LIBOR Transition to SOFR

LIBOR has been an integral part of the global financial system for decades. Due to its ubiquitous nature, transitioning to alternative reference rates will need careful consideration to limit adverse impacts to the global economy. Regulators, industry working groups and market participants are invested in a synchronized and timely execution of this mandate. Impacts will be felt at all levels of financial institutions, and senior leaders will need to act in these organizations to ensure that effective working groups are assembled to tackle the issues at hand. A call to action has been made, and urgency is needed to accelerate the timeline surrounding LIBOR transformation in preparation for the decommissioning of LIBOR at the end of 2021.

Background

While we know global markets are retreating from the use of the London Inter-bank Offered Rate (LIBOR), the means of transition to a new standard rate is far from clear for the financial services industry. In 2018, the Financial Conduct Authority (FCA) announced that banks will no longer be required to provide inputs for the calculation of LIBOR. Following this announcement, the Federal Reserve’s working group, known as the Alternative Reference Rate Committee (ARRC), identified the Secured Overnight Financing Rate (SOFR) as the frontrunner to replace U.S. Dollar (USD) LIBOR rates domestically. The Federal Reserve Board, International Swaps and Derivatives Association (ISDA), and other regulatory oversight bodies are proactively monitoring transition plans. The inevitable transition away from LIBOR has raised concerns and spawned challenges for banks; this paper will explore these challenges in greater detail and outline an approach that will help banks to limit transition risks and create synergies across their cross-functional teams.

Rate Alternatives and Industry Outlook

SOFR, an overnight rate based on Treasury repurchase agreement transactions, has been recommended and promoted as the preferred rate to replace LIBOR in the U.S. by the ARRC. Consisting of private-market participants, including past LIBOR contributing banks, the ARRC has identified SOFR as a robust alternative. SOFR succeeds in several areas underlined in the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks where LIBOR failed (i.e. governance, conflicts of interest)1.

It has been over a year since the Federal Reserve initially published SOFR. Coinciding with market confidence, acceptance of SOFR is steadily growing as the new rate is utilized by more banks and lenders. The CME Group estimates SOFR’s calculation to be based on over $1 trillion in overnight Treasury repo transactions2.

Regulatory and industry working group progress is accelerating. ISDA issued their final consultation on fallback language, and the ARRC released their latest newsletter highlighting a new checklist on how to implement the transition. The Financial Accounting Standards Board (FASB) issued a new proposal around fallback language to mitigate any fallout from the transition relating to contract modification and hedge accounting. These updates will still require cooperation from the financial services industry in applying fallback language in a prompt and coordinated manner across financial market participants.

Many institutions face SOFR transition challenges stemming from the uncertainty around regulatory, operational and systemic impacts to the financial markets. Despite these uncertainties, market participants continue to make positive advances.

Challenges, Current Issues and Key Considerations

Due to the prevalence of LIBOR-linked instruments in the global markets, financial institutions face wideranging impacts to their operations. Cross-functional workstreams within global banks face several unique challenges that influence how banks will interact with clients, counterparties and other stakeholders.

Figure 1 - Impacted Bank Functions

The industry is reaching a critical point in the LIBOR transformation timeline. Banks are formalizing transition plans, and industry working groups are setting the standards for fallback language that will guide financial markets closer to ending the reliance on LIBOR. Current uncertainty around term structure creation, fallback language and company exposures to LIBOR are obstacles for many global bank’s program management offices to define the scope of LIBOR replacement. Below we lay out some functional workstreams and key considerations that help guide financial institutions to make more informed and effective implementation decisions.

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Sources

  1. Principles for Financial Benchmarks (July 2013). https://www.iosco.org/library/pubdocs/pdf/IOSCOPD415.pdf
  2. SOFR: A Year in Review (April 2019). https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/SOFR_Anniversary.pdf