What Comes After LIBOR?
Annual Premier Client Kathie Brandt, Partner, Thompson Hine LLP Summit Today’s Objectives
• Understanding the LIBOR problem and how we got here • Discussing transition challenges • Planning for the future • Staying awake for the entire presentation
Annual Premier Client Summit 2 Understanding the LIBOR Problem & How We Got Here
• Setting the context • History of LIBOR
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here • What is LIBOR and how is it derived? – London Interbank Offered Rate – how much would a bank believe they would have to pay another bank to borrow unsecured funds on the London interbank funding market (remember “match funding”?) – First appeared in 1970s; gained traction in 1980s when “prime rate” reached 21.50% – LIBOR rates now published every day in five currencies (USD, British pound sterling, euro, Japanese yen and Swiss franc) and for seven different interest periods ranging from overnight to one year
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here • History of LIBOR – Scandal • Financial crisis in 2008 resulted in investigations of LIBOR and financial institutions • Collusion (not with Russia this time) • 20 major banks subjects of criminal and civil investigations, billions of dollars of fines and penalties assessed and jail time
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here
• History of LIBOR (cont.) – Announcement by Financial Conduct Authority • 2017: FCA’s CEO questions sustainability of LIBOR as a benchmark • FCA announces that after 2021 it will no longer compel panel banks to submit rates to enable the calculation of LIBOR • Y2K or “black swan” event?
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here
• History of LIBOR (cont.) – Why is LIBOR going away an issue? • $200 trillion in outstanding transactions reference USD LIBOR (95% derivatives, 5% commercial and consumer loans) • Current daily transaction volume underlying LIBOR is around $500 million, based on “expert” judgments instead of actual transaction data
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here
Asset Classes Affected1
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here
• LIBOR is not the only rate going away
– EURIBOR
– EONIA (Euro Overnight Index Average)
– TOIS (Tomorrow/Next Overnight Indexed Swaps)
– TIBOR (Tokyo Interbank Offered Rate)
– CORRA (Canadian Overnight Repo Rate Average)
– BUT, so far, CDOR (Canadian Dollar Offer Rate) is safe
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here • Actions to date
– Regulatory bodies worldwide have been setting up working groups to come up with risk free, alternative reference rates (RFRs)
– US – Federal Reserve convenes the Alternative Reference Rates Committee (ARRC)
• Public/private working group
• 27 firms and 10 government agencies
• Mission: identify best practices for alternative reference rates, develop an adoption plan, and create an implementation plan with metrics of success and a timeline
• October 2017 – ARRC announces Paced Transition Plan, which established a process and timeline
• ARRC establishes SOFR (Secured Overnight Financing Rate) as US alternative to LIBOR
Annual Premier Client Summit Understanding the LIBOR Problem & How We Got Here
Other Relevant IBOR Replacement Rate Replacement SONIA GBP LIBOR Rates (Sterling Overnight Index Average)
SARON CHF LIBOR (Swiss Average Rate Overnight)
TONAR JPY LIBOR (Tokyo Overnight Average Rate) ESTER (Euro Short-Term Rate) Euro LIBOR/EURIBOR GS Pooling Deferred Rate RepoFunds Rate
Annual Premier Client Summit Transition Challenges
• Global coordination required
– Different products and currencies – Derivatives linked to loan facilities • LIBOR is forward looking term rate • Proposed RFRs for different currencies calculated on different basis from each other (ex. SONIA vs SOFR) • Proposed RFRs likely to come online at different times • LIBOR factors in a credit risk and proposed RFRs do not
Annual Premier Client Summit Transition Challenges
• Template documentation cannot be prepared until an alternate rate gains market acceptance • Fallback provisions in existing documents meant to cover short-term disruptions in LIBOR, not discontinuation • Obtaining requisite consent for amendments to existing documentation (significant time and cost implications) • Significant changes to infrastructure and systems of market participants will be required
• Transition may result in accounting and tax issues • Hedging could be less effective if transition of underlying obligation to an alternative rate does not occur at the same time as the related hedge
Annual Premier Client Summit Transition Challenges
SOFR (Secured Overnight Financing Rate)
• How calculated – Measures the cost of borrowing cash overnight collateralized by US Treasury securities – Has been published since April 2018 – Fed publishes SOFR on its website each day at approximately 8:00 a.m.
Annual Premier Client Summit Transition Challenges
SOFR (Secured Overnight Financing Rate)
• Issues/comparisons to LIBOR
– Overnight rate (to begin) – Over $700 billion of daily trades
– New and not well understood – Not easily manipulated – Secured – Not in contracts broadly yet – Risk-free rate – Liquid and deep – Will not widen in periods of credit stress
Annual Premier Client Summit Transition Challenges
SOFR (Secured Overnight Financing Rate)
• Comparison to LIBOR – SOFR should be lower, but spread differential isn’t stable
• Four components to loan fallback language
– Trigger
– Spread adjustment
– Amendment process
Annual Premier Client Summit Transition Challenges
• Two approaches proposed by ARRC
Amendment “Hard-Wired” Approach Approach
• Pros and cons
• Market data – what are lenders and borrowers doing now?
Annual Premier Client Summit Future Planning
• What should be done in existing facility agreements? Review agreements to check: – Fallbacks that apply if the relevant IBOR ceases to exist
Annual Premier Client Summit Future Planning
• Procedure for amending agreement to change the interest rate provisions
– Level of lender consent required?
– Consents of other creditors required (intercreditor agreements)?
– What are the trigger events for the determination of a replacement rate?
– Who selects the replacement rate?
– Any safeguards on selecting the replacement rate (prevailing market convention, rate widely accepted in relevant loan market)?
– Are all necessary changes included in fallback language (adjustment of margins if appropriate)? • Having completed review – should you amend now?
Annual Premier Client Summit Future Planning • What should be done in new facility agreements? Consider the following:
Does an adjustment How to make it as easy as spread need to be added What are (should be) possible to transition to a to the replacement rate to the triggers for applying new rate even if the new make it economically the new rate? rate is not yet specified? comparable to LIBOR being replaced?
What is the prevailing What are appropriate market convention in What is the prevailing fallbacks for the documentation regarding replacement rate(s)? replacement rate? transitioning to a new rate?
Annual Premier Client Summit Q&A
• Questions? • Anyone still awake?
Annual Premier Client Summit What Comes After LIBOR?
Annual Premier Client Kathie Brandt, Partner, Thompson Hine LLP Summit