Whether you’re a lender, a borrower, or an investor, you know about the London Interbank Offered Rate (LIBOR): it’s the benchmark that anchors hundreds of trillions of dollars of financial contracts around the world. Now, after decades as the standard behind a wide range of floating or adjustable rate products, the industry must transition away from LIBOR. The most widely used tenors of USD LIBOR are expected to cease publication after June 2023**, and leading firms have been making progress in preparing to remediate derivative contracts, business loans and other products tied to the widely used interest rate benchmark. As a financial market participant, you’ll probably need to make some adjustments to mitigate disruption when LIBOR ends. It’s time to roll up your sleeves and make the LIBOR transition a top priority.
What comes next: LIBOR will be replaced by a number of Alternative Reference Rates (ARRs), which vary by country and currency. If you have contracts that reference LIBOR — and you almost certainly do — those contracts will need to change. But this transition goes far beyond search and replace. If you are still at the early stages of your LIBOR transition, we’ve prepared a series of recommendations. By now, though, most organizations recognize that the coming switch away from LIBOR will likely require a lot of work, and they’ve started preparing for all the changes that lie ahead for their processes and systems. In this article we go into more detail regarding the steps involved in a smooth transition.
**For years, the industry has been working toward a 2021 transition away from LIBOR. But the benchmark’s administrator, ICE Benchmark Administration (IBA), recently announced that it would continue to publish some LIBOR rates — but not all — for an additional 18 months. See PwC’s LIBOR transition industry and market update for late November 2020 for more details.
If you’re reading this, you’ve most likely already started mobilizing your LIBOR transition team, governance structure and workstreams. This first step is ongoing and to be refreshed throughout the process. It’s not a one-and-done exercise. As you move forward with your transition plan, it is important to understand the firm-wide impact it will have on your organization — business strategies, client management, operational processes and technology infrastructure across the board — and refresh the impact when necessary.
Focus on the following steps to plan your transition:
Similar to the ‘Program structure, governance, and project management office’ step, this is not a check-the-box activity. Your assessment process should be ongoing as you consider each product, project, and portfolio. Many companies built their products and systems with a simple enough proposition: if there was a floating rate involved, that rate would be LIBOR. As the LIBOR era ends, firms could face a fragmented market where they need to apply different standards to different products across different markets. This has implications for everything from technology and risk management to client communication and marketing. The way you manage portfolios — your own and your clients’ — could require a range of different customizations, you’ll want to continually assess the direct and indirect impact of this change.
We recommend you consider the following as you assess your transition impact:
In the US, most LIBOR-linked contracts are expected to transition to the Secured Overnight Financing Rate (SOFR), a daily rate based on the cost of repos: collateralized overnight borrowing. The recommendation of SOFR, a rate based on a liquid market with a substantial volume of underlying transactions, aligns to the overarching goal to transition to benchmark rates that are robust and objective. As widely as LIBOR is used, there are other significant interbank offered rates (IBORs) that are also expected to give way to more objective benchmarks in different countries and currencies.
What does it mean for markets to now rely on SOFR and other ARRs? For one thing, contracts that reference LIBOR will need to be rewritten. Products that reference LIBOR will need to be updated. In addition to strategic considerations, the transition is bound to affect many aspects of your operations: from documentation to lines of software code.
The transition could prove especially complex because LIBOR and the ARRs recommended as replacements differ in some key ways. LIBOR contains a degree of bank credit risk; SOFR does not, as the collateralized nature of repo transactions make them nearly risk-free. LIBOR is a forward-looking term rate quoted in seven maturities up to a year. SOFR is an overnight rate, which is expected to be employed in the form of backward-looking averages. In other words, simply replacing LIBOR with SOFR would not result in economic equivalency. To compensate for the difference, alternative reference rate working groups have recommended a spread adjustment to be added to SOFR when replacing LIBOR in financial contracts.
Financial services firms can smooth the switch of products to SOFR by taking some practical steps now:
For simplicity’s sake, we refer here to the SOFR transition, but the same principles apply to any ARR that replaces LIBOR or another IBOR. In fact, you may well have exposure to other new benchmarks, each of which has its own parameters.
Contract remediation is one of the most important and painstaking steps in the move to SOFR and other ARRs. You should inventory all LIBOR-linked contracts and the nature of existing fallback language. Then, identify terms that need changing. Any revision should be coordinated across different contract types, languages, jurisdictions, and file locations. You can speed contract analysis by using software tools that can assess vulnerabilities and organize contracts by how much remediation might be needed: it’s more involved than search-and-replace.
You may want to consider a three-step approach to updating contracts:
You’ll want to inform your clients, directors, staff, suppliers, and other stakeholders about the transition. You can limit liability and conduct risk by reaching out to your clients to discuss the changeover. Each audience should get a customized message describing the steps in LIBOR transition and potential risks.
Internal and external communications will probably need updating as your move to SOFR unfolds. You should also extend your outreach to regulators such as the Federal Reserve and SEC. Federal officials have repeatedly warned firms to show steady progress in adopting SOFR.
Here are some key steps to keep in mind:
LIBOR is deeply ingrained in the internal data and operational systems at many financial institutions, and the challenges could extend beyond your company’s walls. Third party vendors such as administrators, custodians, and brokers may face their own challenges in switching to ARRs, or they may not be ready with certain capabilities when you need them to be.
By now, you’ll want to be well underway in implementing system enhancements — and that you haven’t missed anything:
We’ve found that many firms may be underestimating how the LIBOR transition affects modeling programs. This is especially true for valuation and risk models, including hedging strategies and risk management frameworks. You should expect some changes to your overall risk profile.
For example, use of ARRs may change the nature of basis risk in derivatives and cross-currency swaps. Different basis risks may make current hedging obsolete, prompting you to update your approach to asset/liability management. During the coming year — perhaps long before the planned end of LIBOR in December 2021 — liquidity in LIBOR-linked products may fall and market volatility may increase. Also, any financial instability during the sunsetting of LIBOR may crimp counterparty cash flows and push up credit risk.
Here are some suggested priorities as you move to curb risks:
While adopting SOFR, you should track IRS tax guidance and changes to financial reporting requirements. The IRS has proposed a regulation that, in general, would consider changing a debt instrument and other financial contracts to an alternative rate as a non-taxable event. The SEC has said that you should view LIBOR transitions as a risk that should be disclosed if necessary.
The switch to SOFR may influence financial reporting regarding hedges, derivatives, fair value, cash instruments, and leases. The Financial Accounting Standards Board (FASB) has issued optional guidance saying that, under certain circumstances, hedge accounting may continue when a contract (derivative or hedged item) is changed. FASB has also simplified the accounting analysis for the high volume of LIBOR-linked contracts that will need modification. The guidance will expire in most cases at the end of December 2022.
You may want to consider these steps:
Global Financial Services Leader, PwC US
Partner, PwC US
US Deals, Strategy & Operations Leader for Tax Reporting & Strategy, PwC US
Financial Services, Principal, PwC US
Asset & Wealth Management, Partner, PwC US
Financial Services, Partner, PwC US
Principal, PwC US
Capital Markets Strategy Partner, PwC US