A Smooth and Successful Transition Away from Libor
February 5, 2020
LIBOR is likely the most important reference index in the history of financial markets and it’s going to sunset at the end of 2021. It is integrally embedded, both visibly and obscurely, in a vast variety of financial instruments such as floating rate bonds, business loans, adjustable-rate mortgages, student loans, municipal bonds, interest rate swaps, and many varieties of insurance products, and derivatives. Per SIFMA, an estimated $200 trillion of financial contracts and securities are linked to USD LIBOR, and that matters to everyone. LIBOR based agreements affect banks, brokers, insurers, asset managers, REITs, and financial market participants including small businesses, corporations, consumers and investors. Only about 60% of these contracts and agreements will mature before 2021 and the remaining millions of agreements for $80 trillion will need remediation through fallbacks, negotiations, or litigation. Despite the mountain of inventory, new LIBOR activity continues unabated today.
In the U.S. in 2014, the Federal Reserve & New York Fed established the Alternative Reference Rates Committee (ARRC) to lead the transition away from LIBOR. The ARRC continues to lead the transition towards the Secured Overnight Funds Rate (SOFR). The regulatory pressures for the industry transition from LIBOR to SOFR create three fundamental challenges. First, SOFR is not conceptually, economically, transactionally, and legally equivalent to LIBOR. The change is much more than applying a simple conversion rate to the values in products to arrive at an economically equivalent contract. The transition will encounter significant challenges not only in financial adaptations but also in legal and counterparty engagements to modify contracts that reference LIBOR within the allowed timeline! Second, SOFR does not have a term structure yet; this will bring considerable costs and risks for financial firms with long-term implications since LIBOR is integral to all manner of financial activity and valuation frameworks. The transition will transform firms market risk profiles, requiring changes to risk models, valuation tools, hedging strategies, payment systems, product design, etc. Third, only the large and informed market players are moving fast and gathering necessary resources in advance; it is highly likely that late adopters will face higher costs to mitigate their internal risks before the sunset of LIBOR at the end of 2021. Given the volume of products and processes that will have to change, the transition away from LIBOR entails considerable work and risk. Preparations should start immediately.