Uncertainty surrounds the shift from LIBOR to SOFR

The end of 2021 will mark a milestone in global financial markets when regulators, in effect, phase out the “LIBOR benchmark” that underpins much of the global financial system

Most financial services firms in the US are not ready for the transition from the London Interbank Offered Rate (LIBOR), according to recent findings published by SRS Acquiom and based on a survey of investment banks, hedge funds, fund managers, distressed debt funds, direct lending funds and business development companies.

According to the survey, 46% of respondents say their organization is “not well prepared” for the switch from LIBOR to a new dollar reference rate, and 35% claim they are only “somewhat well prepared.” Barely one in five believe they are ready.

The shift to SOFR in the US

For dollar transactions, the Secured Overnight Financing Rate (SOFR) was selected to replace LIBOR across the board by the Federal Reserve Board-led industry group, the Alternative Reference Rates Committee (ARRC). The Federal Reserve Bank of New York, which has published the daily rate since 2018, describes SOFR as “a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.”

In the long term, SOFR is a good alternative for the market to LIBOR because it is determined based on a large volume of actual transacted rates and thus is harder to manipulate than the scandal-prone LIBOR benchmark. But, in the short term, it may also increase risk, uncertainty and friction between different market players.

LIBOR and SOFR are fundamentally different. The former represents a forward looking unsecured rate while the latter is a fully secured overnight rate that will likely be lower on most days than the LIBOR rates it replaces.

The ARRC and market participants hope to correct this mismatch through a spread adjustment. This adjustment will be reflected by an extra number of basis points added to the SOFR rate when contracts are converted from LIBOR to SOFR. However, this transitional approach is presenting problems of its own.

First, although the ARRC continues to take positive steps to prepare the market for the benchmark transition, it has yet to decide on a comprehensive methodology for this spread adjustment. Second, many buy-side institutions, which borrow money at floating rates linked to dollar LIBOR, are skeptical that the ARRC will establish a spread adjustment they deem fair. Many members of the ARRC are large sell-side institutions that face both sides of the market and therefore are more immune to the spread adjustment.

The necessity of a spread adjustment also highlights the importance of “papering” contracts, whether drafting new contracts or master agreements that can accommodate the transition to a new reference rate in the future or amending existing contracts in anticipation of this transition. This is a significant task, and, as institutions delay their work, they risk being unable to fully address, in a timely manner, the many risks the transition presents before the 2021 phase out of LIBOR.

Derivatives and contract language

Derivatives are often used to hedge lenders’ or borrowers’ exposure to LIBOR fluctuations, and LIBOR replacement creates issues unique to the derivatives markets. Consider a company that decides to switch its lending or borrowing to SOFR. At the moment, it is more expensive to hedge this exposure using SOFR-linked derivatives because liquidity for the newly tracked SOFR is still thin.

The transition itself also creates potential basis risk arising from the possibility that the hedge and the related floating rate LIBOR debt may transition at different times or to a different rate, and that different adjustments might apply. In theory, companies could hedge this basis risk through a tailored swaps contract with a bank. But, in practice, banks are reluctant because they cannot hedge their own basis risk in the wider market.

The way forward

To address these problems, financial institutions and corporates should proactively prepare for the LIBOR transition. At a minimum, this preparation should include the following. They must assess the different risk exposures across the institution as to both new and existing transactions that will survive the 2021 transition. This includes taking a full inventory of the transactions and the accompanying contracts and agreements that need updating. In addition, they must identify and quantify any potential risks that those amendments may involve. They must also decide the best way to mitigate those risks and implement a detailed strategic plan to do so. Finally, they need to ensure that the risks and mitigation plans are communicated throughout the organization to ensure it is prepared as a whole. This is especially important in large institutions with multiple departments and offices.

For buy-side institutions, it makes sense to avoid the temptation to set everything in stone before the post-LIBOR landscape is fully understood. Many are already rejecting a “hardwired” approach, where clauses are added to preexisting and new contracts under which parties agree to abide by whatever spread adjustment the ARRC may choose.

Instead, institutions are more frequently taking a “fallback” approach, inserting clauses saying, more vaguely, that the parties will agree at a later date on the new rates and spreads to be used once a LIBOR phase out occurs. According to the study by SRS Acquiom, 63% of respondents favor this more flexible approach, where the agent selects the successor rate, subject to lender and borrower consent, rather than explicitly identifying a rate in the amended contract.

This does not mean those affected by the transition from LIBOR should adopt a wait-and-see strategy. Instead, as discussed above, each institution needs to keep its collective finger hovering over the fast-forward button, so that it can react rapidly to minimize risks once it has the information it needs.

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