End of LIBOR Has Potential to Disrupt Markets Globally
The end is coming soon for LIBOR; The London Interbank Offering Rate. By the end of 2021, this benchmark rate would no longer be available for reference.
Historically, LIBOR has reflected the unsecured short-term interest rate at which major global banks would lend to one another for a combination of currencies and maturities. This was then adjusted accordingly to reflect the risks associated with other investment and lending products. For example, securitized debt, mortgage loans, student loans, etc. would be offered at an interest rate of LIBOR +/- some basis point adjustment indicative of the product’s underlying risks.
Over the last twenty years the LIBOR rate reached a high of almost 8%, plummeted to less than 1% and now hovers at approximately 2.5%. That volatile history has significantly impacted millions of lending arrangements and the associated interest payment streams.
It is estimated that there is over $350 trillion in loans and securities across the globe linked to LIBOR; including approximately half of the mortgages and millions in non-government backed student loans in the US.
The demise of LIBOR will impact several parties, such as consumers, commercial enterprises, not-for-profits, financial institutions, and governments, and affect global economies around the world. The transition will be costly not only because long-term financing arrangements extending beyond 2021 will need to be renegotiated, but also because this change could affect several processes which need to be assessed to avoid any business disruptions after 2021 (such as pricing or valuation processes, IT systems and accounting).
Further, the criminal manipulation of the LIBOR rate by some larger financial institutions, which plagued our news feeds in recent years, added to the challenges facing LIBOR to remain one of the most meaningful internationally used benchmarks.
At this juncture, financial market stakeholders and regulators are working to identify a replacement benchmark rate. In April 2018, the Federal Reserve of New York began publishing the Secured Overnight Financing Rate (“SOFR”) which reflects the overnight borrowing rate and is identified by the Alternative Reference Rate Committee (the “ARRC,” – a committee assembled by the FRB in 2017, comprising several large banks to select an alternative reference rate for the United States) as the benchmark rate for instruments denominated in USD.
However, SOFR has only been quoted since 2018 and some feel it doesn’t yet have the history to replace the long-standing LIBOR and accurately and timely reflect the changes in global economic markets. In addition, because SOFR represents a secured rate, backed by US Treasury securities, it trends lower than the traditional, unsecured LIBOR rate.
SOFR currently covers only a short-term rate, quoted overnight, while the LIBOR reference rate covers seven different maturities (from overnight to 12 months) in five currencies. These differences make the transition from one variable rate to another quite cumbersome and thus far have provided no certain resolution.
To assist its constituency in the transition process, the Securities and Exchange Commission (”SEC”) Staff released on July 12, 2019 a published Staff Statement on LIBOR Transition (the “Statement”). The Statement encourages market participants to be proactive in the transition process.
The Statement also highlights that: “Working groups have been formed in each of the United States, the United Kingdom, the European Union, Japan, and Switzerland to recommend an alternative rate to LIBOR for its respective currency. In the U.S., the ARRC is comprised of a diverse set of private-sector entities, each with an important presence in markets affected by USD LIBOR, and a wide array of official-sector entities, including the Commission, banking regulators, and other financial sector regulators, as non-voting ex-officio members.”
The Statement goes on to discuss some key considerations and steps to be taken during the transition process. First and foremost, market participants need to identify those contracts that are LIBOR indexed and extend beyond 2021.
In the event there is no fallback rate identified, the Staff suggest an evaluation of the impact a change in rate would have on the underlying agreement and identification of which alternative rate would best reflect the risks of the transaction. To the extent LIBOR impacts derivative contracts and related hedges, the Staff reminds those counterparties that hedge effectiveness would need to be re-evaluated in terms of the alternative rate employed.
As it relates specifically to SEC reporting entities, the Statement states the Staff’s expectation that the risks associated with the LIBOR transition be adequately disclosed by its registrants in all affected reporting periods.
The transition from LIBOR will affect all major global economies and many millions of their participants. While the process is ongoing, the end date is just over two years away and to paraphrase Robert Frost, “there are miles to go before we sleep.”