Publication of the familiar LIBOR (London Interbank Offered Rate) is likely to cease at the end of 2021. However, an uphill battle remains to transition the 100s of trillions of LIBOR linked dollars to alternative Risk-Free Rates (RFRs). Coordinated action from both market participants and regulators is required to avoid a major market disruption.
Where do we stand?
- Working groups have been established for the five LIBOR currencies, each having selected a replacement overnight RFR
- The selected RFRs differ from LIBOR in several material aspects and now the focus is on how to manage those differences and solidify the transit
The majority of new interest rate related business continues to reference LIBOR rather than RFRs, particularly USD exposures and global loan markets. New products using RFRs are not yet mature or liquid and few legacy transactions have been transitioned. Progress has been held back by uncertainties around where and whether term RFRs or alternative credit sensitive benchmarks will be available.
The industry will likely struggle to transition legacy positions if meaningful volumes and liquidity have not developed in the alternative rate markets, increasing the risk presented by LIBOR discontinuation.
Parties to LIBOR linked contracts face unpredictable transfers of value, even with the adoption of new fallback clauses which aim to, but cannot guarantee to, mitigate value transfer upon LIBOR discontinuation.
Differences: LIBOR vs RFRs
LIBOR is a forward-looking term rate, meaning that the rate of interest is fixed and publicly available at the beginning of each interest period, and is quoted for a range of different maturities. Term rates allow users to manage their cashflows by providing them with visibility into their future financing costs.
By contrast, RFRs are backward looking, overnight rates. This means that interest must be calculated daily based on the relevant overnight rate and, whether it is paid daily or aggregated and paid at agreed intervals, the parties cannot calculate the amount due in advance. This lack of visibility is problematic for cash products, such as loans.
The economic difference between LIBOR and the replacement RFRs ultimately means that any transition will be much more complicated than a simple administrative change in the benchmark rate. Adjustments will be needed in order to minimise the economic impact of the transition, most likely by including a risk premium. The calculation of this risk premium is further complicated by the fact that the historical spread differential between RFRs and their corresponding LIBOR rates has not been a fixed constant but has varied over time.
The transition will also impose additional demands on market participants and their operational systems. Any operational changes will likely take several months to implement and could involve significant costs.
What does this mean for me?
The majority of new interest rate related business continues to reference LIBOR rather than RFRs. However, traction is slowly growing with several RFR linked bilateral loans being signed since 3Q19. In Europe, the focus to date has been on increasing flexibility to agree amendments in the future, whereas, in the US, the Alternative Reference Rates Committee (ARRC) has released recommended contractual fallback language to be added into documentation now, thus avoiding the need for amendments in the future.
Unlike hedging agreements (which can utilise ISDA amendment protocols), loan agreements cannot be amended wholesale and must be addressed on a loan by loan basis.
In Europe, most loan agreements that mature after 2021 contain Loan Market Association (LMA) benchmark fallback language, which would apply in the event of LIBOR being suspended. However, these are intended to apply on a temporary basis only and are unlikely to be suitable for a permanent discontinuation
In contrast, in the US, most loan agreements fall back to the US Prime Rate, if LIBOR ceases. This rate is generally significantly higher than LIBOR, creating additional credit risk for borrowers.
Existing Derivative Trades
The fallback provisions for derivatives are almost exclusively linked to ISDA. In the 2006 ISDA Definitions, if the applicable -IBOR does not appear on the specified screen, the calculation agent must obtain quotes from four major banks in the relevant interbank market. This fallback language does not provide a practical long-term solution.
What can you be doing now?
- Collect and inventory your existing LIBOR linked products (loans and hedges)
- Start conversations to renegotiate your existing LIBOR linked contracts to reference an alternative rate where possible
This will help reduce the use of existing fallback clauses if/when LIBOR is discontinued. Relying on existing fallback clauses to transition from LIBOR creates major operational, credit, and unforeseen risks.
- 3Q 2020 – Issuance of GBP LIBOR linked cash products maturing beyond 2021 ceases
- 2H 2020 – US Central Clearing Counterparties (CCPs) switch from LIBOR to SOFR discounting
- 4Q 2021 – The ARRC expects a term structure for SOFR
- 4Q 2021 – Publication of LIBOR likely to cease
From a risk management perspective, the LIBOR transition and phase out introduces additional uncertainty to an already uncertain world. It is never too early to start considering the effects on your portfolios. If questions arise, Validus is here to help navigate the path forward.
Author: Richard Hall