Buckle up, treasurers. The UK Financial Conduct Authority (FCA) has said that it no longer plans to compel banks to submit London Interbank Offered Rate (Libor) quotes past 2021. Once that happens, Libor will lose its status as the global interest rate benchmark and that title will likely be taken over by an Alternative Reference Rate (ARR).
Over the past several years, markets have begun to craft alternative rates that would effectively replace Interbank Offered Rates (IBORs). The Alternative Reference Rate Committee (ARRC) in the United States has selected the Secured Overnight Financing Rate (SOFR) for U.S. dollar derivatives and other financial contracts, and it is the heir apparent for loans. SOFR differs greatly from Libor, and that has major implications for corporate treasury.
“In almost every credit agreement in the world, the applicable interest rate that corporates are paying on their loans is tied to Libor,” said Kimberly C. MacLeod, partner with Hunton Andrews Kurth LLP. “So now Libor could go away at the end of 2021, and the [fallback rate] is a lot more expensive than Libor. The SOFR rate, which is what [the International Swaps and Derivatives Association (ISDA)] has said it will move to, does not translate exactly to Libor. So there are some adjustments that would be required to move to SOFR for credit agreements.”
Libor has been an endangered species for some time now. In 2012 it was revealed that financial institutions were manipulating the rate for their own gain. The results were investigations, fines, jail terms, and reputational damage to the financial sector.
“The global financial crisis exposed excessive risk-taking and a long series of lapses in judgment, and the Libor scandal further undermined trust in the ethical standards of the banking industry,” said William Dudley, President and CEO of the Federal Reserve Bank of New York, who called for “aggressive action” to move to a more resilient benchmark.
Following the Libor scandal, the International Organization of Securities Commissions (IOSCO) established a set of principles for determining a good benchmark rate, and Libor doesn’t fit that criteria. For example, a key principle is for benchmark rates to be “anchored by observable transactions,” rather than based on so-called “expert judgment” by the banks. “In most instances, Libor is based on expert judgment. On average less than 30 percent of submissions are based on actual transactions,” said Ming Min Lee, principal, financial services for Oliver Wyman.
Lee added that the transactions underlying Libor submissions—unsecured wholesale term lending to banks—are no longer active following the financial crisis. “Banks have largely moved away from interbank lending to something that is more stable,” she said. “So that’s a big change and we don’t expect the transactions that used to underpin Libor to come back.”
There are currently more than $200 trillion in USD Libor-based contracts outstanding. The majority of existing exposures to Libor are slated to mature before 2022, but not all. According to the New York Fed, in the U.S., approximately $36 trillion in notional outstanding will not mature before Libor is set to end, assuming there are no new Libor-based issuances. While most of that exposure is in interest rate derivatives, longer-dated positions in other asset classes are sizeable, such as an estimated $4.7 trillion in consumer and business loans.
Corporates need to start thinking about their options. Finding an alternative rate is critical because it will affect funding costs. And since the fallback rate would be higher than Libor, treasury departments will want to look for a comparable or cheaper rate.
Lee pointed out some key ways that treasurers could be impacted by the shift, the most obvious being floating-rate debt instruments, and committed lines with banks. But there are other areas that practitioners might not be thinking about, such as intercompany funding agreements and late payment penalties that could be Libor-based.
Libor could also be used in a corporate’s systems and processes. “Libor has been around for 30 years,” Lee said. “If you have a billing or contract management system for your supply chain management activities that has an implicit interest rate built into it, it wouldn’t surprise me if Libor is the reference rate.”
Treasurers also need to consider that Libor is currently managed by one administrator across five currencies and a range of tenors. “Multinational corporations will need to care about the evolution of the alternatives for all five currencies, each on its own timeline,” Lee said. “In all likelihood, we will have a multitude of conversion approaches; not just one.”
MOVING FROM LIBOR TO SOFR
SOFR, an overnight rate based on a Treasury repo transactions, is the preferred alternative rate for USD Libor. SOFR daily trading activity is at around $800 billion, which is about 1,500 times daily Libor transaction volume.
Jerome Powell, a member of the Board of Governors of the Federal Reserve System, and Christopher Giancarlo, chairman of the U.S. Commodity Futures Trading Commission, noted that the choice of SOFR “resolves the central problem with Libor, because it will be based on actual market transactions currently reflecting roughly $800 billion in daily activity. That will make it far more robust than Libor.”
But there are a few key differences between the two that are immediately apparent to a corporate treasurer or CFO. First, Libor is an unsecured rate at which banks purportedly borrow from one another—it includes a bank credit risk premia. SOFR, in contrast, is a nearly risk-free rate based on repo financing of U.S. Treasury securities; it’s not a purported rate like Libor.
Second, SOFR is also currently an overnight rate only; it’s not a rate of multiple maturities. That could eventually change; the ARRC’s Paced Transition Plan includes the development of a term reference rate based on SOFR derivatives. But right now, they don’t exist. That could mean big operational changes for treasurers, who currently borrow at one month, three months, etc. For that period, Libor is fixed for them.
“There was some amount of predictability,” noted Joseph Buonanno, partner with Hunton Andrews Kurth LLP. “But now, they’ll have a SOFR rate that can change on a daily basis. So not only will you have to manage the adjustments that the banks notify you of on a daily basis, but you’ll have to keep track of it yourself because you’ll need to be much more careful about how rates are changing and what the volatility is in rates so you can continually adjust your funding mix. How is the daily adjustment to SOFR relative to the weekly or monthly adjustment to Libor?”
Buonanno believes that corporates will begin to hedge interest rate risk more frequently in the near future than they’ve traditionally done using ISDA derivatives. “A lot of corporates already do that to comply with all the Dodd-Frank Act rules to continue to trade derivatives on an OTC basis,” Buonanno said. “But I think you’ll see greater use of derivatives in the future.”
WHAT TREASURERS NEED TO DO
Lee, Buonanno and MacLeod recommend that treasurers take a five key actions as they prepare for this probable shift from Libor to SOFR.
Take inventory. Understand where Libor exists within your organization. Take note of all your borrowing and funding commitments that are dependent upon Libor. Consider payroll loans, supply chain financing, factoring, asset based lending, in-house banking, etc. Figure out what your spreads and maturities are, and what you’re going to need to refinance your contracts, and what the results of triggering existing fallback language will be.
Do your homework on SOFR. Learn as much as you can about this new rate and how it is performing relative to Libor. Figure out what that means for your own credit spreads, because credit spreads are based on risk, and each corporate is its own individual risk. Corporates need to compare themselves not only to businesses in the same industry, but also comparable benchmarks and credit spreads that they have historically tracked.
Consider the impact SOFR will have. Once you get your mind wrapped around SOFR, it’s time to begin thinking about how transitioning to it will affect you. Consider the procedures you’ll need to put in place to track SOFR on a daily basis. Contemplate whether or not you need to do a periodic analysis more often to optimize your capital structure.
Get your bankers to include fallback language in your agreements. If you’re doing a refinancing or are entering into an amendment for an existing credit facility, discuss SOFR with your bank partners and see if you can get fallback language implemented into the agreement if your loans extend beyond 2021. Banks may be willing to address the issue and include language that states if Libor goes away, the borrower and the administrative agent will agree on a replacement index. If you have the prime/alternative base rate as a fallback rate, you should probably look to renegotiate to a different reference rate or at a minimum have a clause on how a reference rate would be determined.
Get involved. Get feedback from your fellow AFP members and your bankers, and perhaps even reach out to the ARRC directly to help you anticipate upcoming challenges. There may even be opportunities to work with them and help make this a more seamless transition.
The shift away from Libor is an important development that AFP will be watching closely. Be sure to visit AFP's Libor Transition Guide for the latest updates.