The end of LIBOR is approaching, and despite the bombardment of emails, publications and media reports warning of this transition, many treasury teams are far from the finish line.
As every corporate treasurer should know by this point, the end of the London Interbank Offered Rate (LIBOR) is not just a problem for banks and investment firms. Any company that has issued LIBOR-based variable rate debt, entered into a swap or forward contract to hedge risk, or borrowed with LIBOR-linked pricing will be affected by the transition.
Navigating the path to a new interest rate benchmark should be a top priority for treasurers, as well as CFOs, CEOs and boards of directors, for the rest of the year. But where to start ?
Treasurers often need to look back and forward when analyzing the financial performance of their business. It would make sense to take the same approach to understand the details of how the LIBOR transition will happen.
The long road to transition
LIBOR underlies more than $ 200 trillion in financial instruments. The move away from the benchmark began following the global financial crisis. In 2017, the UK’s Financial Conduct Authority (FCA) made the official decision that all LIBOR parameters would cease to be provided by its administrators and that LIBOR would no longer be a representative benchmark rate after the end of 2021. Much of the transition has gone along its original timeline, with all but a few of the U.S. dollar (USD) denominated rates expected to be completely phased out by the end of this year.
In the United States, the LIBOR transition is being driven by the Alternative Reference Rate Committee (ARRC), a group of market participants brought together by the Federal Reserve and the New York Fed to ensure a successful transition from USD LIBOR to a more robust reference. rate. The ARRC recommended the Guaranteed Overnight Funding Rate (SOFR) as a replacement.
SOFR is a transaction-based rate that measures the day-to-day borrowing costs on transactions secured by US Treasury securities. Since SOFR is based only on guaranteed overnight rates, two key features of LIBOR are missing: a forward component (as in one-month, three-month and six-month LIBOR) and a dynamic credit spread. . These differences create challenges in the transition.
In May 2020, the ARRC has published best practice recommendations for completing the transition from LIBOR to SOFR for various classes of financial products. For business loans, the ARRC recommends that LIBOR not be used for origination or securitization transactions in the future (in particular, for any creation after June 30, 2021).
While some banks and corporations are prepared, many are still lagging behind. Some are also expressing concerns about the conversion, especially when a “SOFR term” has not materialized within the originally expected timeframe. The problem is that before banks and their corporate clients can use SOFR as a benchmark for a loan, they have to convert the overnight rate to a term equivalent.
Banks and treasurers currently have two alternatives to solve this problem. The first is the “in arrears” method for calculating SOFR, which bases the interest rate for each day of the contract on the compound interest of the previous days in the term of the contract. The obvious challenge with this approach is that instead of knowing their interest rate before the start of the interest period, borrowers using the “in arrears” method only know their real interest rate at the end. of the interest period. The second method of calculating SOFR is the “up front” method, in which the rate is determined by composing a historical rate prior to the interest period of the contract.
Based on anecdotal feedback in my discussions with Bloomberg corporate clients, these SOFR benchmark calculation options are a significant part of what has troubled corporate treasurers about the LIBOR transition. Since mid-2020, the ARRC has advised using the “in arrears” method for bilateral and syndicated loans, and the “upfront” method for inter-company loans. However, this approach creates an inconsistency that treasurers must balance. It also makes it difficult to know borrowing costs in advance with a high degree of certainty, which is problematic for treasurers accustomed to the clarity that LIBOR has provided for over 40 years.
Many treasurers are also concerned about the uncertainty surrounding the mechanical operation of SOFR in their systems. They wonder: how expensive and time-consuming will it be to implement different versions of SOFR? Will we have to rethink all of our systems? How much retraining will our staff need?
3 Steps to Alleviating Treasurer Transition Problems
With all of these complications, one can hardly fault corporate treasury teams for feeling lost as the transition draws to a close. To simplify the process, we recommend that treasurers take the following three steps:
1. Analyze all of your LIBOR exposures and supporting documentation. The first step in a successful LIBOR transition is to gather as much information as possible about your company’s exposure. If you haven’t started this process yet, now is the time to do it. From bonds to swaps to mortgages, exposures can arise in a wide variety of expected and unexpected places.
Equally important, treasury teams should analyze the documentation underlying these financial instruments. For bonds, sort the contracts. For swaps, carefully examine the fine print of the contract. Each instrument incorporates LIBOR in its own way, and some are easier to modify than others.
For example, if you have a centralized interest rate swap, the clearinghouse can unilaterally change the benchmark rate from LIBOR to SOFR or another successor. However, modifying an OTC derivative or variable rate loan may require approval from the loan counterparty or dozens of bondholders.
In this process, pay close attention to “fallback language,” the clause in the underlying securities contract that specifies how rates and payouts will be calculated if LIBOR stops publishing. Some contracts, especially those that are not written around guidelines set by associations like ISDA or LSTA, are vague on how it works or contain no provision. You can find this language by browsing the documents manually. Or you can save time by reviewing a centralized database for security fallback provisions.
2. Decide on your future financing costs. One of the biggest misconceptions among treasurers is that they have no choice. Although regulators have recommended SOFR as a replacement for LIBOR, they have also indicated that market participants are free to use alternatives, as long as benchmarks are based on solid transaction data and meet international standards. such as the IOSCO Principles for Financial Benchmarks.
Financial services companies have produced potential alternatives to SOFR that derive information from the same products that banks use to fund themselves – such as commercial paper, certificates of deposit, bank deposits, and short-term bank bonds – and maintain favorable aspects of LIBOR, including the term structure and the components of credit risk.
One such alternative is Bloomberg’s Short-Term Bank Yield Index (BSBY), which is intended to measure the average returns at which large banks access wholesale unsecured USD funding. The BSBY index is dynamic, it incorporates a sensitive element to credit and it reflects the marginal funding cost of banks over five different maturities (day to day, one month, three months, six months and 12 months).
Before choosing a LIBOR replacement, treasurers should understand the differences between the alternatives and compare their overall cost, including the variances that accompany each rate. The benchmark used by a company should match the organization’s LIBOR exposure profile, and it should be effective to implement and easy to explain to the management team.
3. Over-communicate throughout the process. Treasurers are likely to be called upon to oversee the LIBOR transition for their business, but it is important to keep in mind that a wide range of stakeholders inside and outside the business will be critical. to the success of the transition.
First and foremost, you need to make sure that the internal stakeholders of the business are aligned. This means close coordination not only with the management team (up to and including the CEO), but also with departments such as compliance, legal, IT, operations and investor relations. Additionally, if any of the company’s products are LIBOR-based, for example mortgages, the marketing and client / client teams should be added to the list of internal stakeholders that should be involved.
Once you’ve established an inclusive table within the company, turn your attention to external stakeholders. As a treasurer, you will have a direct line with your company’s financial counterparts, including banks, financial advisers, and stock exchanges. Make sure they are all up to date with your plans and provide you with the support you need during the process.
In addition, be sure to adequately disclose to your investors all the risks the organization will face during the transition. And let customers and clients know of any changes that may affect them.
2021 has been a year of transformation for the economy and for the financial markets. Nonetheless, the LIBOR transition may not be just one more item on the long list of business concerns for treasurers in 2021.
If not managed properly, moving to a new baseline could pose huge risks to your business. But if done right, it could help you pivot to 2022 on a confident financial footing.
David Mullen is a senior product manager for Bloomberg LP, focused on developing indexed products, including the Bloomberg Short Term Bank Yield Index, to support the LIBOR transition. Previously, he served as Senior Commercial Director for Bloomberg Fixed Income ETFs and ETF Trading Platform. Mullen has been with the company for over 20 years and was previously responsible for developing, improving and sustaining analytics, relative value, price discovery and other key fixed income features on the terminal. Previously, he spent several years as a trader and fixed income seller at several Wall Street companies including Deutsche Bank, Donaldson Lufkin & Jenrette and Prudential Securities.