Breakups can be messy and switching from the London Interbank Offered Rate (LIBOR) to alternative reference rates (ARRs) will be no exception for trading, operations, fintech, risk and compliance managers in 2022.
An ounce of preparing next year can translate into a pound of preventing errors in 2023, caution LIBOR operations and legal experts who offered FinOps Report a three-step best practice approach for the transition. Over US$350 billion notional exposure across derivatives, bonds, loans, and other instruments will be impacted by the elimination of LIBOR as the world’s most important benchmark after regulators decided it helped create the 2008 financial crisis and led to scandals involving manipulation by rate-setting banks.
ARRs are considered more difficult to manipulate than LIBOR, because they are based on actual transactions rather than estimated borrowing rates. However, the benefit comes with a steep cost; the change to ARRs will cause angst for buy and sell-side firms as replacing LIBOR isn’t as simple as replacing a number. “The value of the assets affected, and other agreements must remain constant, and the ARRs are not identical to LIBOR,” explains George Bollenbacher, president and owner of financial services consultancy GM Bollenbacher & Co in New York specializing in LIBOR transition projects. “Performing the right calculations and making the right judgement calls on what changes to make will be critical to preventing conduct risk– the potential for investors and counterparties to be worse off with the ARRs.”
As of December 31, US dollar-denominated financial instruments and contracts with a two week or one month tenor can no longer count on LIBOR as a benchmark and neither can all non-US dollar denominated financial instruments, As of June 2023, LIBOR will cease to exist for the remainder of US-dollar denominated contracts and will be replaced by the Secured Overnight Financing Rate (SOFR)– a daily rate based on the cost of overnight borrowing, with US Treasury securities used as collateral.
Financial firms borrowing, lending, or investing in currencies other than US dollars will need to transition to alternative rates which have their own characteristics, different start dates and different liquidity. Among the other ARRs that will go into effect as of early 2022 for non-dollar denominated contracts are the Bank of England’s Sterling Overnight Index Average (SONIA), the Tokyo Overnight Average Rate (TONAR), the Swiss Average Rate Overnight (SARON), and the Euro Short-Term Rate (ESTR). Hopefully, most contracts relying on LIBOR as a benchmark will have matured by June 2023, but if financial firms and corporations continue issuing financial contracts using LIBOR an estimated 30 percent of all outstanding contracts could be affected.
After speaking with operations and legal experts, FinOps Report has devised a three-step plan to ease the pain of transitioning away from LIBOR. The plan falls under the acronym SEA, reflecting the sea of change and incorporates recommendations made by the US Alternative Reference Rate Committee in 2020 which focus on SOFR as a replacement benchmark.
Search: As the world’s largest reference rate, LIBOR can be found in a multitude of places, not just financial instruments. “Bond indentures for corporate and other fixed-income instruments cite LIBOR and so do agreements for syndicated loans,” says Venetia Woo, global LIBOR transition advisor at global consultancy Accenture. “Over-the-counter derivative contracts, such as interest rate swaps, also mention LIBOR.”
Other contracts shouldn’t be overlooked such as those between fund managers and custodian banks about cash collateral reinvestment, securities lending, and sweep account fees. Stacey Tecklin, special counsel in New York at the law firm of Katten Muchin Rosenman, cites the example of a late dividend payment made by a custodian bank to a fund manager client that is tied to LIBOR as one unique example of LIBOR’s use. Once the LIBOR-linked contracts are identified, financial firms must look up the counterparties and investors to address the affected contracts and steps for remediation. “We can’t wait for counterparties to call us first so we have been proactive in reaching out to them ahead of time with our proposed transition plans,” says one operations manager at a US fund management firm.
Evaluate: Not all contracts explain just what will happen when LIBOR ceases to exist and even the ones that have fallback language may not be crystal clear as to what alternatives are available. “Syndicated loan market participants should be actively evaluating existing credit agreements for LIBOR replacement options as loan margins and interest rates are directly tied to an investor’s rate of return,” explains Tecklin. She cautions that there are smaller, more isolated contracts that are also impacted by LIBOR’s transition.
In the case of OTC derivatives, the trade group International Swaps and Derivatives Association (ISDA) has come up with fallback language for those which don’t have some fallback provisions. The protocol applies a set of provisions to transactions which introduce a switch mechanism and will automatically apply to all OTC derivative transactions issued after January 25, 2021, unless excluded. When swap contracts don’t rely on the ISDA’s transition protocol, counterparties must adjust the contract so that the economic terms of the contracts don’t change. If both sides can’t agree on the new terms, the contract could end up being unwound or monetized. Some legal experts predict there will be an uptick in litigation even with fallback language because the provisions may not work in practice. Many are temporary fixes designed for a brief cessation of LIBOR’s publication and a counterparty may renege on applying fallback language on the basis it will be economically harmed.
In April 2021 New York, under former Governor Andrew Cuomo, adopted legislation that would allow existing financial contracts without fallback provisions to use replacement indexes recommended by regulators with a “safe harbor from litigation.” The New York measure establishes SOFR as the replacement by “operation of law” and provides for a set adjustment recommended by the Federal Reserve Board, Federal Reserve Bank of New York, the Alternative Reference Rates Committee (ARRC) or any successor. However, the legislation is limited to contracts established under New York law.
Adjust: Once financial firms have located the LIBOR–affected instruments and contracts, they must determine how they can be tweaked. LIBOR is quoted to include bank credit risk and a liquidity premium based on the relevant term. Because they are overnight rates, the alternative rates do not have such elements. “Regardless of what rate is chosen as an alternative rate to LIBOR, there will need to be an adjustment for the difference between LIBOR and the alternative rate,” explains Madhukar Ramu, head of data strategy and global operations for corporate actions at data and post-trade processing giant IHS Markit. The task isn’t a one-off responsibility for operations managers. “Calculations for spreads added to account for credit quality must be done daily and adjustments made when floating rates are reset,” says Bollenbacher.
In most cases, issuers of bonds will need the consent of bondholders to make any changes to their indentures even if they have fallback provisions. “Issuers must propose the adjustment based on the fallback language when seeking consent, which might need to be unanimous or majority-based depending on the terms of the indenture,” says Ramu. When consent doesn’t happen, issuers might resort to either exchange offers or redemptions leaving fund managers to decide on the best option to select. Borrowers and lenders can negotiate on new terms for syndicated loans using framework provided by the US trade group Loan Syndications and Trading Association (LSTA). “While some credit agreements are relying on the amendment approach to adjust to new rates, many new syndicated loan originations can address post-LIBOR benchmark rates using the LSTA’s methodology and option of Term or Compound Daily SOFR, either with a built-in adjustment spread or a spread to be determined at the benchmark transition date,” says Tecklin.
It will likely take a village of experts at fund management firms, banks and broker-dealers to figure out just how to handle the multitude of downstream changes, apart from the trading desk, the transition away from LIBOR will require. Changes to new alternative rates could impact financing products, balance sheets, income statements and hedging strategies. Therefore, trading. Treasury, and accounting platforms which relied on the legacy LIBOR will need to be recoded. “Over two dozen applications must be changed at our firm as the transition will have a widespread effect on front, middle, and back offices,” one operations manager at a US broker-dealer tells FinOps Report. Financial firms depending on external vendors for some functions will need ask them about their transition plans to ensure they will be in sync.
While accuracy is critical to shifting away from LIBOR to ARRs, so is continuity. ‘The challenge will be ensuring business as usual for customers and counterparties amidst all of the operational and product changes,” say Woo. The right technology and data can ease the transitional burden and there are plenty of third parties targeting specific areas to reduce time and error. Global consultancy PwC says that its Model Edge platform customizes automation solutions for model development, validation, and documentation. SS&C Technologies’ Intralinks subsidiary has a VDR platform which centralizes, indexes, encrypts, and classifies all potentially affected loan contracts using artificial intelligence. CME Group says its triReduce platform can reduce gross exposure to legacy benchmarks for OTC derivatives and can convert the remainder into ARR benchmarks. Bloomberg Index Services has started calculating and publishing the fallback ARRs for OTC derivatives covered by ISDA’s Master Agreement while the LSTA publishes SOFR documentation outlining various types of SOFR-based US dollar credit facilities and risk-free based multicurrency credit facilities which use an in arrears benchmark. IHS Markit also provides LIBOR replacement data for syndicated loans that address rate info in credit agreements.
However, without the right governance structure in place, misconduct can occur. “There are still too many firms dragging their feet or thinking the June 2023 deadline will be extended,” warns Bollenbacher. The UK’s Financial Conduct Authority and the US Securities and Exchange Commission warn that their examiners are closely watching how financial firms transition to LIBOR, so now is the time for firms to create a transition team, if they haven’t done so already.
“The LIBOR transition program needs to include all the key stakeholders on board from the front office trading and risk desks to middle office valuations and marketing departments which must handle client communications,” recommends Woo, who cites two ways to measure success in transitioning to new ARRs. The economics between the legacy LIBOR and ARR-linked products must be equivalent, she says. In addition, clients and internal counterparties must be updated and able to support the new ARR-linked products. With so many roles and activities affected, it will take the right change management approach to ensure an error-free transition.