What is LIBOR?
Globally, the London Interbank Offered Rate (LIBOR) has been used extensively as the benchmark rate for many financial transactions, from derivatives to loans to businesses and consumers. Estimates of U.S. Dollar (USD) denominated LIBOR exposure run as high as $200 trillion.
Why is LIBOR going away?
Since its inception decades ago, LIBOR—a reference interest rate for transactions in certain international markets—has been used by many banks around the world. Over time, its value as a reference rate has diminished. In the aftermath of the financial crisis, authorities learned that some finance industry professionals had manipulated the rate. As a result, the markets began to lose faith in the value of LIBOR as a benchmark. In 2014, while working on plans to reform and improve LIBOR, officials noted trends—including a lack of active underlining markets and diminishing term transactions—that raised questions about the continued viability of LIBOR as a reference rate.
Financial authorities’ response
To address the issues with LIBOR, the Federal Reserve, along with the Treasury Department and the Commodities Futures Trading Commission, formed the Alternative Reference Rates Committee (ARRC) in 2014. The ARRC, which includes private-market participants, had the role of identifying robust and risk-free alternative reference rates for USD LIBOR. Many other countries took similar actions for their currencies. To the extent possible, ARRC’s actions were coordinated internationally.
ARRC selected the secured overnight funding rate (SOFR) for use in new USD derivatives and other financial contracts. SOFR is a short-term USD interest rate based on overnight Treasury repo transactions. In contrast to LIBOR, SOFR is based on a much deeper, more liquid market and better reflects today’s funding practices. ARRC also released a paced transition plan to facilitate timely adoption of SOFR. Institutions don’t have to use SOFR in place of LIBOR, but they will have to choose a new reference rate. Based on ARRC’s recommendation, officials are encouraging SOFR’s use for USD contracts.
In 2017, the UK’s Financial Conduct Authority (FCA), which regulates LIBOR, announced that it had reached a voluntary agreement with twenty bank reporters to continue to support LIBOR through the end of 2021. The intervening period, from 2017 through 2021, will allow a smooth transition to alternative benchmarks.
Supervisory message
The transition from LIBOR to other benchmarks is complex and challenging and, if not handled appropriately, puts the stability of the financial system at risk and exposes firms to substantial operational, legal, and reputational problems. Despite the progress that firms have made, it is imperative that all organizations make an immediate, concerted effort to transfer existing contracts to alternative benchmarks and discontinue using LIBOR in new contracts.
In its November 2019 Supervision and Regulation Report, the Federal Reserve noted that assessing LIBOR transition readiness will be a supervisory priority in 2020. Supervisors will focus on the overall preparedness of the largest firms and consider transition risk and plans for small and regional firms. As always, firms will face increased expectations depending on their size and business model.
In remarks to the ARRC in June 2019, Randal Quarles, the Federal Reserve’s vice chair for supervision, noted that, “With only two and a half years of further guaranteed stability for LIBOR, the transition should begin happening in earnest…beginning that transition now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients.”
Quarles highlighted steps institutions can take to prepare for the transition from LIBOR to SOFR:
- Use the market for SOFR futures and swaps to close out LIBOR positions in derivatives that are used to hedge cash exposures.
- Adopt the ARRC’s fallback contract language for new issuance of cash products that refer to LIBOR. This fallback language is designed to limit the risk to institutions and customers from a LIBOR disruption.
- Stop using LIBOR. The UK’s FCA has made it clear that LIBOR has a limited lifespan. Relying on fallback language to transition to another reference rate when LIBOR is no longer available carries significant operational and economic risks. Prudent investors and borrowers should carefully consider accepting new instruments that are tied to LIBOR, given its pending demise.
Preparation
Authorities have been reaching out to financial institutions to provide information on the transition from LIBOR to other reference rates. The Federal Financial Institutions Examination Council has suggested that firms consider the following questions when preparing to transition from LIBOR to another benchmark:
- Which existing assets and liabilities (including off-balance sheet) refer to a LIBOR rate?
Firms should conduct an inventory to identify LIBOR-based transactions and determine exposure. - What contracts/loan agreements will require revision before the transition?
Firms should consider using fallback language provided by ARRC or the International Swaps and Derivatives Association to backstop existing LIBOR contracts in the event of disruption. - Which risk management systems will require updating?
Examples include, but are not limited to, governance, compliance, internal controls systems (including information technology systems), and accounting (including hedge accounting and valuation). Significant disruption is possible if the operational aspects of the LIBOR transition are not identified and addressed. - What disclosures to or communications with retail consumers are necessary?
Firms must be mindful of their obligations to comply with consumer protection laws. Failure to comply could result in consumer harm and carry significant reputational and legal risk.
In September 2019, ARRC issued a checklist for SOFR adoption, which includes a simplified overview of steps to transition from LIBOR to SOFR, as well as a detailed list of items for firms to consider in executing a prudent transition.
These implementation guides provide a great deal of direction for firms making the transition from LIBOR to SOFR or another benchmark. Ultimately, however, it is up to individual institutions to assess their exposure to LIBOR and prepare for a smooth transition in keeping with prudential obligations and fiduciary responsibilities.
January 1, 2022, will be here before you know it. There’s no time like the present to prepare!