Life after LIBOR?

Why are LIBOR’s days numbered?

The alleged manipulation of Interbank Offered Rates (IBORs) such as the London Interbank Offered Rate (LIBOR) revealed fatal flaws in the system and raised doubts as to its ability to react to stressed market conditions – and effectively spelled the beginning of the end. With the expected discontinuation of LIBOR at end-2021, concerted efforts are under way to prepare for its cessation. 

National working groups and industry organizations are developing alternative reference rates (ARRs) and templates for amending the contracts tied to LIBOR corresponding to outstanding positions of at least USD 260 trillion. Organizations that have grasped the immense implications have already started to give serious thought to preparing the transition.

In this blog we’ll outline the issues and how you can respond. The guidance is drawn from PwC’s new paper “Farewell LIBOR: Transition to alternative reference rates for new and legacy contracts”, which is well worth a read if you want a more in-depth understanding of the issues and how to resolve them.

What’s to be done?

Assess the work involved

First you need to work out the budget, time and headcount you’ll need to ensure a smooth changeover to a world without LIBOR – including the work involved in amending contracts – by assessing your exposure to LIBOR, the number of legacy contracts affected, the types of products impacted, and the fallback provisions in place. At the same time you should already be avoiding increasing your LIBOR exposure. You can do this by referencing alternative rates when issuing products or entering into new contracts maturing beyond 2021.

Find out about the alternatives

Secondly you need to familiarise yourself with the ARRs being proposed – and understand their characteristics and how they differ from LIBOR. Working groups in the EU, Japan, Switzerland, the UK and the US have identified the following ARRs for LIBOR :

• Switzerland: The Swiss Average Rate Overnight (SARON) has been chosen as the preferred ARR. SARON based futures, options and cross-currency basis swaps are currently being designed, and five different SARON-based methodologies to calculate CHF reference interest rates with a maturity beyond overnight are being assessed.
• EU: The working group in the EU has recommended the Euro Short-Term Rate (ESTER) as the ARR and is exploring possible approaches for ensuring a smooth transition.
• US: The designated ARR is the Secured Overnight Financing Rate (SOFR). SOFR futures have already been launched.
• UK: The Sterling Overnight Index Average (SONIA) has been chosen as ARR, and corresponding futures have been launched.
• Japan: The study group responsible has identified the Tokyo Overnight Average Rate (TONAR) as the preferred ARR and has drafted a guide on Japanese Yen Overnight Index Swaps. The next step will be to establish a new body to continue with the Japanese benchmark reform.

Be aware of the differences

There are some major differences to bear in mind:

• LIBOR is a forward-looking rate with a range of seven maturities; the ARRs are backward-looking overnight rates.
• LIBOR is reflecting interbank lending and thus factors in bank credit risks, while the ARRs are near risk-free.
• There are inconsistencies between the ARRs. For example SARON and SOFR are secured rates, while ESTER, SONIA, and TONAR are unsecured rates.

What’s next for the national working groups and industry organizations?

One of the major challenges that still has to be tackled is to adjust the designated ARRs to fit the needs of the financial markets. Although this topic is mainly driven by national working groups and industry organizations, it’s important to keep track of these discussions, because the outcome will likely have to be included in contracts tied to LIBOR.

What’s next for organizations?

An ISDA survey shows that while organizations are worried about their exposure to LIBOR and similar benchmarks and are aware of the need to transition to ARRs, their actions don’t yet match this concern.

Contract management is key to a smooth transition. Many companies assume that existing contractual fallbacks will ensure that positions will continue as intended. That’s not the case. Be aware that fallback clauses already built into existing contracts may not be robust enough to enable a smooth transition in the absence of LIBOR. You need to take an inventory of your existing contracts, analyse them carefully, and make amendments to prevent disruptions.

Even though generic template wordings for some instrument types such as derivatives, syndicated loans, bonds, floating-rate notes and securitizations should be available in time for the transition, don’t underestimate the work involved in the contract management process. There are a number of potential pitfalls to keep an eye on, including mismatches in hedging mechanisms, loss of grandfathering status, and accounting and tax implications. Remember it’s also important to identify dependencies between contracts.

Another point to bear in mind is the upcoming replacement of other IBORs, such as the Japanese TIBOR and the euro zone’s EURIBOR. It might make sense to include these IBORs in your transition efforts, especially when it comes to reviewing existing contracts and creating an inventory.

Help!

Sounds confusing? Not necessarily. While it’s important not to underestimate the effort involved, there are commonsense approaches that will help you get an overview and manage a smooth transition to a world without LIBOR. Here are some useful steps to consider:

• Define the scope of the project and clarify whether other IBORs are to be addressed along with LIBOR.
• Consider integrating the LIBOR transition with ongoing projects related to benchmark regulation.
• Set up good project governance and identify the departments impacted, define the stakeholders responsible, calculate the resources required, and set milestones and a timeline.
• Avoid increasing your exposure to LIBOR by entering into new contracts or issuing products referencing ARRs.
• Take an inventory of contracts tied to LIBOR, differentiating them according to the 2021 cut-off date and according to the fallback provisions in place.
• Assess dependencies between contracts and understand their nature and the impact of a transition away from LIBOR.
• Reach out to counterparties early on to facilitate the process of amending contracts.
• Monitor developments at industry organizations such as the ISDA, AFME and LMA, and at national working groups.