That is the question on the minds of treasury professionals the world over. Organizations are all over the spectrum, from having addressed their exposures and being done to not having started yet, “after all, we have until 2023.” With the arrival of the new year, is there anything wrong with the latter?
In a recent webinar hosted by the Association for Financial Professionals (AFP), a panel of four treasury professionals addressed the LIBOR transition from the perspective of both private and public entities. The speakers included Jeff Diorio, managing director, PMC Treasury Inc.; David Bowman, senior associate director, Board of Governors of the Federal Reserve System; Mack Makode, vice president and treasurer, Under Armour, and moderator Tom Hunt, CTP, director of Treasury Services, AFP.
What will change in 2022
It’s true that LIBOR won't stop outright until June 30, 2023. What this means is that while legacy products have time to make new deals, everyone else does not. If you're renewing deals, you may well be out of luck because the supervisory guidance in the United States — and most other jurisdictions — is that banks are strongly being advised not to enter into any new LIBOR deals after the end of 2021.
“If you go to any bank next year and say, I want to renew, or I want to negotiate a new revolver, or I want to increase the amount or extend the maturity, the bank is probably going to tell you they can't do that. Their supervisors will have advised them that it is an unsafe or unsound practice, and they can't help you,” said Bowman.
Why LIBOR will be stopping
The federal reserve convened the Alternative Reference Rates Committee (ARRC) in 2014 to address what was seen as considerable risks around LIBOR. When LIBOR was created in the late 1960s, it was a fairly niche product that simply syndicated loans. Over time, it grew to be one of the cornerstones of the financial system. Now it's pervasive. “It's in derivatives, consumer products, intercompany loans, contracts, non-financial corporate contracts — it's everywhere,” said Bowman. Despite that, no one really cared how LIBOR was created or where the numbers came from. Those who did understand where the numbers came from were afraid that we put too much weight on it, because it’s working from a very informal panel: a poll of a small panel of banks.
Up until recently, you could simply ask someone at the bank, what's the rate today? They would tell you what the rate was, and they didn't have to back it up. They didn't have to provide any documentation or evidence whatsoever. Not surprisingly, there were attempts to manipulate LIBOR, which resulted in several billions worth of charges to banks.
The other weakness, as the official sector stepped in, is that you could reform that governance and try to get people to provide some documentation or evidence or point to actual transactions, but in the market that LIBOR is meant to represent, which is bank-unsecured, wholesale funding, banks just don't fund themselves that way anymore. And so most banks don't have any transactions they can actually point to most days. The panel banks had grown uncomfortable with that and had wanted to leave for a long time — and are leaving — and this is why LIBOR will be stopping.
The birth of SOFR
The first task that the federal reserve set for the ARRC was to identify a robust rate — a better alternative — that you could put consumer products and derivatives and intercompany loans and all these products on. The ARRC has recommended SOFR, which stands for secured overnight financing rate. LIBOR is different from SOFR, and some banks will complain about that. “But the ARRC didn’t want to pick a rate with the same problems that LIBOR has: Picking another rate like LIBOR would have been building a bridge to nowhere,” said Bowman.
SOFR is very different on a number of fronts. Its methodology is separate and fully transaction-based, so there is no expert judgment. In terms of liquidity, it's based off the largest rates market in the world: The overnight treasury repo market, which is secured with treasury collateral, i.e., the private sector risk-free rate. There's a depth in which the methodology really can be robust and quite different from LIBOR. For example, LIBOR was comprised of just banks and was not a risk-free rate.
Everything moves closely with monetary policy, but if you look at particular events, for example the financial crisis of March 2020, when banks and non-financial corporates wanted funds, as did borrowers, SOFR went down — matching what happened with monetary policy and most money market rates at those times — while LIBOR tended to go up. That is the key difference: In times of stress, LIBOR is likely to rise and SOFR is likely to fall and move in tandem with monetary policy. It's a difference that benefits borrowers, and was more appropriate given that LIBOR really doesn't reflect the large amount of bank funding.
The ARRC looked at every market they could think of and every potential rate, even if it didn't exist at that time. They chose SOFR because it reflects the deepest and largest rates market in the world. It reflects a market that's widely used; banks are not the only institution involved. Insurance companies, hedge funds, and asset managers all go into this market. Also, it is produced by the Federal Reserve Bank of New York, so it is produced for the public good, which was also important to ARRC.
“SOFR is by far the most transparent and robust rate of any of the alternatives that the ARRC had available, or that it could conceive of ever being available,” said Bowman.
The different forms of SOFR
There are four different forms of SOFR that can be used in loan agreements: 1) daily simple SOFR in arrears, 2) SOFR compounded in arrears (will be used in the derivatives market), 3) SOFR compounded in advance, and 4) forward-looking term SOFR. The form of SOFR you use depends on your organization’s needs.
In their negotiation with lenders, Under Armour has landed on Term SOFR, “because it looks and acts like LIBOR,” said Makode. “LIBOR is forward-looking, and Term SOFR is engineered to be forward-looking.”
Loans and hedging
By and far, the biggest concern among treasurers is the language in the agreements as they are being renegotiated. “That’s something you should look at carefully,” said Diorio.
Some of the language of concern included trigger clauses for converting that were at the counterparty’s sole discretion. Another treasurer was concerned that they had a loan and a derivative with the same counterparty, and the language in those agreements was different: The derivative could get changed over to an alternate rate before the loan could, meaning they could wind up in a situation where they no longer had effectiveness, because they were borrowing LIBOR and hedging SOFR.
The other thing that treasurers are very concerned about is that the new rate will not be the same all-in rate. Right now, it seems that there is a 6-20 basis-point potential increase in borrowing costs, which is of course concerning. Diorio advised treasurers to be sure they’re getting the economical equivalents when in the review process.
The ARRC recommended spread adjustments in order to deal with the over $200 trillion in contracts referencing USD LIBOR. They can’t all be renegotiated at the same time, and some can’t be renegotiated at all because they require unanimous consent. Also, derivatives have no workable fallbacks whatsoever.
When it comes to legacy contracts and derivatives, you just need to know, in many cases, what rate you are going to use. There is no process where the issuer asks you about the rate. So, the ARRC went through the process of coming up with a methodology to conduct what is a fair and historically accurate spread adjustment. However, it — 11 basis points as the fallback spread adjustment on a legacy loan — only applies when you’re converting a legacy LIBOR product to SOFR. When it comes to new loans, the market should determine the rate, based on the competitive market.
Using treasury technology to prepare
According to Diorio, there are two tests your technology should be able to pass to help ensure you’re prepared for the transition: 1) calculate interest for payments/settlements and associated interest accruals for accounting, and 2) calculate mark-to-market or valuation of instruments. “If it can do those two things for the new instruments, then the minutia underneath it is covered,” said Diorio.
Most vendors are more than capable of accommodating these calculations. The big challenge comes from, if you are not on a SaaS solution that automatically upgrades, whether you can get the upgrade in time. That’s the struggle many companies are having.
Some actionable steps you can take include:
- Identify. Identify which systems or third-party vendors you are using to track, account and potentially revalue your LIBOR-based financial transactions.
- Assess. Utilize the vendor questions in the appendix of AFP’s Corporate Treasury Technology Preparedness for LIBOR Transition to assess the preparedness of these systems to support alternative rates.
- Engage vendors. Engage relevant vendors or consultants on any additional costs or resource availability in supporting your system reconfiguration.
- Plan to upgrade. Develop a plan to upgrade your existing system, or a bridge strategy until your system can be upgraded, or a transition plan to a new system or service that can support the new financial instruments.
- Resource and budget. Resource and budget for the effort and potential cost of configuring the new alternate rate transactions in your system, or upgrade and configuration if an upgrade is required, or deployment of a new system and technology.
What if we don’t stop
In federal reserve rules, guidance is principles based; it's not a granular thing. The principle is: you should be stopping new LIBOR use. This includes automatic renewals. When the renewal period comes up, move away from LIBOR.
“Regulators expect to see limited use of LIBOR in 2022 and are prepared to access the full set of supervisory tools at their disposal if they feel a financial institution is engaging in unsafe or unsound practices,” said Bowman.