What Happens to LIBOR-Based Instruments When LIBOR Is Phased

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What Happens to LIBOR-based Instruments When LIBOR is Phased Out? With Over $400 trillion Outstanding, Transitioning Exposures to a New Benchmark will Require Extraordinary Planning

Introduction approximately $200 trillion of debt and contracts tied to it. Yet a volume of only $300 to $500 million in daily bank-debt For years, LIBOR has underpinned a vast variety of debt trading underpinned that rate, rendering it vulnerable and derivative investments. Now the LIBOR index is being to manipulation. After the global financial crisis and phased out. This raises complex and important questions subsequent years exposed market events and rate about how investments pegged to LIBOR will be handled in manipulation, it became clear to regulators that a new the interim between when LIBOR is phased out and when reference rate was needed based on transactional data the investments mature. with robust trading volumes. This article provides background on LIBOR, summarizes Regulators have sought new rates based entirely on market how and why the changes are taking place, and outlines transactions, so that the rates that could not be manipulated important steps to be taken by State Street Global Advisors by a few market participants. Regulators have also been and other managers and investors to ensure the transition interested in “risk-free rates” — ones that did not include a occurs with a minimum of disruption. credit component and thus would not increase funding costs in stressed markets. In contrast, some investors have wanted Background to keep that credit component, because it hedges against credit moves: as credit conditions deteriorated or improved, While LIBOR has been around for 150 years, it truly became the rate would represent current credit conditions. an interest-rate tool in the mid-1980s when derivative contracts began using it to hedge interest rates. Since then, LIBOR has always been leveraged as a representative rate, Formalizing New Transaction-Based Indexes not a market rate; in other words, it is based on expected, not In the US, the Federal Reserve convened the Alternative actual, funding costs. Banks use it as the rate at which they Reference Rate Committee (ARRC), to introduce a new borrow or lend money among one another. rate, and to create a path enabling market participants to There was a time when LIBOR rates were quoted in transition existing cash debt and derivative contracts to the 10 different currencies across 15 different maturities. new rate. This led to the Secured Overnight Financing Rate Currently LIBOR rates are limited to five currencies (SOFR) which launched and began publishing rates in April (USD, GBP, EUR, JPY and CHF) and seven maturities. 2018. One-month and 3-month futures contracts began Each currency has representative banks that submit their trading on the CME in May 2018. SOFR is based on rates. There are 16 banks that submit GBP and USD LIBOR approximately $800 billion in daily volume by which rates, 15 that submit EUR rates, 11 for CHF rates and 12 for US Treasuries are funded in repurchase agreements (repo). JPY LIBOR.1 By some estimations there are more than $400 The volume is made up of three parts: dealer-to-dealer repo, trillion worth of notional contracts and outstanding debt, bi-party repo and tri-party repo. All three weighted average benchmarked versus LIBOR ($200 trillion, £36 trillion, rates are published daily with a one-day lag. The combined and €120 trillion).2 Upwards of 90% of that exposure is weighted-average rate is also published with a one day lag. to derivatives. In the United Kingdom, the Bank of England, along with Over the past decade LIBOR has been shrouded in the Financial Service Authority, created a working group controversy. The representative nature of LIBOR has that has established the Sterling Overnight Index Average intrinsically posed an integrity problem. Three-month (SONIA) as the pound’s new benchmark rate. SONIA was US dollar LIBOR is the most widely used rate, with created in 1997 and maintained by the British Bankers What Happens to LIBOR-based Instruments When LIBOR is Phased Out?

Association until 2016 when the Bank of England assumed Still questions about novation costs remain, so we must responsibility and became the administrator. Most recently, identify cash bonds that are outstanding. According to the the Bank of England and the Financial Conduct Authority second report issued by the ARRC there are four categories have established a working group to examine the impact of of cash products: securitizations, floating rate notes, business the transition away from LIBOR on markets. This group will loans and collateralized loan obligations, and mortgages and study any outstanding issues and potential solutions for other consumer loans. The report states business loans, infrastructure support as the market transitions to SONIA surprisingly, have the highest exposure to US dollar LIBOR. as the new benchmark rate. There was $3.4 trillion worth at the end of 2016, though roughly 80% of these loans were set to mature prior to the In Europe, the European Central Bank’s Governing Council end of 2021. State Street Global Advisors has little or no has decided that the Euro Short-Term Rate (ESTER) will be client exposure to business loans. Much of the floating-rate its new benchmark risk-free rate. Data determining this rate exposure is hedged to fixed rates given business interest in is already available in the euro system. The rate will begin predictable cash flows. Business loans can also be issued with formal publication in October 2019.3 In the meantime, call features that would mitigate exposure to an unforeseen investors can view interim rate data. This rate is currently or less predictable benchmark post December 2021. being published with the same methodology ESTER will use except with the inclusion of revisions, corrections and At the end of 2017 there was an estimated $1.8 trillion of cancelations. Currently over 30 banks submit data, there outstanding floating-rate notes referencing US dollar LIBOR; is over €35 billion of daily volume in the calculation that is roughly 84% of those were due to mature before the end of made using a weighted-average trimmed mean, a similar 2021 and 92% of them before the end of 2024. Nonetheless, calculation to that of SOFR. there is still a significant amount of debt tied to LIBOR that matures after the potential end of the LIBOR rate. Typical Transitioning Away from LIBOR contract language for floating-rate notes has the calculation agent polling various banks for a rate if LIBOR is not The transition from LIBOR to these new index rates raises published. If quotes are not received, then the note would many questions. In the US, ARRC has been publishing convert to a fixed-rate instrument at the last published value various documents to help market participants understand of LIBOR. Typically, these terms can only be changed with a what is in store during the transition. All of these documents unanimous noteholder vote. In many instances this might be are publicly available on their website. Most recently ARRC impossible. The ARRC suggests it might not even be feasible announced they would hold weekly conference calls4 for to locate all the noteholders. market participants to solicit feedback and ask questions. This potential conversion to a fixed-rate bond could be They have also published reports with data specific to disruptive. Consider an account that can only buy floating- market outstanding balances, transition methodologies rate notes. If a bond converted to a fixed rate it would be and best practices. ineligible and need to be sold. This could cause performance At State Street Global Advisors we have little to no exposure issues. If the bond was held and remained in the account, to interest-rate derivatives or swap contracts. We do, there could be challenges with duration extension. But some however, have substantial exposure to floating-rate debt recently issued floating-rate notes have contract language that uses LIBOR as a benchmark. There has been concern that gives the issuer, affiliate or non-affiliate third party surrounding the transition of these cash bonds to new the right to name a market-accepted successor rate as benchmarks. How will the novation to a new index occur? calculation agent if any of the other fallbacks specified, What basis will be used for the novation and will there be including potential fallbacks to SOFR, were exhausted. winners and losers in that transition? It is important to note two points. First, a significant Next Steps, What Should You Do amount of the debt we own for our clients matures before It is clear that the move away from LIBOR as a benchmark December 2021 and second, the market has already begun index has been and will continue to be disruptive and at pricing US dollar floating-rate debt based on SOFR. By some times confusing. But the regulators have confirmed that accounts the process of transitioning to this new benchmark this move will happen, so identifying exposure and is well ahead of schedule. SOFR debt issuance volumes have transitioning those exposures to a new benchmark will been robust with borrowers including Fannie Mae, Freddie require extraordinary planning and collaboration. Much of Mac, Federal Home Loan Bank, MetLife, Natixis, Credit that planning is already well underway and, in some cases, Suisse and the World Bank. seemingly ahead of schedule.

State Street Global Advisors 2 What Happens to LIBOR-based Instruments When LIBOR is Phased Out?

description of seeking another rate or defaulting to the last previous LIBOR setting. This might work on a cash bond LIBOR exposure could include: with six months to maturity, but might not work for long- • Committed credit agreements term contracts. A new benchmark must be identified and • Multi-currency credit agreements agreed upon, and that might be the easy part. The challenge will be agreeing to the calculation method of that • Inter-affiliated/intra-group loans benchmark. In the case of SOFR there are several options: • Term loans forward-looking term SOFR, SOFR rate compounded in • Floating-rate notes advance, SOFR compounded in arrears, and simple daily SOFR in arrears. It is expected that market participants will • Asset securitizations migrate to certain conventions but not without significant • Accounting (including fair value calculations, lease discussion and debate. valuations, capitalization of interest and derivatives) Once the calculation method is agreed upon then the • Asset purchase and sale agreements basis (yield difference) between the old benchmark and the • Supply agreements new benchmark will have to be established. There could be various calculations and time horizons used for this method, • Long-term capital goods purchases and this could lead to gamesmanship and other trickery. • Employee benefit payments But historical data should solve much of the debate. And it’s possible that the basis could be established in the future if certain conditions are met. No matter what your known exposures are to LIBOR in any In the US there are 28 members of the ARRC. Each member currency, it is imperative to begin working on identifying represents a specific entity that is affected by LIBOR and the those exposures and on transitioning to a new benchmark transition from LIBOR. At a recent conference, 4 members rate. The complexity of this transition will take years to sort of the ARRC were very clear about the preparation needed out and prove daunting to anyone late to the process. for this transition. They encouraged corporations and institutions to identify all their LIBOR exposure. 1 Source: https://theice.com/iba/LIBOR. 2 Source: Barclays: Experts Panel on LIBOR Transition Jan 2019. Once exposures are identified, documents and contracts 3 Source: https://ecb.europa.eu/paym/initiatives/interest_rate_benchmarks/ must be analyzed to determine fallback language. Simply euro_short-term_rate/html/index.en.html. put, what will happen if LIBOR ceases to exist? As 4 https://ecb.europa.eu/paym/initiatives/interest_rate_benchmarks/euro_short- previously noted, most of the language now includes a vague term_rate/html/index.en.html.

State Street Global Advisors 3 What Happens to LIBOR-based Instruments When LIBOR is Phased Out?

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