In July 2017, the head of the UK Financial Conduct Authority recommended a phaseout of the London Interbank Offered Rate by Dec. 31, 2021.
LIBOR is the benchmark interest rate banks charge each other for overnight, one-month, three-month, six-month and one-year loans. The LIBOR rate is published daily in five currencies: the Swiss franc, the European euro, the British pound sterling, the Japanese yen, and the U.S. dollar, so the migration away from LIBOR will be a global event in the financial markets. In fact, it’s estimated $370 trillion in commercial loans, mortgages, investments and financial derivatives are tied to LIBOR.
In response to the UK Financial Conduct Authority’s recommendation, the Federal Reserve tasked the Alternative Reference Rate Committee with developing a new risk-free reference rate based upon market transactions. In July 2017, ARRC recommended the Secured Overnight Financing Rate as the reference rate that represents best practices for use in the United States for financial contracts and derivatives.
SOFR, published daily and administered by the Federal Reserve Bank of New York, is based on more than $700 billion in overnight repurchase transactions secured by U.S. treasuries. This transition will be highly complicated and will impact both borrowers and their banks.
Today, LIBOR influences all aspects of the U.S. financial system, including large corporations, privately held, middle market companies, small businesses and consumer loans.
This transition … will impact both borrowers and their banks.
LIBOR is a fundamentally different interest rate than SOFR. The former represents an unsecured, forward-looking term rate, while SOFR is a backward-looking, secured, overnight, risk-free rate. As a result, SOFR will tend to be lower than LIBOR.
A spread adjustment to SOFR will be necessary to make it commensurate with LIBOR.
Borrowers and their banks may proactively negotiate new fallback language that clearly states which rate will be referenced in the event LIBOR is no longer available.
In the April 2019 issue of The RMA Journal, Sandie O’Connor, committee chair of the Alternative Rates Committee, identified three areas to focus on regarding fallback language:
1. What are the triggers? How do you identify when LIBOR is no longer able to be used?
2. What is the benchmark you fall back to?
3. What is the spread adjustment that will be part of the conversion that will minimize the value transfer between whatever the new risk free-free rate is that you’re falling back to and the existing LIBOR.
With respect to interest rate swaps, the development of protocols is being managed by the International Swap Dealers Association. ISDA is the source for global industry standards in documentation for interest rate swaps.
Unlike commercial bank credit agreements, interest rate swaps are documented under standardized master agreements and definitions published by ISDA. The existing definitions were intended primarily to address short-term disruptions in the publication of LIBOR and did not anticipate its permanent discontinuation. It is widely agreed that existing interest rate swaps referencing LIBOR will have to be modified, to address the discontinuation.
While the phaseout is still over two years away, commercial borrowers and their banks should have a discussion sooner than later about the transition away from LIBOR. It will be important for banks to educate their borrowers about the new fallback language and conversion methods. Commercial borrowers should also understand the impact of the difference in the spread between LIBOR and SOFR.
James M. Hagerty is an executive vice president and chief lending officer for Westerly-based The Washington Trust Co.
