Getting started on the LIBOR transition journey
Banks use it. Asset managers and insurers use it. Energy companies and private equity firms use it. For decades, LIBOR has been the benchmark, or reference rate, behind millions of daily transactions involving derivatives, bonds, loans, and securitizations. Now, it’s going away.
The London Interbank Offered Rate (LIBOR), the benchmark for $350 trillion in financial contracts worldwide, will be phased out at the end of 2021. LIBOR is giving way to several Alternative Reference Rates (ARRs) that vary by region, currency, tenor, and basis. In the US, most of the contracts that now refer to LIBOR will instead use rates based on the Secured Overnight Financing Rate (SOFR) — a daily rate based on the cost of overnight borrowing, with US Treasury securities posted as collateral.
This is a big deal. As you prepare to make this shift, you may have to update operational systems that handle contracts, pricing, and more. You’ll want to reach out to clients, redefine the way you think about some risks, and redesign some products. The scope of work can seem daunting, especially if you’re just starting to prepare for the transition. Some firms already preparing for LIBOR’s end have found it more time-consuming than they’d expected, as they confront challenges in IT, investment strategy, and coordinating with vendors.
And there’s a lot of work to do. For example, many firms will discover that they have literally thousands of contracts that reference LIBOR — including exposure that they may not have known about. To be sure, some contracts may not require remediation, and others may be easy to fix. But many others could require bilateral negotiation — and before you start, you’ll want to model the economic effects of that change. There are a lot of steps, and many potential missteps.
You may feel you have more significant priorities, including responding to the pandemic. Yet regulators have insisted that the December 2021 cutoff date will remain unchanged, even as COVID-19 has jolted markets and strained balance sheets. In fact, the interim deadlines start in 2020. At this point, if you delay your transition project, you could experience negative financial consequences and reputational consequences as you fall behind well-prepared rivals.
When moving past LIBOR, companies face two broad challenges
Complexity
The new ARRs differ from LIBOR in important ways. For example, LIBOR is a forward-looking term rate with a range of seven maturities up to a year, tracking loans that might be made in the future. In comparison, SOFR is a backward-looking overnight rate, reporting on loans that have already been made. And, while LIBOR reflects a measure of credit risk, SOFR is derived from repos: collateralized transactions that are effectively considered risk-free.
SOFR has gradually been gaining appeal, based on daily trading in SOFR-linked futures and the volume of SOFR-linked debt. Still, the number of contracts tied to LIBOR dwarfs SOFR-linked transactions. One reason may be that SOFR still does not offer any forward looking term rates, while many of today’s loans are typically tied to three month LIBOR.
Whether you are a trader, a lender or a borrower, the transition may be more complex than you expect at first. With a lot to do and not much time to do it, you’ll want to start now.
Ambiguity
Regulators are working with the financial industry to plot a way forward without LIBOR. In the US, much of this work has been led by the Alternative Reference Rates Committee (ARRC), a group of industry and public sector organizations convened to smooth the transition. The ARRC has published an implementation checklist, a list of best practices for completing the transition, and a range of other materials to help firms adapt.
Yet regulators aren’t defining how the changeover from LIBOR must take place. The broad outlines are in place, and most of the issues have now been resolved, but you’ll still have to create your own roadmap geared to your specific operations and current uses of LIBOR. For example, if you borrow, lend, invest or hedge in currencies other than US dollars, you’ll likely need to prepare to transition to one or more other ARRs beyond SOFR. Each ARR has its own characteristics, with different start dates and varying liquidity.
The eight elements of an effective LIBOR transition plan — and one pitfall to avoid
Every company’s LIBOR transition plan may be slightly different — because their product offerings and portfolios vary, their business and hedging strategies are unique, their customers have their own priorities, and their industry sector may have distinct characteristics. Still, we’ve found that there are eight elements to developing and implementing a successful LIBOR transition plan:
- Program structure, governance, and project management office
- Impact assessment
- New benchmark markets and product transition
- Contract remediation
- Client strategy, outreach, and communications
- System and process changes
- Risk and valuation models
- Financial reporting and tax
Where technology can help (and where it can’t)
It’s hard to imagine a LIBOR transition program without advanced technology tools to help. If you need to quickly evaluate thousands of contracts to assess where the risks are, software can help you scale your effort effectively. But firms can burn resources needlessly by jumping too quickly into a technology decision.
In our experience, companies get better results by strategically balancing technology and people. Start by finding all of your contracts. Are they all digitized? Do they follow the same naming conventions? How many use standard, “boilerplate” language? By defining the scope of the project carefully, you may shrink the remediation effort considerably. PwC has developed a tech-enabled solution, LIBOR Strategy and Analytics Contracts Analyzer, using supervised machine learning to quickly identify and extract the clauses that need to be remediated. Our financial products and contract processing specialists analyze this data to accelerate the remediation, while spotting and proactively managing contracts that may have greater risks so you can prioritize the work.
- Program structure, governance, and PMO
- Impact assessment
- New benchmark markets and product transition
- Contract remediation
- Client strategy, outreach, and communications
- System and process changes
- Risk and valuation models
- Financial reporting and tax
Program structure, governance, and PMO
Start with the basics: mobilize your team by defining a LIBOR transition program that gets everyone on board with what needs to be done, and why. From the beginning, be sure to build a list of stakeholders that’s well thought out and includes every aspect of the organization that might be affected. (You don’t want to learn at the last minute that something was overlooked.) You’ll want to create a clear roadmap — and share it with your key stakeholders. Project management is critical during the transition, because there are so many roles and activities involved at various times. It’s also important to develop and implement a tailored governance structure that can help you manage your program across your business units and the geographies where you operate.
Impact assessment
How much work will you need to do? Very possibly, more than you’d expect. To analyze your direct and indirect exposure to the LIBOR transition, you’ll want to understand what positions you hold, how your risk management models will change, how valuations will change: defining, collecting, and assessing data. In this stage, you’ll conduct assessments across your operations to help you understand where remediation might be needed with your products, functions, and systems. The coming LIBOR switch can affect everything from front-end sales to back-end operations.
New benchmark markets and product transition
Define a strategy for transitioning legacy products and developing new ARR positions. You’ll want to evaluate how your products should change once markets are no longer tethered to LIBOR. Similarly, you should assess the economic implications for your new offerings, and the downstream effects of any changes you might make. You may find that switching to SOFR gives you new opportunities to provide value to your clients.
Contract remediation
You might think it’s easy to identify, inventory, and digitize affected contracts. Very often, it’s not. You’ll want to allow sufficient time to assess LIBOR-linked contracts and extract the relevant data, analyze those contracts for risks, and create a remediation plan to support your negotiations with customers and counterparties. Technology tools may help you find, analyze, and alter documents. For example, a contract lifecycle management (CLM) tool can streamline counterparty outreach, negotiation, and contract amendment.
Client strategy, outreach, and communications
Though the LIBOR transition can affect everyone from finance professionals to homeowners with adjustable rate mortgages, even educated market participants may not see the full range of what’s ahead. You’ll want to create an outreach plan for clients, vendors, and regulators — and this effort may also help you manage conduct risk. You’ll also want to understand how your counterparties are approaching the transition, including whether they are adhering to the industry’s proposed fallback protocols. Customer relationship management (CRM) and other software can help you customize messaging and monitor communications from clients.
System and process changes
You’ll want to prepare systems for the change in benchmarks. This will likely require you to identify and manage system updates to establish ARR processing capabilities, including trading, treasury and accounting platforms. If your company relies on external vendors for some of these operational services, you’ll want to understand what your suppliers’ conversion plans are. Will they be ready when you are?
Risk and valuation models
SOFR and other ARRs have some material differences from LIBOR, including tenor and credit risk, and this could eventually affect your product pricing and capital reserve requirements. You’ll want to adjust your models and incorporate changes to risk capital calculations. Automation tools, like our Model Edge offering, can help you scale your model development and validation processes with inventory tools, testing framework analytics, execution workflow and monitoring, and model documentation.
Financial reporting and tax
The coming change will likely have balance sheet and income statement effects. Your transition plan should include efforts to adapt your accounting and tax programs to assess the impact of the LIBOR transition. You may want to evaluate if using SOFR-linked products will trigger different hedge accounting rules, and you should consider updating automated systems involving transfer pricing.
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John Oliver
Partner, Governance Insights Center & National FinTech Trust Services Co-Leader, PwC US
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