As previously discussed in this PubCo post, one of the risk areas that SEC staff have advised they will be monitoring and have urged companies to address—and soon—is the effect of the LIBOR phase-out. LIBOR, the London Interbank Offered Rate, is calculated based on estimates submitted by banks of their own borrowing costs. In 2012, the revelation of LIBOR rigging scandals made clear that the benchmark was susceptible to manipulation, and British regulators decided to phase it out by 2021. LIBOR has been used extensively as a benchmark reference for short-term interest rates for various commercial and financial contracts—including interest rate swaps and other derivatives, as well as floating rate mortgages and corporate debt. As cited by SEC Chair Jay Clayton, according to the Fed, “in the cash and derivatives markets, there are approximately $200 trillion in notional transactions referencing U.S Dollar LIBOR and…more than $35 trillion will not mature by the end of 2021.” (See also this PubCo post.)
Clayton indicated that an alternative reference rate, the Secured Overnight Financing Rate, or “SOFR,” has been proposed by the aptly named Alternative Reference Rate Committee. For public companies that have floating rate obligations tied to LIBOR, Clayton warned, a significant risk is
“how to manage the transition from LIBOR to a new rate such as SOFR, particularly with respect to those existing contracts that will still be outstanding at the end of 2021. Accordingly, although this is a risk that we are monitoring with our colleagues at the Federal Reserve, Treasury Department and other financial regulators, it is important that market participants plan and act appropriately. For example, if a market participant manages a portfolio of floating rate notes based on LIBOR, what happens to the interest rates of these instruments if LIBOR stops being published? What does the documentation provide; does fallback language exist and, if it exists, does it work correctly in such a situation? If not, will consents be needed to amend the documentation? Consents can be difficult and costly to obtain, with cost and difficulty generally correlated with uncertainty. In the area of uncertainties, we continue to monitor risks related to the differences in the structure of SOFR and LIBOR. SOFR is an overnight rate, and more work needs to be done to develop a SOFR term structure that will facilitate the transition from term-based LIBOR rates.”
As reported by the WSJ in this article, companies have begun to analyze and disclose some of these risks. According to an accountant cited in the article, in conducting their analyses, companies “must look at three areas—borrowing, derivatives and investments—when assessing the scope of their exposure….They must also consider any implications for hedging and hedge accounting, as well as how the risk varies by currency and jurisdiction.” While, because of LIBOR’s integral role in many of their products, financial institutions may be a step or two ahead of the game, for many other companies, uncertainties related to the transition may make it difficult to predict the impact at this point. However, “Libor-related disclosures will become more detailed in the coming quarters as regulatory efforts to establish alternative benchmarks advance and as companies get a firmer grasp of the risks….Finance chiefs don’t yet have a clear path to transition away from the benchmark, limiting what they can tell investors….” To be sure, the article observes, it’s possible that the transition from LIBOR “could translate to higher corporate borrowing costs and even dent company profits and stock prices.”
In addition, the shift to SOFR as the potential new benchmark is also expected to have a significant impact. This article from Compliance Week discusses the “compliance headaches” that many companies will face in connection with the transition away from LIBOR. According to a BDO partner quoted in the article, the “transition is not as simple as swapping out a new rate for an old one….While LIBOR is a rate banks use to lend among themselves, SOFR is a secured overnight rate. Credit risk is embedded in LIBOR, but not in SOFR, he says. ‘There’s going to have to be some negotiation for the credit spread that was implicit in LIBOR….That will take some time.’” (See this PubCo post.)
What’s more, as discussed in this article from the WSJ, there has recently been unusual volatility related to SOFR, perhaps raising some questions about its viability as the substitute reference rate. More specifically, the market for overnight cash loans used for repurchase agreements spiked at the end of last year, which caused concerns because “repo trades are a key component of [SOFR].” According to the WSJ, if “SOFR proves unusually volatile or hard to predict, it would diminish the benchmark’s appeal to companies that are considering tying their borrowing costs to it, adding uncertainty to the market’s search for a suitable Libor alternative.” The “three-month dollar LIBOR rate… is based on an estimate of what banks would pay to borrow for that period and is set at the time of the loan, resetting every three months.” In contrast, the “three-month SOFR rate is calculated using overnight yields during the period, so the rate isn’t known until the cumulative yields have been compounded. This method exposes borrowers and lenders using SOFR to market volatility, as yields in the repo market can move along with the yields on short-term Treasurys….That volatility could make it harder for borrowers to use a benchmark subject to unexpected spikes depending on supply and demand within the cash market.” The ARRC, however, is working “to develop pricing models that they expect will make borrowers and investors more comfortable using SOFR as a benchmark for longer-term securities. Overnight repo rates can often be volatile, but the underlying reasons for and timing of many of those swings ‘are well-known and predictable,’ according to an explanation about SOFR on the website maintained by ARRC. When averaged over time, Treasury repo rates are less volatile than U.S. dollar Libor, the statement said.” Whether the new pricing models offer the necessary comfort level remains to be seen.