Are You Ready for LIBOR’s Demise?
Dropping the universal lending benchmark will impact everything your treasury touches. Here’s how you should prepare.
LIBOR, the much-criticized international wholesale lending interest rate, is going away at the end of 2021. Good riddance, say financial regulators and others who believe LIBOR was easily manipulated and proved itself unequal to the global financial crisis in 2008, in both its reliability and its accuracy.
For business and financial leaders, LIBOR’s demise means that no later than 2022, and likely well before then, they’ll have to reference a new benchmark for an estimated $200 trillion in financial contracts, from short-term bank loans to long-term infrastructure financing agreements. But few of those executives have thought through the implications of a shift that will affect nearly everything a corporate treasury touches, including swaps, financial hedging strategies, commercial contracts and even quarterly closes. Now is the time to start planning.
The leading candidate to replace US dollar LIBOR, endorsed by the US Federal Reserve, is SOFR, the Secured Overnight Financing Rate. It’s considered superior to LIBOR in that it reflects actual transactions and not what banks think money will cost. But SOFR has other features managers must anticipate and prepare for, or they risk surrendering profits and predictability to counterparties and the market itself.
The Birth—and Death—of a Benchmark
From its beginnings as a mechanism to price a Swinging Sixties club loan in chummy London banking circles, LIBOR exploded in popularity, eventually becoming embedded in everything from exotic derivatives to consumer loans and student debt. It’s quoted as an indicator of market expectations on central bank interest rates, money market liquidity and, as we saw in the global financial crisis, a gauge of the financial health of the major global banks themselves.
The Fed’s Alternative Reference Rate Committee (ARRC) announced in June 2017 that it had selected SOFR as the preferred alternative to LIBOR, and the Fed’s New York branch began publishing daily SOFR rates in April 2018. The Fed believes SOFR—as a virtually risk-free rate pegged to actual market transactions—is more appropriate for derivative transactions. It is also based on a vast liquid market: The repurchase market represents $800 billion in daily trading activity, 1,500 times daily US dollar LIBOR transactions.
One key difference: LIBOR includes longer-term rates, including a popular three-month rate, while SOFR is strictly overnight (currently). Commercial lenders and borrowers strongly prefer forward-term rates; few banks or borrowers want to calculate future loan interest based on a daily historical rate. The Fed is publishing a three-month compounded historical rate but still circulating ideas on how to derive forward-looking term rates based on SOFR futures.
Another wrinkle: Post-LIBOR, the reference rate for wholesale loans will no longer include the lender’s risk premium. Borrowers risk a “value transfer” to lenders unless they can identify the proper spread reflecting their risk and not the bank’s. And SOFR can spike at quarter- or year-ends, when repo market participants engage in balance sheet window dressing, as they did in December 2018.
Preparing for the End
Preparing your organization for the end of LIBOR is an exercise in change management, like any other shift that affects every part of the organization. Done right, it could resemble the worldwide effort to prepare computer systems for Y2K. By identifying all the hardware and software that could be crippled by a failure to compute dates after December 31, 1999, and rewriting defective code, businesses averted potential disaster. Recently, the US Securities and Exchange Commission published a statement encouraging market participants to proactively manage their transition away from LIBOR and outlined potential areas needing increased attention during the transition.
Banks will be under no obligation to report LIBOR after 2021, so as with Y2K, doing nothing isn’t an option. Managers need cross-functional, cross-organizational visibility into how the loss of a widely used reference rate will affect operations. Then they need to generate a comprehensive plan to deal with the predictable consequences of that change, with contingency plans in case it doesn’t go exactly as anticipated.
Here are some basic steps that would apply to most exercises in change management:
Inventory. Make a list of everything that is touched by the old rate. Trust me, it will be huge. Many companies have a vast architecture somehow linked to LIBOR, whether it’s a portfolio of swaps used to dampen interest-rate risk on long-term assets and liabilities or an interest rate embedded in a contract with a supplier. Don’t be surprised if LIBOR pervades accounts receivable.
Assess. Are you pricing transactions today based on interest-rate projections that extend beyond 2021? What are the underlying assumptions? Is the forward rate based on transactions in a liquid market, or is it just somebody’s guess? Would a different rate in the out years have a material impact on the value of the deal?
Begin. Changing the reference rate will require careful modifications to financial agreements. While the Fed hopes to have a replacement for LIBOR and standardized contract language available long before the transition, managers should start thinking about specific issues—such as fallback solutions and value transfer—today. It could be difficult to shop around for better terms on a complicated transaction that doesn’t expire until well after 2021.
Brace. The Fed has anointed its successor to LIBOR but can’t force the market use it. LIBOR still has a liquid forward market, while SOFR is just getting started, injecting uncertainty into long-term plans. Even as the forward market to be developed for SOFR emerges, it will behave differently than LIBOR because of its fundamental attributes. Some predict the persistence of “Zombie LIBOR” after 2021, as borrowers and lenders will continue to cite a benchmark that may no longer exist or may behave quite differently instead of rewriting contract language to account for a new benchmark.
For such a momentous change, the LIBOR phaseout seems to be occurring with relatively less input from the people most affected by it: borrowers. The Fed and overseas financial regulators have been pushing change for multiple political and economic reasons, and the transition so far reflects it. The firm deadline in 2021 serves to focus everyone’s mind, but significant detailed work remains to be done before borrowers and non-financial users, in particular, will be fully prepared.
After all, no corporate treasury wants to be bitten by this century’s financial version of the Y2K bug.