The end of LIBOR in December 2021 will affect corporations in unexpected ways. Understanding and planning for the transition to new risk-free rates (RFRs) now can minimise the financial impacts and disruption. With the USD LIBOR gross notional estimated at $200tr., corporations must remain attentive to key issues and current global progress to effectively plan for a smooth transition.
The Financial Stability Board (FSB) via the G20, has been tasked with coordinating the development of RFRs to replace LIBOR through national and regional Alternative Reference Rates Committees (ARRCs). So far seven of the G20 have nominated an RFR, while Canada and Australia have reformed their existing non-LIBOR reference rates. The US's secured overnight financing rate (SOFR) and the UK's sterling overnight index average (SONIA) are the most advanced RFRs.
Three Primary Impacts
Transitioning from LIBOR to a new RFR will impact corporations in three ways:
- Benchmark Rate Change – A new benchmark on existing and new financial contracts.
- Interest Rate Valuation Curves and Market Conventions – New interest rate discount curves derived from RFR-based instruments.
- Regulatory Reporting – Amended hedge accounting standards and regulatory reporting based on new benchmarks and discount curves.
Benchmark Rate Change
Financial contracts referencing LIBOR are varied, ranging from cash instruments, such as corporate credit lines, floating rate notes (FRNs), inter-company loan agreements, in-house bank interest terms, or bank interest on accounts (physical and notional pools) to non-cash interest rate derivatives. They might even include penalty interest rate clauses on supplier agreements.
Transitioning all financial instruments referencing LIBOR to a new RFR is governed by what is called â€œfallback languageâ€, which must have three elements:
- Trigger – A defined event that replaces LIBOR with an RFR.
- Identification – Identification of the replacement RFR (e.g. SOFR).
- Adjustment – Definition of how contract terms may be adjusted to take account of any expected value differences between LIBOR and the replacement RFR.
Interest Rate Valuation Curves and Market Conventions
There are two valuation impacts arising from the LIBOR replacement:
- The projection of future SOFR rates for SOFR-linked instruments
- The transition to a SOFR-based zero coupon discount curve for valuation
Both require existence of a liquid, term structure of SOFR-based instruments, which now isn't the case beyond a few years (SOFR futures). There is no liquid SOFR swap market. Until this market is more liquid, the development and transition to a SOFR-based discount curve is unlikely. Overnight indexed swap (OIS) spread curves or LIBOR/SOFR basis curves may be used in the short term until a SOFR term structure is more liquid. Related is the availability of historical market data for proxy instrument valuation for hedge accounting purposes.
Market conventions are continually evolving for SOFR and currently include:
- A daily fixing with a lag (five business days)
- Interest compounded daily or averaged and paid in arrears.
- Uncompounded margins
- Day adjusted interest periods
- Act/360-day count basis
LIBOR impacts corporates quarterly regulatory reporting via:
Hedge AccountingÂ – The FASB (via ASC 815 regulations governing accounting for derivatives) allows changes at the individual hedge relationship level and generally not requiring a redesignation following trigger events. However, derivative valuations will change; interest rate derivatives more than foreign exchange or commodity derivatives. Corporates will need to make some changes to hedge relationships. For example:
- Fair Value Hedges – SOFR has been added as a new hedgable benchmark rate. Existing long-haul LIBOR benchmark hedges may transition to a SOFR benchmark without de-designation, and a new credit spread calculated. The revised basis adjustment (based on SOFR benchmark and credit spread at hedge inception) may be accounted for separately. Short Cut treatment may be continued under most circumstances.
- Cash Flow Hedges – SOFR-based hypothetical derivatives will replace LIBOR-based hypotheticals in existing hedge relationships. Critical Terms Match may continue under most circumstances.
Interest Rate Sensitivity – Market risk disclosures on interest rate sensitivity of interest expense/income and asset/liability fair values are now done by shocking the LIBOR curve. In the future, this will be done by shocking the SOFR rather than LIBOR curve.
The impacts of replacing LIBOR will be far-reaching and irreversible. Progress will continue and accelerate. Identifying impacted contracts, trigger events, dependencies and system enhancements now is essential for creating an effective plan for a smooth transition to a new RFR.