WASHINGTON, D.C. – Corporate treasury departments still have time to prepare for the transition away from the London Interbank Offered Rate (Libor), but 2022 will be here before you know it. That was the view from a meeting Monday morning at the U.S. Chamber of Commerce.
David Bowman, special adviser of the Board of Governors of the Federal Reserve, stressed that corporates need to begin working on their transition plan now. The crux of the problem, he explained, is that many of the existing contracts out there were poorly structured because people didn't think Libor could ever stop. “Because these contracts didn't take into account an end for Libor, if the rate went away, it could be devastating to the financial system,” he said.
The Alternative Reference Rates Committee (ARRC), which has been working diligently to help prepare businesses for this massive change, is nearly at the point where it is ready to work on the implementation of a new rate, said Tom Wipf, Vice Chairman, Institutional Securities, Morgan Stanley and Chair of the ARRC. With the prep work finished, he also urged companies to begin to consider moving on from Libor. “Thirty months is the blink of an eye,” he said.
Participants in several different panels throughout Monday’s event agreed that the Secured Overnight Financing Rate (SOFR) is the only viable alternative to Libor. “The $200 trillion-plus on Libor will move somewhere,” Wipf said. “So we have to think about where the safest place it is for it to land. [The ARRC thinks] the safest is overnight SOFR.”
Unfortunately, the market as a whole is still apprehensive about SOFR. Ann Battle, assistant general counsel for the International Swaps and Derivatives Association (ISDA), who also participated on the AFP 2018 panel with Bowman, called on market participants to educate themselves on the rate, as there’s really only so much trade associations and regulators can do. “We've given the market the tools they need, now the market needs to learn how to use SOFR,” she said.
The goal of SOFR is to be a durable, IOSCO compliant rate, Wipf said. The ARRC sees SOFR is the key pillar that could support the vast majority of current market activity. “We don't want to do this again,” he said. “We want to do it once and do it right.”
However, the ARRC isn’t going to be the one to move U.S. companies onto the new rate. Bowman, who participated in a Libor panel discussion at AFP 2018, stressed that the transition from Libor to SOFR needs to be decided by businesses. “Ultimately, we can’t dictate what prices you pay for your contracts or what rates you use in your contracts,” he said. “So this transition ultimately has to be up to the private sector. So we're giving you one path that you can choose to go down if you're going to transition.”
An attendee asked Bowman and Wipf about how corporate treasurers are going to handle the spread between Libor and SOFR. He specifically wanted to know whether the Fed would be offering some sort of independent benchmark that would help to mediate this spread. “If we’re all going to the banks individually, it is going to be a tough challenge,” he said. “It would help a lot if there was an independent benchmark that we could look to and tell our boards, ‘We were at Libor plus 125 and now we’re at SOFR plus 140; here’s the independent view that the spread is reasonable.’”
Bowman responded that it wouldn’t really be the Fed’s place to establish a benchmark. “I don’t think the ARRC or the Fed can say, ‘This is a fair price.’ That needs to be settled in the market,” he said. “But I agree that it’s an issue for corporate treasurers who might say, ‘I’m used to Libor and I think I know what a fair spread is, but don’t know what a fair spread is now with SOFR. I don’t want to have to go to my board after the fact and say that it should have been 30 and I got 25 or 40.’”
Bowman believes treasurers will gain a better understanding following the release of an upcoming ISDA protocol. “It will give a little more clarity to the fact that the long-dated Libor curve, I believe, really is SOFR. If you’re trading at 10-year Libor swaps, you already have SOFR risk. Once that protocol is closer to being finalized, it’s going to give a lot of clarity to the market, at least what that long-term spread should be,” he said.
Tess Virmani, associate general counsel and senior vice president of public policy for the Loan Syndications and Trading Association (LSTA), noted that what many stakeholders desire is a forward-looking term rate. However, that may not actually be attainable without first moving to a rate like SOFR. “It’s starting to dawn on people that if everyone in the cash markets waits on a forward-looking term rate, we have a problem there,” she said. “If we wait, we may not get that rate.”
Battle agreed. “The reality is, you don't get a forward-looking rate based on SOFR until you have a robust market based on SOFR,” she said. “The derivatives market has to be based on SOFR for there to be a forward-looking term rate.”
Making the Transition
Jennifer Earyes, director of corporate development for Navient and a member of AFP’s Treasury Advisory Group who also participated in the AFP 2018 Libor discussion, provided some insights on how legacy loan contracts will transfer from Libor to SOFR. Navient provides student loans, and consumers likely aren’t following the Libor transition the way corporates are. Thus consumers need to be educated by anyone who lends to them.
However, the uncertain future of benchmark rates creates new problems. Contract fallback language may state that if Libor becomes unavailable, then the lender will be able to select a comparable rate. “Of the bat, that sounds great, until you realize that we don’t know when this is going to happen,” Earyes said. “And so we need to coordinate and we need more folks at the table who are nonbank lenders who are participating in that kind of market to bring voices and perspectives that are not present right now.”
Earyes advises companies who provide loans to educate their frontline employees on this transition. “Are your call centers prepared to explain this quickly and simply to a borrower in a way that they realize that they are not being harmed?” she asked. “Are they understanding that authorities are compelling us to consider a world where Libor does not exist?”
So while 2022 may still seem long enough away, corporate treasurers need to begin their transition away from Libor as soon as possible. If they don’t, they put their companies in jeopardy—and even risk upending the entire financial system. “2019 is a mission critical year,” Wipf said. “The time to act is now.”