With hundreds of thousands of contracts around the world glued to the doomed LIBOR reference rate– and valued at an estimated $225 trillion – there’s a lot riding on counterparties revising contracts to ensure a smooth transition away from the long-used London Interbank Offered Rate, reports affiliate title Regulatory Capital Watch.
To put all of that in perspective, recent US Securities and Exchange Commission Form ADV data show advisors manage cumulatively $102 trillion.
It has been four years since the move away from LIBOR began, in part because some banks were manipulating the key rate to which deals involving derivatives, loans, bonds, mortgages and other products are pegged. The deadline for LIBOR leaving has been extended, most recently to 30 June 2023.
“The market should expect that these are the firm dates when LIBOR goes away,” said Manuel Frey, a partner with Paul Weiss in New York. He and his colleague Jane O’Brien, a partner based in Washington, DC, joined RCW via Zoom recently. View the video by clicking the box below.
O’Brien noted that regulators – including the SEC, FINRA and the US Federal Reserve – are monitoring how firms are moving toward the transition away from LIBOR. RCW has shared a Division of Examinations document request letter containing examiner questions tied to LIBOR. The topic drew enough attention that DOE put out a related risk alert last year.
If your firm has deals tied to LIBOR, you should consider disclosing how you’re dealing with the transition, O’Brien stated. “A firm may consider disclosing the notional value of contracts referencing LIBOR that extend past the anticipated cessation date,” she added.
Help can be found from the International Swaps and Derivatives Association. ISDA has assembled backgrounders on the transition and education on the so-called “fallback” language that will need to be added to existing contracts that extend beyond the 2023 cessation date to accommodate the phasing out of LIBOR. However, the ISDA protocol appears to be available only to its members.
The leading contender to replace LIBOR, at least in the US, is the Federal Reserve’s Secured Overnight Financing Rate. A committee of the New York Fed has assembled best practices to help firms ready for the transition because “LIBOR is used in such a large volume and broad range of financial products and contracts, its vulnerabilities pose a potential threat to individual financial institutions and to financial stability”.
Here’s an example of ISDA’s protocol fallback language that could be added to a contract:
US dollar LIBOR, Fallback Rate (SOFR) or if a Fallback Index Cessation Event has occurred with respect to Fallback Rate (SOFR), then the Applicable Fallback Rate for any Fallback Observation Day that occurs on or after the Fallback Index Cessation Effective Date with respect to Fallback Rate (SOFR) will be the Secured Overnight Financing Rate (“SOFR”) administered by the Federal Reserve Bank of New York (or any successor administrator), to which the Calculation Agent shall apply the most recently published spread, as at the Fallback Index Cessation Effective Date with respect to Fallback Rate (SOFR), referred to in the definition of “Fallback Rate (SOFR)” after making such adjustments to SOFR as are necessary to account for any difference in term structure or tenor of SOFR by comparison to Fallback Rate (SOFR) and by reference to the Bloomberg IBOR Fallback Rate Adjustments Rule Book.
Steps to take
Frey encouraged several steps firms should take to get ready for the transition. “The covid pandemic didn’t help” things, he noted. Still, there’s a “good chance the markets will be prepared”, he added.
While the deadline has been extended to 2023, firms should not sit and wait, cautioned Frey. He recommended you establish a multidisciplinary working group to tackle the issues involved. The group should include legal. Next, “you need to identify the exposure that you have at your firm… on the assets and liability side”, ie, how many of your current contracts never anticipated an end to LIBOR and extend beyond June 2023, he continued.
“Once you establish what your legacy contracts do and say” develop a strategy for “contractual remediation”, he said, meaning to add the relevant fallback language so a deal won’t blow up when LIBOR goes away.
“Lastly, you need to test the operational readiness” to ensure your systems “can handle different reference rates”, Frey stated. You also should not be entering into any new arrangements tied to LIBOR – unless they include a playbook for what happens after LIBOR disappears.
“After June 2023, that’s when the fallback language we talked about kicks in,” he continued.
Like derivatives, LIBOR’s reach can be complicated, with deals based on the rate at one-, two-, three-month and even longer intervals.
Lawmakers have taken notice, too. New York State passed legislation to assist with the transition but Frey said, “it’s not meant to be a last line of defence…because it’s only meant to address very narrow situations and in a very generic way”.
Greater risks should transition falter
“If everyone’s taking it seriously and are going through the preparedness steps… then the likelihood of it being an enormous systemic disruption to the markets is much lower,” said O’Brien. However, there have been signs “to be concerned that some firms are not taking it seriously, are not taking the steps that they need to take and are not prepared, in which case, it could be bad”.