LIBOR transition: Lessons from around the world, and what’s next

John Oliver Partner, PwC US April 27, 2021

As the benchmark phases out by year-end, lenders and borrowers are quickly running out of time to prepare for the complex transition.

Watching the London Interbank Offered Rate (LIBOR) transition has been a bit like watching a rollercoaster clanking its way to the top of the first hill. For a few years, we’ve seen anticipation and some anxiety, but not much motion. Now the cars are starting their descent, and the fun begins.

In our April 2021 webcast, hosted by PwC partners Jessica Pufahl and Gaurav Shukla, we looked at perspectives from around the world on the end of LIBOR. The message was clear: it’s time for everyone to get real about their plans to step away from LIBOR. We also heard some interesting views on the role of SOFR (Secured Overnight Financing Rate, the recommended alternative to USD LIBOR) and the possibility that other rates could emerge.

Where we are now

Most observers know that USD LIBOR rates will now be published for certain tenors through June 2023. But all of our presenters agreed that nobody should take this as reason to delay a transition away from LIBOR. While some rates will be extended for 18 months beyond the original 2021 deadline, regulators at the US Federal Reserve, Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) issued direct supervisory guidance last year that lenders should stop linking new loans and other financial instruments to LIBOR as soon as practicable, but in any event by the end of 2021.

Continued publication into 2023 will allow about two thirds of outstanding bilateral loan contracts to naturally mature, while the regulatory guidance caps further LIBOR production.

Certainly, borrowers, lenders and legislators are thinking about the “tough legacy” problem — evaluating the best options for dealing with legacy contracts which have no practical way to replace a benchmark that will no longer exist. But in general, we’re now well on the path away from focusing on legacy transition and toward new activity. And, as we look around the world at trades involving GBP, EUR, JPY and CHF LIBOR, major markets will sunset their LIBOR activity completely by the end of 2021.

The global view

In the webcast, we heard consistently that the US can learn a lot from other IBOR transitions that are underway around the world — largely, without hiccups. One presenter noted that the UK market had a bit of a head start, given that the Sterling Overnight Interbank Average Rate (SONIA) has been well known for more than two decades. This means that lenders and borrowers are more likely to view the risk-free rate (RFR) as an established benchmark. Another key ingredient to the success of GBP LIBOR transition has been the excellent collaboration between the public and private sectors. All the UK RFR working group members have worked closely to set milestones and execute measures to create a smooth transition away from LIBOR.

Around the world, there are still issues to address. In the UK, for example, regulators still have to finalize a synthetic LIBOR approach for tough legacy contracts. But, in keeping with the public-private partnership view, market participants seem to be working together to find a solution that might win broad support. We also heard that, while lenders are updating their systems to deal with whatever their customers might require from daily simple RFRs to compound-in-arrears conventions, many borrowers are still on the sidelines. Many overseas customers have held off on contractual amendments and new RFR facilities. Instead, they seem to be waiting to see how USD and other LIBOR markets develop. This is risky, because the delay could lead to a late rush, stretching resources and capabilities at both lenders and borrowers.

Compounded SOFR — or something else?

While SOFR has clearly been viewed by many market participants and by regulators as the USD LIBOR replacement, that perspective hasn’t been unanimous. Meredith Coffey, executive vice president of the Loan Syndications and Trade Association (LSTA) and also a member of the Alternative Reference Rates Committee (ARRC), observed that both borrowers and lenders “really want a rate that is known in advance of the interest period.” She indicated that for new business loans, she has seen resistance from lenders to use SOFR compounded-in-advance where the compounded average of SOFR from the prior interest period is applied to the next interest period, in part due to concerns about asset and liability management. She noted that both LSTA and ARRC have spent the last few years thinking about and developing documentation for three different kind of architectures built upon different rate types:

Rate type

Example

Comment

Rates are known at the beginning of a given interest period

Term SOFR

Replacing LIBOR with a rate that has such an architecture should be “plug and play.”

Rates change daily but no major calculations are needed

Simple average of SOFR during an interest period or “Daily Simple SOFR”

Replacing LIBOR with this kind of rate requires updates to documentation and operations, but calculations simply require division (i.e. sum of daily rates divided by number of days).

Rates change daily and are compounded during an interest period

SOFR Compounded-in-arrears

This kind of rate structure is better for asset and liability management but it requires changes to documentation and operations. Calculations can be complex, especially for lending facilities where the principal can change during an interest period.

Given the loan market’s preference for a forward-looking term rate, Coffey suggested that the choice for business loans may be Term SOFR or one of the newly launched credit sensitive rates featuring a forward-looking term structure, such as the Bloomberg Short Term Bank Yield Index (BSBY).

Tom Wipf, who chairs the ARRC and is also vice chairman of Morgan Stanley, noted that SOFR was chosen by the ARRC after a two-year consultation with market participants. According to Wipf, LIBOR’s original problem was that too many contracts were based on rates derived from a relatively small number of transactions. He expressed concern that using a credit sensitive rate which is derived from a small pool of underlying transactions could recreate the same problem. Wipf strongly encouraged that companies do their due diligence before selecting a rate other than SOFR, stating “Although something looks and feels like LIBOR, that doesn’t make it the right answer.” Wipf also noted that UK regulators have resisted credit sensitive rates as alternatives including such an approach in the GBP LIBOR transition, and corporate borrowers have raised concerns as credit sensitive rates may become much higher than risk-free rates during the time of marketwide stress.

Wipf argued that for applications like consumer mortgages, where payments must be known in advance, SOFR compounded-in-advance calculations are already a market standard. Similarly, for business loans and middle-market lending with shorter interest periods, there is only a marginal basis risk difference between assets and liabilities even while using a compounded-in-advance calculation methodology. 

Wipf added, “We do agree that there’s not going to be one answer, but I certainly believe that SOFR, in all its forms, can solve 90% of these problems. And as we approach the day where we may be able to deliver a term SOFR from the start, we can cover the entire market.” Indeed, the CME Group just announced a Term SOFR rate that aligns with ARRC principles, suggesting that we may soon see an array of Term SOFR solutions for cash products.

Time to move

The webcast closed with a flashback to a recent speech delivered by Randal Quarles, vice chairman of the Federal Reserve, who said “there is no scenario in which US dollar LIBOR will continue past June of 2023.” To underscore the guidance, he added, “After 2021 we believe that continued use of LIBOR in new contracts would create safety and soundness risks. And we will examine bank practices accordingly.”

There’s no ambiguity there

There’s also no support for waiting for term rates, even though there are encouraging signs that Term SOFR may be getting close. Most people agree that borrowers and lenders should take advantage of the  18 months between now and mid-2023 to remediate contracts and identify tough legacy problems that will need special attention.

At PwC, we believe that SOFR has a well-thought-out rationale with broad market and regulatory support. But we also recognize that there could be continued demand for multiple rate products, and some credit sensitive rates may gain traction over the next two years in some segments of the market. For now, both lenders and borrowers should analyze their options to understand how rates are constructed and how they might behave under stress.

Whether USD LIBOR is ultimately replaced by SOFR, a different ARR or a combination of architectures, one thing is clear: LIBOR is going away. Depending on the nature and scope of your company’s operations, you could face systems and operational issues, financial and tax implications, contract remediation challenges and more. Industry leaders have been preparing for this moment, lining up internal and external resources to support favorable operational outcomes. The unified message from our webcast: you should too.


Understanding the LIBOR transition

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.

For more information, see Understanding the transition away from LIBOR and subscribe to our semi-monthly newsletter, LIBOR transition industry and market update.