the development of additional currency-specific risk-free rates such as the Bank of England’s sterling overnight index average (SONIA), the European Central Bank’s euro short-term rate (ESTER), the Swiss National Bank’s average rate overnight (SARON), and the Bank of Japan’s Tokyo overnight average rate (TONAR).
On a market-wide basis, ISDA is developing standardized contractual language to update provisions in existing over-the-counter derivatives documentation that prescribe when, how, and which “fallbacks” will be triggered when LIBOR is discontinued. In addition, ISDA is developing language for new swap contracts which are being entered into with the awareness that LIBOR could be discontinued permanently (as opposed to temporarily, say, due to force majeure). In July 2018, ISDA also issued a consultation seeking input from market participants “on technical issues related to new benchmark fallbacks for derivatives contracts that reference certain interbank offered rates (IBORs).” More specifically, the consultation describes and sets out options for adjustments to the fallback rate in the event an IBOR is permanently discontinued. The consultation concluded in October 2018. Once an approach is selected (a decision that will not be straightforward), ISDA is expected to issue a request for proposals for an independent third-party vendor to build a system to publicly disseminate the adjustments. ISDA further has announced that it will publish the final approach for review and comment before any changes are made to its standard documentation. Some market observers believe that whatever adjustments ISDA ultimately promulgates for the derivatives market are likely to be adopted in the cash markets as well. However, responses to the ARRC’s first round of consultation papers already indicate that cash market participants’ views on how to approach LIBOR transition diverge from those of derivatives market participants on numerous major issues.
As noted, concerns already have been expressed about the pace and priorities of these and other efforts – or the lack thereof. One area where things are not moving as quickly as might be hoped is in developing term rates for SOFR. Unlike LIBOR, which offers seven different rates for various maturities out to one year, SOFR currently only offers an overnight rate. The ARRC has indicated that it does not plan or expect to have term rates for SOFR until 2021, which does not offer much time to work out any problems before the expected LIBOR cessation at the end of that year. If LIBOR goes away sooner, it will be too late.
What happens if nothing is done?
For many years, both the derivatives and cash markets have included “fallback” language in contractual documentation to address the possibility of LIBOR not being available. But such language was designed for the possibility of a temporary, short-term unavailability of the necessary rate(s), not a permanent termination. Accordingly, most fallback language mandates the use of the last available LIBOR rate. In the case of a permanent cessation of LIBOR, this would immediately transform trillions of dollars of floating-rate instruments into fixed-rate instruments – not a result that anyone expected or wanted, particularly now that interest rates are on the move again.
Such “accidental” fixed-rate instruments would confer significant windfalls, upset contractual expectations on a massive scale, and produce other significant consequences. For example, transactions that are intended to hedge or fund floating-rate obligations could become disconnected economically from the obligations they are meant to hedge or fund, creating operational challenges with potentially large economic impacts. Similarly, margin calls may be made where they otherwise would not be warranted or may not be available where they should be. In short, the possible range of (largely unintended) consequences is enormous.
What should people be thinking about now?
Although much of the heavy lifting to address LIBOR transition is being done on an industry-wide or national level, there is much to be done within individual firms.
Perhaps the first to recognize and act on this imperative have been the large banks, some (but not all) of which have launched enterprise-wide LIBOR transition efforts. Yet firms of all sizes need to consider and take early action to address the potential consequences of LIBOR transition, regardless of whether they consider themselves to be in the “financial” business. Here are some action items to consider:
- Figure out where LIBOR is embedded in your business. Now is the time to review the documentation for virtually every form of funding, borrowing, lending, hedging or other financial activity to determine where LIBOR is referenced.
- Identify existing fallbacks. For transactions or instruments that were entered into before 2018, chances are the language was not drafted with a permanent cessation of LIBOR in mind.
- Identify new fallbacks. Unfortunately, this will not be as simple as substituting a SOFR rate for a LIBOR rate. For one thing, SOFR does not yet offer term rates, and for another, SOFR represents a secured rate whereas LIBOR represents AAA-rated banks’ unsecured borrowing costs. Virtually any different rate will benefit one party at the other’s expense. How different rates will work requires not only contractual changes but economic analysis to identify the solution that makes sense for both (or all) parties.
- Begin negotiations to amend fallbacks. For swaps, this might be as simple as adopting new language promulgated by ISDA. For other matters, transaction-by-transaction negotiations might be necessary. For still others, it might make sense to terminate a transaction and start over with a new transaction using a different risk-free rate. The sooner any changes are made, the more time firms will have to put in place arrangements that make the most contractual and economic sense for them. In addition, the closer the end of LIBOR gets, the more firms can be expected to address the transition opportunistically, as it becomes clearer who the winners and losers will be.
- Develop a strategy for future transactions. Again, this will not be purely a matter of choosing SOFR or some other rate. Transactions entered into in the near term, in which the end to LIBOR is foreseeable, but SOFR is not truly ready for widespread adoption, will have to be handled differently than those executed after SOFR and other rates have fully evolved, and their economic characteristics have become better understood.
- Consider whether and how to disclose LIBOR-transition risks and exposures. It is becoming increasingly common for securities issuers to note in offering documents and other materials the magnitude and scope of their LIBOR risks and exposures as well as their plans for addressing them. The Wall Street Journal reported in November 2018 that Kyle Moffatt, chief accountant at the SEC’s Corporation Finance Division, has stated that “To the extent that the phaseout of Libor is material to a company…we would definitely expect a company to disclose that fact and describe the implications of the phaseout, including any associated risks, to investors.” Moffatt also noted that such disclosures are going to need to change over time, stating “With respect to both Libor and Brexit, the other thing to keep in mind is your disclosures need to evolve. Every quarterly period or annual period you need to make sure that you reassess your disclosure and add any updates.”
- Include LIBOR transition efforts, risks and disclosures in your due diligence. Just as investors and regulators are starting to expect LIBOR-transition disclosures, firms generally should make sure that their funders, lenders, service providers and others, as well as any potential investment targets, are on top of and properly disclose their LIBOR transition risks and mitigation measures.
In light of the significance of LIBOR transition, Friedman Kaplan has formed a firmwide LIBOR Transition Task Force to assist clients in addressing its impact. The Task Force includes partners Anne Beaumont, Gregg Lerner, Eric Corngold, Andrew Goldwater, and Asaf Reindel.