The impending replacement of LIBOR - what should we expect?
On June 22, 2017, the Alternative Reference Rates Committee (“ARRC”) selected the Secured Overnight Financing Rate (“SOFR”) as their final choice to replace USD LIBOR past calendar year 2021.
At present, LIBOR is the most widely used benchmark on the globe as it is used in a wide variety of financial products such as mortgages, corporate loans, government bonds, credit cards, as well as for a variety of Eurodollar and interest rate derivatives. As LIBOR presently underlies assets that are estimated to total more than $350 trillion in notional amount, the undoing of these products is expected to be extremely complex and fraught with challenges.
What is LIBOR and what is SOFR?
LIBOR is the most widely used benchmark interest rate today and is meant to reflect the rates by which the world’s largest banks charge each other for short-term loans, effectively defined as an Interbank Offering Rate (“IBOR”). LIBOR, which is the acronym for the London Interbank Offering Rate, is published across five currencies and seven maturities by the Intercontinental Exchange Benchmark Administration and is based on daily submissions by contributor banks.
SOFR is a comprehensive measure of the cost of borrowing cash, which is based on transactions in the overnight Treasury repurchase market and is widely considered as representative of the general funding conditions in the repo market. Rates such as SOFR and the Overnight Index Swap Rate (or “OIS”) are termed Alternative Reference Rates (“ARR”). SOFR is published by the Federal Reserve Bank of New York and is supported by the broadest measure of transactions in comparison to any other Treasury repo rate available today.
What types of valuation hurdles can we expect in this transition?
The most apparent obstacle that has surfaced in the transition is that LIBOR is a term-based rate whereby SOFR is an overnight rate. As the structures are fundamentally different, trying to convert from an overnight rate to a term structure is going to require that a projection method be developed. The consequences of making this conversion to already existing contracts is going to create unforeseen value transfers as an equivalent rate may not be that equivalent.
Second, modelling complexity is most likely going to increase as various techniques are going to be needed to perform calculations that were considered mainstream in the past. Techniques that will include a multi rate environment and curve building and development are all going to become more relevant. For example, curves and bases for dollar denominated instruments will need to be modelled in LIBOR, OIS and the new ARR. If multiple currencies are added, the modelling approach will expand exponentially. This will lead to increased complexity and modelling risk.
The final obstacle worth mentioning is that no comparable history currently exists for many of these new ARRs, which will make back-testing almost impossible. As a result, data that is presently relied on to calculate volatility and convexity is going to need to be created. In addition, until new products are traded with increased frequency, implied data also will not exist. Hence products such as options, swaptions, etc. will be difficult to value.
What should users be doing to prepare for this transition?
All indications lead us to believe that a transition from LIBOR to SOFR is going to take place. The questions that are more uncertain are when it will take place and how it will unfold. At present, there are various pieces that are beginning to take shape.
First, various groups, such as the International Swaps and Dealers Association (“ISDA”), have been taking a more active role in the transition by focusing on fall-back language and protocols for derivative products. From a recent consultation, the ISDA has been crafting language to be implemented for new and existing LIBOR based instruments, thereby lessening the impact of a disruption should a triggering event, such as LIBOR cessation occur.
The other supporting event that has occurred is the advent of 1- and 3-month SOFR futures trading on the CME and the recent initialization of trading of SOFR swaps. Albeit, liquidity is limited on some of these instruments at present, comments regarding how the instruments were received has been positive and volume has been steadily increasing. The hope is that increased trading in these products will provide enough liquidity to achieve critical mass and to address pricing over the entire yield curve in less than two years, making the transition from LIBOR to SOFR more plausible.
All these positive steps do nothing to diminish the need for preparedness and planning, which should already be taking place. Recent surveys indicate that many companies are taking a wait and see attitude or are expecting the markets to sort it out prior to getting involved. This posture has many concerned in that it will only intensify the tipping point when it does arrive.
Companies should already be focusing on this topic. This would include performing a risk assessment and taking inventory of all of the current IBOR-based instruments in their portfolio, performing an assessment or impact analysis to understand any potential exposures, formulating a transition plan to be implemented (including the implementation of fall-back language and possible scenarios) and establishing policies and procedures to address the process going forward.
Read our full blog on the transition from LIBOR to SOFR on our US website.