LIBOR transition was a top priority in 2021 and the markets – and market participants – are now considering life after LIBOR. TMI engages David Mullen, Senior Product Manager, Fixed Income, Bloomberg, in a Q&A to consider the next steps for treasurers.
While some currencies and tenors of LIBOR, such as USD, will continue to be calculated until 2023, regulators are encouraging the market to treat LIBOR as obsolete from 2022. A majority of firms have successfully transitioned their positions away from the benchmark, but there’s still more work to be done. This will continue to be a complex process, so what’s top of mind for corporate treasurers following the sunset of LIBOR across most markets?
TMI: First, how well prepared are market participants for life after the transition from LIBOR?
David Mullen (DM): Although the official LIBOR transition date has passed, there are still a number of firms that have a way to go before they will be able to fully transition off the rate. Larger firms which have historically had more exposure to LIBOR on their books are ahead of the curve, while others are still working to complete their respective transition processes.
Another major consideration is the alternative rates firms are choosing to use. There has been significant adoption of risk-free rates (RFRs) in most use cases, but in some areas such as the US loan markets, firms are looking to rates that include a credit component for asset and liability management. Many of LIBOR’s designated successor RFRs are secured rates and most lack a credit sensitive component the market is seeking for certain products.
TMI: How great a priority should the LIBOR transition be for corporate treasurers?
DM: LIBOR transition has been a top priority for treasurers, as well as CFOs, CEOs and boards. Though LIBOR replacement might seem like primarily an issue for banks and investment firms, in reality it affects any company that has issued LIBOR-based floating-rate debt, entered into a swap or futures contract to hedge price or interest rate risk, or financed an investment with a loan tied to LIBOR. As a result, firms of all types and across all markets are impacted by the transition.
TMI: What are the alternatives to LIBOR?
DM: The markets globally are well on their way to fully transition to RFRs, which were introduced by regulators and industry bodies in each country or region. These include SOFR in the US, SONIA in the UK and €STR in Europe, among others.
SOFR, the transaction-based rate that measures overnight borrowing costs on trades that are collateralised by US Treasury securities, is the rate recommended by the Federal Reserve’s Alternative Reference Rates Committee (ARRC). While the adoption of SOFR continues to grow across various parts of the market that historically relied on LIBOR, it is important to remember that it is based solely on secured overnight rates and, as a result, it does not have two critical characteristics of LIBOR: a forward term component (as in 1-month, 3-month and 6-month LIBOR) and a dynamic credit spread. Term SOFR was made available and then endorsed for certain use cases late last summer, which was a welcome development by several market participants.
To address this gap, vendors have developed alternative rates to serve the needs of the loan and credit markets. This includes Bloomberg’s Short-Term Bank Yield Index (BSBY), which is designed to measure the yield at which systemically important banks access USD unsecured wholesale funding. It is dynamic, incorporates a credit sensitive element and reflects marginal funding cost of banks across five tenors (overnight, one month, three months, six months and 12 months).
TMI: What are the biggest challenges for treasurers when it comes to the LIBOR transition?
DM: RFRs such as SOFR are overnight rates and, in order to use them as a LIBOR replacement, certain adjustments need to be made to create term versions and, in some cases, add historical spread adjustments.
One version is the ‘in-arrears’ method for calculating SOFR. In this method, historical SOFR rates are compounded for the relevant period following the contract, rather than before. That is challenging to understand and poses operational challenges. Another is the ‘in-advance’ method, where the rate is determined by compounding a historical rate before the interest period of the contract.
Since mid-2020, the ARRC has advised that the in-arrears method should be used for bilateral and syndicated loans with the in-advance method be used for intercompany lending.
However, this approach creates an inconsistency that treasurers must balance. Treasurers want to know their borrowing cost with a high degree of certainty, such as they had with LIBOR for more than 40 years.
Treasurers worry about the how SOFR will work mechanically in their systems. They find themselves asking: how costly and time consuming will the implementation of SOFR and their various versions be? Will it require us to re-engineer all our systems? What amount of retraining will our treasury personnel require?
TMI: What should treasurers be paying attention to when it comes to fallbacks?
DM: Treasurers should pay particular attention to ‘fallback language’, which is the clause of the underlying investment contract that specifies how rates and payments will be calculated should LIBOR cease publication. Some contracts can be vague as to how this works, or don’t have any provisions at all.
This language can be found by combing through the documents manually or more efficiently by reviewing a centralised database of security fallback provisions. Specifically, for bonds, it is often included in the indentures, while for swaps it will be in the contract governing the trade. Some instruments are easier to transition off LIBOR than others. For example, a centrally cleared interest rate swap can be changed unilaterally by the clearing house from LIBOR to SOFR or any successor rate they may choose. However, an over-the-counter derivative or a floating-rate loan may require the treasurer to obtain the approval of their trade counterparty or bondholders, which can be a tricky process.
TMI: What are some of the biggest misconceptions about a post-LIBOR world?
DM: One that immediately comes to mind is that treasurers do in fact have a choice as to what replaces LIBOR depending on their use case. While SOFR is the preferred rate, bank regulators have consistently recognised that having a choice of rates is necessary.
In December 2021, the US Congress passed a bill intended to provide safe harbour from litigation for certain so called ‘tough legacy contracts’. This was a positive development for the market and included some key language that asserts that the market has choice regarding the use of alternative rates.
Whichever LIBOR replacement a treasurer chooses, it is important to understand the differences and compare the overall cost of including the different spreads that come with these rates. Important considerations include how well a new rate matches the firm’s existing LIBOR exposures; how easily the new rate can be implemented; and how its costs and benefits can be presented and explained to the firm’s decision-makers.
TMI: Which stakeholders need to be involved in the transition?
DM: There are a number of internal stakeholders that should be involved in understanding, managing and co-ordinating a firm’s LIBOR transition process. This means close alignment not only with the firm’s leadership but also with individual departments including compliance, legal, technology, operations and investor relations, among others.
Beyond this, companies should strive to ensure that external stakeholders, including banks, financial advisers and exchanges, are kept up to date with their plans. As a result, these stakeholders will be well placed to offer the right support during the process and ensure that any risks associated with the transition are disclosed to relevant parties, such as investors.