The now confirmed extension of certain USD LIBOR tenors alleviates near-term pressures of the transition but should also be treated as a valuable opportunity to further enhance your transition plan.
The daunting shift away from London Interbank Offered Rate (LIBOR), which has long been the primary benchmark for securities, loans and derivatives, and is embedded in many contracts, will have significant impacts on hundreds of trillions of dollars of financial instruments. While initially slated for cessation by the end of 2021, extensive consideration has led regulators to the conclusion that the markets may need more time to appropriately qualify and quantify the impacts of the proposed changes and to promptly implement effective transition plans that account for all potential components of alternative rate adaptation.
The recent announcement that the cessation of certain USD LIBOR tenors will be extended to June 2023 has indeed relieved some of the short-term pressure. However, the event, and preparation for the event, remain very much at the forefront for anyone with LIBOR exposure. Deadlines have been set by instrument type regarding when the last LIBOR-based issuance activity can occur, with the stoppage of all new issuance targeted by the end of 2021, if not sooner, and banks (one of the largest counterparties) have been encouraged to complete their transitions as soon as practicable and no later than the end of 2021.
A Migration of Epic Proportions
While the postponement of most USD LIBOR benchmarks appears to have bought the market additional time to transition, it should not be a reason for delay or, worse, a reprieve. There is a tremendous amount of work to be done to adequately prepare for the LIBOR cessation. Understanding the nature of your exposures, developing a comprehensive plan, identifying the appropriate personnel within your organization to be part of the transition team and documenting the progress will allow for a smooth transition.
There are many factors that must be considered in preparation for the transition. The process begins with developing an understanding of LIBOR exposures, in particular the contractual provisions regarding alternative reference rates, fallbacks, governing jurisdiction and amendments. Understanding the full breadth of exposure can be overwhelming, and implementing an effective plan requires a thorough review of all relevant governing documentation. This document review and data collection process must be conducted to understand the existing transition language, such as fallback terms and timing, as well as to identify responsibilities, inclusive of disclosures to counterparties and regulators alike.
Given the scale and complexity of developing a comprehensive exposure assessment and transition execution plan, several focal areas have been outlined based on recommendations from the Alternative Reference Rate Committee (ARRC), Office of Compliance Inspections and Examinations, International Swaps and Derivatives Association and the Financial Conduct Authority, to name a few. Robust governance in which senior executives direct and oversee the coordination and delivery of results in line with the institutions’ objectives is critical. A smooth transition requires platform-wide integration to effectively evaluate and mitigate the potential risks associated with both existing and new exposures. To accomplish this, the appropriate key resources by functional areas throughout the organization must be identified, and proper communication channels and educational resources must be established and documented to inform internal and external stakeholders along the way, as needed. We are working with clients at varying stages of their transition planning, with some still waiting in the hopes of legislative relief, while others have transition planning teams that have already performed impact assessment analyses to guide their plan and are currently issuing non-LIBOR instruments and remediating legacy contracts as needed.
To Each Their Own—Plan Customization
As if the comprehensive exposure assessment and transition execution plan did not pose a large enough hurdle, the process is further complicated by businesses spanning multiple instrument and exposure types. At its core, the foundation of a successful LIBOR transition exercise is understanding what your exposure is, how and when each instrument is expected to transition, and what is required to ensure that you are properly positioned to handle the transition to an alternative rate. For example, have analyses been performed to understand what, if any, changes in future cash flows are expected based on the LIBOR transition provisions? Have systems been prepared and tested to process multiple reference rates with potentially updated calculations and methodologies, as well as proper flow through to accounting, tax, valuation, treasury and risk models? Clear organization, documentation and communication with limited partners, regulators and advisors are critical to a successful transition plan.
Upon completion of the contract review process, institutions need to assess the potential impacts of the anticipated transition to better understand and inform possible remediation steps and priorities. For existing contracts and benchmarks that reference LIBOR, strategies for renegotiating and repapering to negotiate fallbacks where they do not adequately exist must be documented and approved as appropriate, considering enhanced fallbacks or amendments, along with potential refinancing or restructuring activities.
Understanding the Potential Alternative Reference Rates
While several alternative rates have been considered as potential USD replacement rates for LIBOR, secured overnight financing rate (SOFR) has been identified by the ARRC as the rate that represents the best fit for use in loans, derivatives and other financial contracts. The SOFR index is based on U.S. Treasury repurchase transactions (versus LIBOR, which was tied to unsecured interbank lending rates). While SOFR has been identified as the presumptive alternative reference rate, other indices that market participants are choosing to consider in their transition plans include Ameribor and the prime rate.1,2
One of the biggest hurdles that will be faced by market participants as they migrate to an alternative reference rate will be the structure of these rates. For example, SOFR is currently a daily rate market without an active and observable derivatives market. As such, while synthetic forward curves can be constructed with available data, there are currently no objectively observable forward term rates for the SOFR market that can be used when projecting future expected rates.
The Time for Transition Preparation Is Now, Not Later
Irrespective of whether you enact a wait-and-see strategy looking to further announcements before acting or you take a more proactive stance and begin transitioning to an alternative reference rate now, preparing a comprehensive inventory that quantifies and documents your exposures is a critical initial step to a successful transition. Once the key LIBOR transition provisions are catalogued, having a detailed transition timeline and plan which identifies the key professionals throughout the institution and outside advisors that will lead the effort, will enable effective communication with regulators, investors and counterparties, and allow for a smooth transition.
It is important to note that this unprecedented and multifaceted transition does not have to be one taken alone. Duff & Phelps, a Kroll Business, has the breadth of expertise to provide a comprehensive cross-functional team able to efficiently consider all inter-dependencies in your LIBOR transition. Duff & Phelps offers customized solutions that align with your transition progress thus far, as well as the facts and circumstances of your portfolio and businesses. This support can be either through full end-to-end solutions or specific components, depending on what is prescribed. For more information on Duff & Phelps’ LIBOR transition advisory services, please visit our LIBOR landing page on the Duff & Phelps website here.
1.Ameribor is determined based on the actual borrowing costs between the small and midsize bank institutions that are members of the American Financial Exchange.
2.Prime rate, according to The Wall Street Journal, is the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks.