The end of LIBOR to be anything but simple

No one ever said replacing LIBOR, the predominant derivatives and fixed-income valuation benchmark supporting hundreds of trillions of dollars in contracts, would be easy.

With millions of investments tied to the London interbank offered rate, such as interest-rate swaps and long-duration fixed income, investors and their service providers could have to renegotiate with counterparties on a new benchmark, but coming to an agreement isn't so simple, sources said.

"I have read hundreds of these (contracts) and many are terrible because no one expected LIBOR to end and until recently there weren't even replacement rates," said Adam Schneider, a New York-based partner in Oliver Wyman's digital and banking practices in the Americas.

"There's an enormous amount of work just to understand what's going on and then once you know what you have to do, there's a tremendous amount of work which would start when the actual LIBOR publication ends," he added. "You can't just willy-nilly change a contract."

In the U.S., the Federal Reserve's recommended alternative reference rate is the Secured Overnight Financing Rate, or SOFR. The transition to SOFR is being led by the Alternative Reference Rate Committee, an industry group established by the Fed.

LIBOR, which has been plagued by cases of bank manipulation, is set at different currencies, including the U.S. dollar, British pound sterling and euro. New LIBOR-based contracts will cease at the end of 2021, but in November, the Intercontinental Exchange Inc. announced that the ICE Benchmark Administration, which administers LIBOR, would explore ceasing the most utilized U.S. dollar LIBOR tenors in June 2023 instead of late 2021. On March 5, Britain's Financial Conduct Authority confirmed the 2021 and 2023 cessation dates for LIBOR, although it retains the option for a synthetic calculation if needed.

The extension to June 2023 would allow more time for outstanding contracts to mature, thereby reducing the chance of potential disruptions, U.S. regulators said in a December statement.

But the majority of contracts extend beyond mid-2023.

Some of those outstanding contracts do not have sufficient "fallback" language in the event of LIBOR's cessation, which means in some cases the contract would use the last available rate, meaning that a floating-rate instrument could become a fixed-rate instrument, said Chris Killian, New York-based managing director of securitization and corporate credit at the Securities Industry and Financial Markets Association. "And because of regulations and the way transactions are typically structured there generally isn't somebody who can or would be comfortable just unilaterally changing the rate to a different index," he added.

Josh Smith, CEO and co-founder of Solovis Inc., a multiasset-class portfolio management, analytics and reporting software-maker, based in Irving, Texas, is telling clients to prepare for the transition well in advance. But he is still expecting a number of calls "from people saying, 'my rates fell and all this stuff happened overnight' and we're going to have to jump in and help."

While renegotiating outstanding contracts could be a lot of work for the market at large, for pension funds and other institutional investors it is "basically a non-event," because the difficulty in switching over to a new rate will likely be outsourced, said Eric Bernstein, president of asset management solutions at Broadridge Financial Solutions Inc., Lake Success, N.Y.

"The benefit of the buy side right now is it tends to outsource a lot of the mid- and back-office to fund administrators and third parties, so it becomes someone else's problem," Mr. Bernstein said. "But that's just passing the problem to someone else; it's still a problem."

At this stage of the transition, pension funds should be asking their managers pointed questions, like on the status of fallbacks in securities owned and whether there's an active program using rate derivatives, and, if so, what are they doing about transitioning, said George Bollenbacher, president and owner of GM Bollenbacher & Co. Ltd., a consulting firm based in New York.

Mr. Schneider is urging all market participants, no matter their LIBOR exposure, to not only be operationally ready, "but to really have an opinion of how much they will gain or lose on LIBOR transition. We have found substantial value gained and lost in the fallbacks. We have found substantial value gained or lost after moving to new non-LIBOR products. You need to have an opinion about that, you're a fiduciary and to date we see a lot of institutions that are skating around this issue."

Other sources do not expect there to be "winners" and "losers" after outstanding contracts are amended.

The overarching goal of the Alternative Reference Rate Committee and the International Swaps and Derivatives Association is to try and avoid that as much as possible, Mr. Killian said. "Instead of going from LIBOR just to SOFR, you're going to SOFR plus some kind of spread to make up the difference. Winners and losers lead to unhappy people, so I think that's trying to be avoided here."

The International Swaps and Derivatives Association on March 5 finalized its automatic fallback spread for outstanding derivatives contracts. The announcement is useful for counterparties in the derivatives space that choose to adhere to the protocol, but there are still hurdles for the market at large, Mr. Schneider said. "The derivatives have a path out, but it's still optional and the other contracts" — like loans and bonds — "are in an equally sized mess," than they were previously.

In addition to the Fed's SOFR, central banks around the world have established their own replacement rates, including the Bank of England's sterling overnight index average, or SONIA; the European Central Bank's euro short-term rate, or ESTER; the Swiss National Bank's average rate overnight, or SARON; and the Bank of Japan's Tokyo overnight average rate, or TONAR.

A major issue in the transition is that LIBOR is based on an average of bank lending rate estimates, while the replacement rates are based on actual overnight money market transactions — making it impossible to have an apples-to-apples transition to any other rate, sources said.

In January, New York Gov. Andrew Cuomo proposed legislation to provide for a statutory replacement benchmark rate for outstanding LIBOR-linked contacts that contain no fallback provisions or contain fallback provisions that result in a benchmark replacement that is based on LIBOR.

Tom Wipf, ARRC chairman and vice chairman of institutional securities at Morgan Stanley in New York, has repeatedly told market participants to stop using LIBOR "as soon as practicable," including during a SIFMA-hosted webinar in December.

That sentiment was echoed by Nathaniel Wuerffel, a senior vice president in the markets group of the Federal Reserve Bank of New York, during the SIFMA webinar: "Moving quickly will also avoid making the problem worse, with an estimated $200 trillion in gross exposure to U.S. dollar LIBOR, there's already an enormous number of contracts that need to transition from LIBOR and it's detrimental to add to that."

"If firms increasingly use SOFR when writing new contracts, that will build demand for SOFR derivatives," Mr. Wuerffel added. "In turn, this should enable more SOFR-linked issuance in cash markets, a virtuous cycle."

The problem for a lot of market participants, though, is the fact that there is currently no SOFR term rate, although the ARRC is working on one.

Oliver Wyman's Mr. Schneider likened the situation to Build-A-Bear: "If you don't have enough stuffing, you don't get a bear. So we're not missing the idea, we're missing the stuffing. And we're in a weird loop. The stuffing in this case is derivative trades in SOFR and from that they'll build the term rate. But SOFR isn't being used for lending at this point so there are few derivative trades. It's circular."

When looking at interest-rate swaps, Mr. Bollenbacher said the overwhelming activity is still LIBOR-linked. More than $97 trillion of new U.S. dollar-LIBOR swaps were created in 2020 compared to only $1.1 trillion of SOFR swaps over the same period, he said, citing ISDA data.

Though hurdles remain, Richard Sandor, chairman and CEO of the American Financial Exchange LLC, Chicago, believes the transition will go smoothly for the most part. AFX, an electronic trading venue for regional, mid-sized and community banks and non-bank financial institutions to lend and borrow short-term funds, has launched Ameribor, an index based on transactions between the banks that belong to the AFX, as an alternative to LIBOR.

"In the grand scheme of things, I'm a believer in the U.S. banking sector's ability (to) modify their agreements to this change," Mr. Sandor said. "They've dealt with far harder problems, like Y2K, and the banks are going to go through with it and we're going to look at this the same way as Y2K: it's going to come and go and all of a sudden everybody's going to say, 'That wasn't so bad,'" he said.