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."