The London Inter-Bank Offered Rate (LIBOR) clock is ticking…is your firm ready? If not, you are not alone!
With less than 10 months until LIBOR ceases, remediation is not where market participants hoped it would be. While the issuance of new loans referencing LIBOR halted on December 31, 2021, “legacy” contracts still linked to LIBOR – which account for trillions of dollars in investments – need to imminently transition to a new rate. The Secured Overnight Financing Rate (SOFR) has been widely accepted as the USD LIBOR alternative rate by the industry but there are considerations with this replacement rate should firms choose to adopt.
While most companies are busy addressing inflation and a potential recession, few are focusing on early LIBOR transition of their investments. This may lead to a transition bottleneck as we approach June 30, 2023, the last time USD Libor will be published.
So, let’s walk through some important areas of consideration when executing the LIBOR transition at your firm.
Understanding LIBOR and SOFR
LIBOR is a key benchmark used to determine interest rates in trillions of dollars of financial debt instruments. In 2017, the Financial Conduct Authority (FCA), announced that LIBOR should no longer be considered “viable” as the rate had been manipulated since 2007 by the banks reporting the rate. In 2018, the Alternative Reference Rate Committee (ARCC) endorsed SOFR as the replacement benchmark to USD LIBOR.
Below are key differences between these two rates:
Understanding LIBOR and SOFR
LIBOR is a key benchmark used to determine interest rates in trillions of dollars of financial debt instruments. In 2017, the Financial Conduct Authority (FCA), announced that LIBOR should no longer be considered “viable” as the rate had been manipulated since 2007 by the banks reporting the rate. In 2018, the Alternative Reference Rate Committee (ARCC) endorsed SOFR as the replacement benchmark to USD LIBOR.Â
Below are key differences between these two rates:
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How the LIBOR cessation impacts the investment management industry
The differences between LIBOR and SOFR calculation methodologies have enormous consequences in the financial services industry and require adequate economic alignment.
After December 31, 2021, the corporate loan market largely stopped originating new loans based upon LIBOR and now nearly all new assets are issued referencing SOFR and other alternate rates. However, trillions of dollars in legacy LIBOR contracts remain outstanding. To address these, borrowers can:
- Refinance now into a SOFR loan;
- Utilize Fallback language found in the Credit Agreements to set a “waterfall” to sunset LIBOR when it ceases on June 30, 2023.
Key considerations for the LIBOR transition
To ensure that your firm is ready for next year’s LIBOR transition, the following areas are of particular importance:
- Fallback language: What is the replacement rate when LIBOR sunsets?
- Hardwired or Amendment approaches: Is the replacement rate built into documents (Hardwired) or will the change require an onerous Amendment process to determine the replacement rate?
- Triggers: What event will catalyze the shift to the replacement rate?
- Economic neutrality: Consider the Credit Spread Adjustment (CSA) – the SOFR curve is lower and flatter than LIBOR and therefore will require an adjustment to mimic LIBOR.
Action plan – Here are the are the key areas to focus on for readiness for investment firms
Investments
- Review existing investments. Fallback language and rate(s) may significantly change the investment upon cessation.
- Update valuation models to accurately calculate using the replacement rate.
Compliance/Legal
- Identify legacy LIBOR positions and all proper documentation needed to determine the Fallback language, and what, if any, remediations will need to take place upon LIBOR cessation (i.e. Hardwire vs Amendment approaches).
- Review Client and SMA/UMA Investment Management Agreements to determine if any amendments are necessary to benchmark rates.
- Prepare documentation for the LIBOR transition as SEC/OCIE examinations are taking place. These examinations are to assess registrant’s efforts to prepare for the expected discontinuation of LIBOR and their transition to alternative reference rates.
Operations
- Examine the many areas of the Operations division that will be affected by the transition, including Security Master, Pricing, Performance, Attribution and Benchmarks, Client Reporting, Account Reconciliation, Fund Accounting, and Risk.
IT, Middle and Back Office
- Identify LIBOR exposure across portfolios and products and identify where the data is stored
- Different asset classes may store the reference rate in different fields, in different systems, formats, or not at all
- Review Ultimate Parent Securities for underlying securities linked to LIBOR, which may not be noted on the parent security
- Review the software platforms listed below in case upgrades are needed. (Functionality and best practices are always evolving.)
- Accounting platforms
- Investment platforms
- Reporting & Reconciliation software
- Security Master platforms
Moving forward
For investment management firms, preparation is key for the LIBOR cessation. Making sure that your organization is ready with a transition plan now – especially from an Investment, Compliance, Operational, and IT perspective – will be instrumental when LIBOR ceases next summer.
Looking to avoid a fire-drill next year? It’s not too late to start planning. Reach out to Chip Rabus to learn more about how Grandview Analytics can help.
