How to Prepare for the End of LIBOR

The end of LIBOR is approaching, and despite the bombardment of emails, publications, and media reports warning of this transition, many treasury teams are nowhere near the finish line.

As every corporate treasurer should be aware by this point, the end of the London Interbank Offered Rate (LIBOR) is not just a problem for banks and investment firms. Any company that has issued LIBOR-based floating-rate debt, entered into a swap or futures contract to hedge risk, or taken a loan with pricing tied to LIBOR will be impacted by the transition.

Navigating the path to a new interest rate benchmark should be a top priority for treasurers—as well as for CFOs, CEOs, and boards—for the rest of this year. But where should they start?

Treasurers often need to look both backward and forward when analyzing their company’s financial performance. It would make sense to take the same approach to understanding the details of how the LIBOR transition will happen.

The Long Road to Transition

LIBOR underpins more than $200 trillion of financial instruments. The move away from the benchmark began in the wake of the global financial crisis. In 2017, the U.K.’s Financial Conduct Authority (FCA) made the official decision that all LIBOR settings would cease to be provided by its administrators and that LIBOR would no longer be a representative benchmark rate after the end of 2021. The transition has proceeded largely along its original timetable, with all but a few U.S. dollar (USD)–denominated rates set to be fully phased out by the end of this year.

In the United States, the LIBOR transition is being steered by the Alternative Reference Rate Committee (ARRC), a group of market participants convened by the Federal Reserve and the New York Fed to help ensure a successful transition from USD LIBOR to a more robust reference rate. The ARRC recommended the Secured Overnight Financing Rate (SOFR) as the replacement.

SOFR is a transaction-based rate that measures overnight borrowing costs on trades that are collateralized by U.S. Treasury securities. Because SOFR is based solely on secured overnight rates, it lacks two critical characteristics of LIBOR: a forward-term component (as in one-month, three-month, and six-month LIBOR) and a dynamic credit spread. These differences are creating challenges in the transition.

In May 2020, the ARRC published best-practice recommendations for completing the transition from LIBOR to SOFR for various classes of financial products. For business loans, the ARRC recommends that LIBOR not be used for any originations or securitizations going forward (specifically, for any originating after June 30, 2021).

Although some banks and corporations are prepared, many are still lagging behind. Some are also expressing concerns about the conversion, especially when a “term SOFR” failed to materialize in the originally discussed time frame. The issue is that before banks and their corporate clients can use SOFR as the benchmark index for a loan, they need to convert the overnight rate to a term equivalent.

Banks and treasurers currently have two alternatives for addressing this problem. The first is the “in arrears” method for calculating SOFR, which bases the interest rate for each day of the contract on the compounded interest of the previous days within the contract period. The obvious challenge with this approach is that rather than knowing their interest rate before the interest-accruing period begins, borrowers using the “in arrears” method don’t know their actual interest rate until the end of the interest period. The second method for calculating SOFR is the “in advance” method, in which the rate is determined by compounding a historical rate before the interest period of the contract.

Based on anecdotal comments in my discussions with Bloomberg’s corporate clients, these options for calculating the SOFR benchmark are a major part of what has been troubling corporate treasurers about the LIBOR transition. Since mid-2020, the ARRC has advised that the “in arrears” method should be used for bilateral and syndicated loans, and that the “in advance” method should be used for intercompany lending. However, this approach creates an inconsistency that treasurers must balance. It also makes it difficult to know borrowing costs with a high degree of certainty in advance, which is problematic for treasurers used to the clarity LIBOR has provided for more than 40 years.

Many treasurers are also worried about the uncertainty around how SOFR will work mechanically in their systems. They’re wondering: How costly and time-consuming will the implementation of the various versions of SOFR be? Will we have to re-engineer all our systems? What amount of retraining will our staff require?

3 Steps to Ease Treasurers’ Transition Concerns

With all these complications, one can hardly blame corporate treasury teams for feeling lost as the transition nears its endgame. To simplify the process, we recommend that treasurers take the following three steps:

1. Analyze all your exposures to LIBOR—and the supporting documentation. The first step in a successful LIBOR transition is to gather as much information as possible on your company’s exposure. If you haven’t already started this process, now is the time to do so. From bonds to swaps to mortgages, exposures may arise in a wide range of expected—and unexpected—places.

Equally important, treasury teams need to be analyzing the documentation behind these financial instruments. For bonds, sort through the indentures. For swaps, take a close look at the contract’s fine print. Each instrument incorporates LIBOR in its own way, and some are easier to change than others.

For example, if you have a centrally cleared interest rate swap, the clearinghouse can unilaterally change the baseline rate from LIBOR to SOFR or some other successor. However, changing an over-the-counter derivative or a floating-rate loan might require the approval of the loan’s counterparty or of dozens of bondholders.

In this process, pay particular attention to “fallback language”—the clause in the underlying securities contract that specifies how rates and payments will be calculated should LIBOR cease publication. Some contracts, especially those not drafted around guidelines set by associations like ISDA or the LSTA, are vague about how this works or don’t have any provisions at all. You can find this language by combing through the documents manually. Or you can save time by reviewing a centralized database of security fallback provisions.

2. Decide on your go-forward funding cost. One of the biggest misconceptions among treasurers is that they don’t have a choice. Although regulators have recommended SOFR as the replacement for LIBOR, they have also indicated that market participants are free to use alternatives, as long as the benchmarks are based on robust transaction data and adhere to international standards such as IOSCO’s Principles for Financial Benchmarks.

Financial services firms have been producing potential alternatives to SOFR that draw information from the same products banks use to fund themselves—such as commercial paper, certificates of deposit, bank deposits, and short-term corporate bank bonds—and maintain favorable aspects of LIBOR, including the term structure and credit risk components.

One of these alternatives is Bloomberg’s Short-Term Bank Yield Index (BSBY), which is intended to measure the average yields at which large banks access unsecured wholesale USD funding. The BSBY index is dynamic, it incorporates a credit-sensitive element, and it reflects the marginal funding cost for banks across five different tenors (overnight, one month, three months, six months, and 12 months).

Before settling on a LIBOR replacement, treasurers need to understand the differences between the alternatives and compare their overall cost, including the spreads that come with each rate. The benchmark a company utilizes should match the profile of the organization’s LIBOR exposures, and it should be efficient to implement and easy to explain to the management team.

3. Overcommunicate throughout the process. Treasurers are likely to be asked to quarterback the LIBOR transition for their company, but it’s important to keep in mind that a wide range of stakeholders inside and outside the company will be critical to the transition’s success.

First and foremost, you need to make sure the company’s internal stakeholders are aligned. This means close coordination not only with the senior management team (up to, and including, the CEO), but also with departments including compliance, legal, IT, operations, and investor relations. Moreover, if any of the company’s products relies on LIBOR—for example, mortgage loans—the marketing and customer/client teams should be added to the list of internal stakeholders who need to be involved.

Once you have set an inclusive table within the company, turn your attention to external stakeholders. As treasurer, you will have a direct line to your company’s financial counterparties, including banks, financial advisers, and exchanges. Ensure that they are all aware of your plans and are providing the support you need during the process.

In addition, make sure to adequately disclose to your investors any risks the organization will face associated with the transition. And educate clients and customers about any changes that might affect them.

2021 has been a transformational year for the economy and for financial markets. Nevertheless, the LIBOR transition can’t just be one more item on the long list of treasurers’ 2021 business worries.

If not handled properly, moving to a new benchmark could pose massive risks for your business. But if done right, it could help you pivot to 2022 on confident financial footing.

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David Mullen is a senior product manager for Bloomberg LP, focused on development of index-linked products, including the Bloomberg Short Term Bank Yield Index, to support the LIBOR transition. Previously, he served as the senior business manager for Bloomberg’s fixed income ETF products and ETF trading platform. Mullen has been with the firm for more than 20 years, and was previously responsible for developing, enhancing, and maintaining analytical, relative value, price discovery, and other key fixed income functionality on the Terminal. Earlier, he spent several years as a fixed income trader and salesperson at several Wall Street firms including Deutsche Bank, Donaldson Lufkin & Jenrette, and Prudential Securities.