Impending replacement of LIBOR prompts concerns

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The impending transition from LIBOR to SOFR as the reference rate in the global financial market may seem to concern mostly banks and other kinds of financial institutions, but it can also have an impact on accountants and their organizations and clients.

On June 22, 2017, the Alternative Reference Rates Committee of the Federal Reserve selected the Secured Overnight Financing Rate as their final choice to replace U.S. dollar LIBOR past calendar year 2021. At present, LIBOR, or the London Interbank Offering Rate, is the most widely used financial benchmark on the globe. It is used in a wide variety of financial products such as mortgages, corporate loans, government bonds, and credit cards, as well as for a variety of Eurodollar and interest rate derivatives. As LIBOR presently underlies assets that are estimated at more than $350 trillion in speculative funds, the undoing of these products is expected to be extremely complex and fraught with challenges.

Why the change from LIBOR to SOFR?

So, why go through the process of making such an enormous change to the global financial system? Though there is skepticism within some corners of the industry about the magnitude of the task, the continued existence of LIBOR has become more tenuous since the financial crisis. Various reasons have been cited, but the concerns are primarily focused on the lack of transactional data underlying LIBOR, the reduced credibility of the rate-setting process because of recent scandals, and the reticence of member banks to continue making LIBOR submissions. All these factors have compounded the need for a replacement.

The switch from LIBOR to SOFR is viewed as a positive change for the global financial system, as it is intended to increase both short- and long-term stability across participating institutions. SOFR, the alternative rate chosen by the ARRC, is a widely used measure of short-term borrowing collateralized by Treasury securities. As it underlies a repo market with more than $700 billion in daily transactions, there is transactional data that widely supports the published rate, which is very liquid. LIBOR, in comparison, is very thinly traded and subject to a panel of banks that provide their submissions daily.

While there are numerous differences between the two rates, the foremost variance is the tenor of the instruments themselves. Interbank Offered Rates, or IBORs, are instruments that are based on multiple rate tenors (such as one-, three- or six-month durations) that form the basis of the term structure, where ARRs usually are much shorter in duration and do not have this type of structure. The consequence of this difference is that IBORs carry additional risk as a result, whereas ARRs are much more cash-oriented and are truly more risk free.

As such, IBORs tend to include some degree of inherent credit risk, which is captured as part of the rate structure. Since ARRs are very short-term in nature, they tend to be devoid of this additional risk. There was clear evidence of this during the financial crisis, when the LIBOR to Overnight Indexed Swap, or OIS, spread spiked to 350 basis points after lending concerns were raised by banks.

What is the current landscape for organizations as they prepare for the transition?

Although the transition is not expected to occur for some time, the extent of the interaction with a vast array of instrument types, and the complexity of the hurdles that are just now surfacing, are all going to require time to be properly addressed. Meanwhile, as questions emerge around when and how changes will take place, it’s best to begin preparations. At present, various pieces are beginning to take shape.

First, groups such as the International Swaps and Dealers Association have been taking a more active role in the transition by focusing on fallback language and protocols for derivative products. After a recent consultation, ISDA has been crafting language to be implemented for new and existing LIBOR-based instruments, thereby lessening the impact of a disruption should a triggering event, such as LIBOR cessation, occur.

The other supporting event that has occurred is the advent of one- and three-month SOFR futures trading on the Chicago Mercantile Exchange and the recent initialization of trading of SOFR swaps. Even though liquidity is limited on some of these instruments at present, comments regarding how the instruments were received has been positive and the volume has been steadily increasing. The hope is that increased trading in these products will provide enough liquidity to achieve critical mass and address pricing over the entire yield curve in less than two years, making the transition from LIBOR to SOFR more plausible.

All these positive steps do nothing to diminish the need for preparedness and planning, which should already be taking place. Recent surveys indicate that many companies are taking a wait-and-see approach while others are expecting the markets to sort it out prior to getting involved. This posture has many concerned that it will only intensify the tipping point when it does arrive.

What steps can organizations take to prepare?

Companies should already be in the midst, or at least in the initial stages, of focusing on this topic. The following is a list of steps for implementation:

Step One: Determine a driver, transition team and scope. Formalize which individual or group is going to own this process and what it might encompass. Someone like the CFO, treasurer or chief accounting officer could be the right person within the organization to oversee and manage the project.

Ideally, the person leading the team, as well as the participants, should be familiar with the impacted financial instruments, as well as the associated operations that the change could affect, including financial reporting.

Once this transition team has been established, the group should convene to determine the scope of the impact across various elements of the entity. Where are there LIBOR/IBOR-based instruments within the organization? This includes loans, valuations and derivatives.

Step Two: Secure approval, budget and buy-in from senior leadership on the project. It will be important for the success of this initiative for leadership to be fully on board. This is vital to make sure the project gets the attention and resources it requires. Once approved, the transition team should receive an initial budget to begin the inventory, assessment and planning process.

Depending on the findings, there may be more that needs to be addressed than initially estimated. Buy-in from the senior leadership can ensure the project is able to move forward, regardless of a change in scope.

Step Three: Execute the risk assessment and bucket exposures by threat level. Once approval has been secured, perform a risk assessment or impact analysis on the identified instruments to understand the potential exposures and risks associated with each. To determine the next steps, separate the exposed instruments into three categories: high risk, moderate risk and those unimpacted by the change. Examples of potential exposures and their level of severity include:

  • Low/no risk: A derivative portfolio at one of your subsidiaries that is set to expire before 2021, prior to the shift from LIBOR to SOFR.
  • High risk: Longer-dated instruments, like a 15-, 20- or 25-year loan. These may need to be renegotiated, transitioned or monetized.

Step Four: Determine a transition, implementation and backup plan. Formulate a transition plan for implementation (including the implementation of fallback language and possible scenarios) and establish policies and procedures to address the process on a go-forward basis, addressing each bucket of risk. There are several accounting-specific concerns related to the transition, highlighting the importance of accounting input in both the planning and implementation phases.

To determine an action plan for each level of exposure, the potential avenues for resolving each of the various exposures must be explored. For instruments to monetize transactions, what must be done to exit those and make new ones? For existing instruments that must make the transition, it is prudent to determine fallback language or changes in all the elements that go along with amending a contract. These actions should be performed with an understanding of how they will be handled after the change.

The change is also expected to significantly alter the valuation approach, which could result in a substantial difference in the value of any loans currently held or leveraged. For accountants, this may qualify as a debt modification or debt extinguishment. It will be crucial to keep an eye on guidance from the Financial Accounting Standards Board and accounting standards updates on how to address this area, as well as other relevant concerns, in the lead-up to 2021.

What do accountants need to pay special attention to for the transition?

The valuation piece currently presents the biggest challenge — and question mark — for accountants and the organizations they serve. The most apparent obstacle that has surfaced in transitioning from LIBOR to SOFR is that LIBOR is a term-based rate, whereas SOFR is an overnight rate. As the structures are fundamentally different, trying to convert from an overnight rate to a term structure is going to require that a projection method be developed. The consequences of making this conversion to already existing contracts is going to create unforeseen value transfers, as an equivalent rate may not be that equivalent.

Second, modeling complexity will most likely increase as various techniques are going to be needed to perform calculations that were considered mainstream in the past. Techniques that will include a multirate environment and curve building and development are all going to become more relevant. For example, curves and bases for dollar-denominated instruments will need to be modeled in LIBOR, OIS and the new ARR. If multiple currencies are added, the modeling approach will expand exponentially. This will lead to increased complexity and modeling risk.

Depending on how automated your valuation packages are, and the types of packages you leverage, technology may play a large role in the implementation stage for accountants. At a base level, the valuation automation will need to be reset with a different formula to accommodate the new rate. Additionally, there may be various types of packages that are automated. Depending on how those packages are being updated, multiple approaches may be needed once the transition occurs to determine how a package is doing and how the change may impact outcomes.
The final obstacle worth mentioning is that no comparable history currently exists for many of these new ARRs, which will make back-testing almost impossible. As a result, data that is presently relied on to calculate volatility and convexity is going to need to be created. In addition, until new products are traded with increased frequency, implied data also will not exist. Hence products such as options, swaptions, etc., will be difficult to value.

What resources can help accountants prepare for the transition?

As 2021 approaches, it will be important for accountants to monitor and utilize resources from deciding bodies like the ISDA and ARRC, as well as traditional sources like FASB and the International Accounting Standards Board to appropriately prepare for the transition. Though FASB has not released much guidance related to the switch as of yet, activity is expected to pick up over the next year as the change gets closer.

Whether your organization is already in the planning stages or just beginning the process in preparation for change, the time for waiting is over.

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