By now, you probably know that the London Interbank Offered Rate (LIBOR) is well on its way to being phased out after a multi-year effort by regulators and others to migrate toward more objective benchmarks. The change requires significant effort because LIBOR has underpinned our modern economy for decades. In our February 23, 2021 webcast, we discussed the state of the transition with practitioners who are responsible for making the switch in their own organizations, including topics such as:
As of the webcast date, we were awaiting an imminent announcement on LIBOR’s cessation timeline from its administrator, ICE Benchmark Administration, and its regulator, the Financial Conduct Authority (FCA). This notice would codify transition dates and fix the calculation of the spread adjustment intended to account for economic differences between LIBOR and its risk free replacement rates. But as a practical matter, industry participants are already working as if the contents of the formal announcement were known.
It appears that most industry participants support the announced cessation dates. Still, as all new USD transactions are expected to move to a different ARR by the end of 2021, it’s surprising that ARR-based lending has been so limited until now — especially as 2020 saw nearly USD$1 trillion of investment-grade and leveraged-lending issuances, many of which were LIBOR-based.
One issue for corporate borrowers: participating in new loan products with a new ARR will present new funding cost management risks simply because of the immaturity of the cash and derivative market. There are other limiting factors affecting both borrowers and lenders: economic fallout from the pandemic, technology adaptations that remain in development and some vendors that have been slow to adopt SOFR while the industry waits for more clarity. Other priorities, such as Brexit, have also taken away some focus on the LIBOR transition — though, in the UK, new LIBOR lending denominated in sterling is set to cease at the end of March, so adaptation must inevitably accelerate.
In the US, market participants have wondered how liquidity would change for LIBOR-linked instruments as the transition deadline approaches. Many expected SOFR adoption to increase rapidly following the central counterparties’ “Big Bang” discounting transition in October 2020, but the shift didn’t happen on a large scale. For banks, it will likely be hedging at the portfolio level that moves the needle of SOFR adoption — even as some decreasing portion of LIBOR exposures persist through 2023. Many institutions will maintain LIBOR-indexed and SOFR-indexed (or other) instruments in parallel.
As for a snapshot of the broader market, we asked our 451 webcast attendees when they expect SOFR-based commercial lending to start becoming a significant part of new business. Slightly more than half of the respondents chose a date in the second half of 2021, and 39% said this will only happen when LIBOR is no longer an option. Still, as Prakash Mahtani, a Director on PwC’s LIBOR Transition Team, observed, it’s not either/or. While LIBOR continues to lead for now, as long as infrastructure develops successfully, we’ll all be able to operate in a multi-rate environment.
Through the industry, many are grappling with the technology implications of this change. We still don’t have consensus on many aspects of transition systems readiness, such as calculating compounding in arrears. Still, there was some help given when regulators late last year agreed to create a gap between the cutoff of new LIBOR lending and the final rate publication date. Justin Keane, a PwC Principal who focuses on LIBOR and reference rate reform efforts, noted that many were relieved that they wouldn’t be compelled to remediate all their USD-denominated contracts this year. But he also reiterated that it would be a challenge to manage risk in a multi-rate, rapidly changing liquidity environment during a period when new products are referencing ARRs, LIBOR products are running off, and the ability to hedge LIBOR risk is expected to be significantly reduced.
This is where lender views may diverge from those of their clients. While corporations manage far less risk, intercompany loans may still entail significant exposure, they’ll transition at different rates — and they won’t all move to SOFR. Either way, there’s work to be done, and Keane said “there are no easy fixes anywhere.” Regardless of your portfolio, it’s essential to have a consolidated technology transition plan. Systems updates can be expensive, and conversations to identify vendor readiness challenges cannot begin too soon.
There’s been a lot of discussion as to if a forward-looking term SOFR would be an operational barrier or facilitator. It may depend on customer expectations: some want a term structure, while others care about daily volatility or forecasting annual interest. For lenders, it may not matter.
In the UK, most banks’ major clients will adapt to overnight SONIA with a compounding-in-arrears calculation. Meanwhile, in the US, USD LIBOR usage covers a much bigger market, including, for example, mortgages referencing LIBOR. As term SOFR emerges, a much greater volume of underlying overnight SOFR transactions may support it, compared to other currencies.
In the US (representing a majority of the LIBOR market), we’ve also seen a lot of interest in a credit-sensitive rate or a dynamic spread adjustment to SOFR. The desire for a credit sensitive rate stems from bank concerns that pricing fundamentals may not remain intact during periods of market volatility. Still, we haven’t seen widespread adoption of credit-sensitive rates, and we’re running out of time. The market itself is fragmented when it comes to the preferred path forward, as we saw when we asked attendees how they intended to address USD lending transactions this year.
LIBOR is the benchmark rate referenced by $350 trillion in bonds, loans, derivatives and securitizations worldwide. It will be replaced by a variety of alternative reference rates (ARRs) around the globe. In the US, the recommended ARR is the Secured Overnight Financing Rate (SOFR). After 2021, banks will no longer be able to enter into new USD LIBOR transactions, though some rates will still be published until mid-2023. Changing from LIBOR to ARRs requires financial firms to update front- and back-office systems, retrain staff, educate their customers and redesign processes.
We ended our webcast by asking our panel to peek inside their crystal balls. The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and others to help ensure a successful transition, has issued best practice deadlines suggesting that there should be no new LIBOR lending after June 2021. Will the market hit that target? Our panelists expressed some concerns.
In response to a closing question on their recommendations for the path forward, our panelists suggested:
Subscribe to our biweekly LIBOR Transition Market Updates newsletter for more information about our next webcast, when we intend to digest the results of recent consultations on LIBOR cessation, related announcements and associated guidance from the official sector. We’ll consider what institutions should be thinking about on the transition of legacy positions ahead of LIBOR cessation.
Partner, PwC US