The LIBOR Transition:
Five Things to Know Now
Since its establishment in 1986, the London Interbank Offered Rate (LIBOR) has come to occupy a critical role in the valuation of financial instruments and the functioning of capital markets.
Today, it is the base benchmark for $400 trillion in financial products, including debt instruments and interest rate derivatives.1
Industry concern that the calculation of LIBOR was based off an inadequate number of underlying transactions has led to the passage of several reforms. In July 2017, Andrew Bailey, chief executive of the Financial Conduct Authority (FCA), announced the FCA would no longer compel banks to submit quotes for LIBOR after 2021.
At State Street, we are actively engaged with our clients, regulators and industry associations to plan for the upcoming retirement of LIBOR and navigate the path forward. To further advance this vital dialogue, we convened industry experts to discuss the key challenges and opportunities presented by the end of LIBOR.
Here are five key takeaways from our industry panel discussions in July 2019.
1. Avoid a wait-and-see approach
The most important message reverberating through our discussion is that financial organizations must start looking at their exposure to LIBOR now. Market participants must identify and disclose any LIBOR-related issues, and should stop relying on LIBOR. For organizations that don’t have that option, appropriate fallback contract language will be essential. Even though a “hard stop” for LIBOR has not been set, there must be critical mass in products using LIBOR replacement rates for liquidity to exist in the market. And with Rule 22e-4 live now in the US, funds need to consider whether the new rates could alter the effectiveness of their liquidity risk management programs.
2. Disclosure, disclosure, disclosure
The transition away from LIBOR is complicated. That’s why the SEC recommends that asset managers tailor prospectus disclosures now to address how the LIBOR transition will impact a funds’ valuation. Generic disclosure language will not be enough. The SEC is already scrutinizing this issue and it will continue to be an area of focus.
3. SOFR has the momentum, but it’s not a silver bullet
In 2017, the Alternative Reference Rates Committee, (ARRC) identified the Secured Overnight Financing Rate (SOFR) as the preferred replacement for LIBOR in the US. Our panelists agree that SOFR has seen rapid momentum. The notional value of SOFR-linked products grew from less than $100 billion in May 2018 to over $9 trillion as of April 2019.2 By converging around a standard rate, the industry is in a better position to avoid the risks of a fragmented market. That said, SOFR can’t solve for everything and other rates may be appropriate for specific products.
4. Put the new rate through your ‘pipes’
There will be bumps in the road as organizations transition away from LIBOR. Take action now and test how the new alternative reference rates function in your systems to have a better understanding of how the rate works and what gaps need to be filled. Besides assessing exposures to LIBOR, you’ll want to consider accounting and tax implications, contracts, IT systems, communications and third-party vendor readiness to name a few.
5. Be part of the conversation
The industry will need to engage in continued open dialogue with peers, regulators and industry associations to understand what the challenges are and how best to solve them. More voices in the conversation are a good thing. The SEC has issued guidance, and ISDA can offer resources for amended, restated rate options, but their assistance can only take us so far at this point in time. For an orderly transition away from LIBOR, the lines of communication across all market participants must stay open.
We hope you find these insights helpful as you consider your own firm’s future in a post-LIBOR world.
1. BIS Quarterly Review, March 2019
2.SIFMA Insights: Secured Overnight Financing Rate (SOFR) Primer, July 2019