RIP LIBOR: How to Prepare for SOFR
With the pending changes to the world’s principal rate benchmark, Financial Institutions must assess implications and prepare for ensuing operational and technological challenges.
Uncertainty looms over the $370 Trillion of financial contracts in multiple currencies that rely on the London Interbank Offered Rate (LIBOR) as benchmark. The UK Financial Conduct Authority (FCA) will no longer require participating banks to submit LIBOR after 2021. From mortgages to student loans, from government loans to currency swaps, financial institutions across the world must prepare for the potential dissolution of this unsecured rate.
History and Changes
LIBOR first originated in 1969 when Greek banker Minos Zombanakis used this new floating rate on an $80 million syndicated loan to the Iranian Government. One year later, LIBOR became the benchmark for bonds. By 1982, LIBOR was the interest rate used for approximately $46 billion worth of syndicated loans. On a daily basis, a panel of 11 to 18 banks publishes 35 LIBOR rates over five currencies (USD, JPY, GBP, EUR, and CHF) with seven different maturities (overnight, one week, and 1, 2, 3, 6 and 12 months). Participating banks include Barclays, Credit Suisse, Sumitomo, Deutsche Bank and Bank of America.
More recently, because of the increased regulatory scrutiny following the financial crisis of 2007-2008, the volume of interbank commercial paper and unsecured deposits, which is critical for the calculation of LIBOR, decreased drastically. Despite the fact that daily three-month interbank trading determines the rates behind $200 trillion worth of USD contracts, the volume of these transactions is currently only about $500 million. This lack of liquidity compels banks to often use “expert judgement” to form their submissions, which facilitated the manipulation of the rate for proprietary gains, as demonstrated in the LIBOR scandal revealed in 2012 (see exhibit A for the calculation breakdown). Settlements related to the rate manipulation have cost financial institutions over $9 billion in fines.
An independent review of LIBOR by Martin Wheatley, then Chief Executive designate of the FCA, identified a strong lack of oversight and governance on the administrative body of LIBOR. Consequently, as of February 2014, the Intercontinental Exchange or ICE Benchmark Administration (IBA) replaced the British Bankers Association as the LIBOR administrator. ICE is an American company that owns and operates electronic exchanges for financial and commodity markets. Since then, the IBA has sought to maintain LIBOR relevant past 2021 by implementing positive changes, such as improving the LIBOR calculation methodology and instituting procedural revisions. However, alternative rates have been devised for all LIBOR currencies.
Exhibit A: ICE LIBOR Quarterly Volume Report:
ARRC, SOFR, and other Alternative Rates
In the US, the Federal Reserve Board designated the Alternative Reference Rates Committee (ARRC) the responsible body for identifying and facilitating the transition to the alternative rate for the USD LIBOR.”. On June 15, 2017, ARRC, which consists of private market participants and regulatory bodies (including the Bureau of Consumer Financial Protection, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of Financial Research, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, the Securities and Exchange Commission and the U.S. Treasury Department), selected the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR. As the name indicates, this rate differs from LIBOR because the SOFR transactions are backed by Treasury securities as collateral, whereas LIBOR uses an unsecured rate. Therefore, SOFR is an intrinsically lower rate than LIBOR. ARRC also published the Paced Transition Plan (PTP) with specific steps and timelines to facilitate adoption to SOFR.
Although SOFR has a deep, liquid market for overnight transactions, a “SOFR term reference rate” has yet to be developed. May 2018 marked the first trading session for SOFR futures, paving the way for a robust SOFR curve, which AARC expects will be fully developed by the end of 2021. SOFR behaves quite differently from LIBOR due to its risk-free nature. In order to accommodate for the lack of bank credit risk in its calculations, AARC is considering the concept of developing a Credit Spread Adjustment (CSA). There are currently three potential methodologies for the CSA:
Static CSA: measure the gap between LIBOR and SOFR at a time period around cessation, to be kept constant;
Dynamic CSA: ongoing gap measurement between the two rates; or
Dynamic CSA with “break the glass” component: Static CSA with the potential of an additional spread during periods of credit stress.
While AARC has selected SOFR as the alternative or backup rate for the USD LIBOR, market participants across the globe are working to develop potential substitutes for all LIBOR currencies. Fundamental differences between these rates create new challenges for financial institutions, who will have to coordinate across jurisdictions for multicurrency contracts.
Exhibit B: ‘Fallback’ or Alternative Rates:
Preparations for Alternative Rates
As the IBA diligently works to reform Libor in an attempt to maintain it as a relevant term rate, market participants must weigh three potential scenarios after 2021:
|a.||LIBOR regains its reputation and continues as the primary term rate;|
|b.||LIBOR continues to be submitted, but losing influence to alternate rates; or|
|c.||LIBOR ceases to exist and is fully substituted by its currency-specific alternatives.|
Whereas only time will tell how LIBOR is perceived after the FCA stops mandating its submission, market participants must account for potential changes and operational challenges in order to prepare for the cessation of LIBOR.
Given manipulation scandals and lack of confidence in current LIBOR rate calculations, the Federal Reserve Board and other international governing bodies have proposed different rates to potentially substitute LIBOR in its multiple currencies. Changes to key benchmark rates can and will be disrupting to business operations, so it is critical that Financial Institutions have a thorough understanding of potential future scenarios, the impacts to their portfolios and operations, and how to adapt accordingly. Proposed alternative rates, while less reliant on subjective calculations, behave differently from existing LIBOR rates and will require appropriate adjustments in order achieve a seamless transition.
Sia Partners’ Added Value
Sia Partners is a unique management consulting firm and a pioneer of Consulting 4.0. Through unparalleled expertise in the Lending industry, we deliver superior value by providing the following services for our clients:
- Independent impact assessments to identify products, lines of business, reports and portfolios affected by changes to LIBOR;
- Review of bank’s control functions and credit policies and procedures;
- Evaluation of the LIBOR portfolio management process;
- Assessment of credit agreement amounts, terms and covenants;
- Guidance through ARRC’s Paced Transition Plan for SOFR adoption;
- Amendment of loans documentation to determine the new reference rates and trigger events (i.e., LIBOR cessation); and
- Implementation and upgrades of origination and Loan Accounting platforms, including pricing formula and automated pricing updates.
- Although IBA remains firm on keeping LIBOR relevant and active beyond 2021, global market participants and regulatory bodies are working towards developing potential substitutes for all LIBOR currencies.
- Financial Institutions must prepare their Loan Accounting platforms to accommodate for large scale rate changes.
- Independent review of LIBOR portfolio and operational changes carried out by an independent consulting firm is highly recommended.