The first step is to identify the population of contracts impacted. LIBOR may be referenced in a wide variety of contracts, including lending arrangements, leases, procurement contracts, or in a late payment penalty provision in virtually any contract.
Developing a comprehensive list may be challenging as contracts may not be homogeneous or centrally stored. Once a list is developed, a company can begin the intensive task of negotiating amendments to contracts. These amendments will likely need to be tailored across different contract types.
Adding to the complexity is that some instruments, such as public debt and securitization issuances, may have numerous and/or unknown counterparties that require additional outreach and consideration of counterparty rights to remediate. For example, some instruments may require unanimous agreement of amendments by counterparties.
In addition, counterparties may seek to use LIBOR transition as an opportunity to negotiate additional amendments to the agreements.
As 2021 draws closer, the trading volume of products linked to LIBOR is expected to decrease. The decrease in market activity will reduce liquidity and may make it harder or more costly to exit these positions.
Further, the gradual decrease in liquidity will mean various changes to risks in company portfolios between now and the end of 2021. Developing a new financing and investment strategy will be an evolution, and development of these strategies should begin now.
Basis risk and Value transfer
Companies are likely to experience some degree of value transfer as a result of amendments to replace LIBOR. For example, the parties to a LIBOR-indexed contract may agree to apply SOFR plus or minus a fixed spread. Although amendments may have been made with the objective of the transition being value-neutral, by the time of transition, the contract’s value will likely change because:
- there may be timing differences between when negotiations are complete and the change to SOFR occurs,
- practical expedients may be necessary given the potential complexity with calculation; for example, the specified spread may be based on a historical average rather than the actual spread between LIBOR and the ARR, and
- the term structures of LIBOR and the SOFR are different.
Basis risk arises if two contracts that had similar payment terms no longer match. This could occur when debt and a derivative used to hedge the debt migrate from LIBOR to SOFR at different times or with different terms.
Strategies to mitigate these risks may include executing additional derivatives to hedge the difference between the rates.
Companies need to develop LIBOR transition plans and proactively communicate with regulators, investors, lenders, customers, and other counterparties.
- Regulators have made it clear they expect thoughtful transition plans and disclosures to address the risks of LIBOR transition.
- Communication of a clear understanding of exposure and a plan for transition is important for investor confidence.
- Financial services and other companies will need to develop a plan to manage their business conduct with customers impacted by the change. The plan should include oversight and controls of those business units that interact and negotiate with customers.
Operational and technology risk
The introduction of ARRs may necessitate large-scale and potentially costly changes to models, data, and technology. Companies will need to:
- inventory models across all departments that rely on LIBOR for updates and obtain appropriate approvals of any model changes,
- assess new ARR data needs and determine how and where to source those data elements, considering evolving capabilities of third-party vendors, and
- enhance current systems, whether internal or external, that may not be equipped to support contracts referencing ARRs.
Many of these potentially large scale changes could require a long runway to implement, especially when considering requisite process and controls changes.
Financial reporting and tax risk
Contract amendments typically require a company to determine whether the change results in a taxable event or has a financial reporting impact, such as hedge dedesignation or debt extinguishment. Regulators and standard setters have proposed targeted relief from certain financial reporting and tax impacts for transactions that fall within stated parameters. Companies need to assess how the guidance will apply to their facts and circumstances, and should not assume blanket relief. In addition, companies or counterparties may use this as an opportunity to make other contract changes. These additional amendments may impact whether the transaction qualifies for relief.
There may be impacts to the fair value hierarchy from the reduced observability of LIBOR transactions. For example, today, an instrument measured at fair value using LIBOR as a significant input may be a Level 2 investment, but as LIBOR becomes less observable, it may become Level 3.
Finally, the SEC continues to remind companies to include relevant disclosures related to the expected discontinuation of LIBOR as appropriate within risk factors, management’s discussion and analysis, board risk oversight, and the financial statements.