Life After LIBOR: The $350 trillion question
On an otherwise quiet, summer Thursday, the news yesterday morning of the expected future discontinuation of LIBOR has created a flurry of conversations around the risk management implications relating to the specifics of the transition process. The distinction of yesterday’s development was that the U.K. Financial Conduct Authority (FCA) indicated that the benchmark underpinning approximately $350 trillion of financial contracts would be phased out by the end of 2021. While the news may initially seem alarming, there are two key observations to keep in mind.
1. The news of the initiative to replace LIBOR with a more robust transactions-based index was already well known to financial market participants.
2. Markets remained open and liquid. There has been no discernable impact on liquidity since the headlines came out, including derivatives priced off LIBOR that mature beyond 2021.
What we know today
The mention of this discrete timeline brings the somewhat abstract concept of a change in the future into relevance today. The following quote from yesterday’s announcement may help provide balancing context to the somewhat more alarmist posture of some of the news headlines.
“This transition away from LIBOR will take time. The transition will be less risky and less expensive if it is planned and orderly rather than unexpected and rushed. And a further lesson of the past few years is that work on transition is unlikely to begin in earnest if market participants continue to assume LIBOR will last indefinitely.”
Mr. Andrew Bailey, Chief Executive of the FCA
Public / Private cross-sector working groups led by the Fed, Bank of England, and the Bank of Japan have been established to select alternative reference rates. On June 22, 2017, the Alternative Reference Rates Committee (ARRC) in the U.S. identified a broad Treasuries repo financing rate which is proposed to be published by the Federal Reserve Bank of New York in cooperation with the Office of Financial Research. The current expectation is that this index will not begin to be published until the first half of 2018.
As it relates to derivatives tied to LIBOR, current ISDA documentation provides a mechanism to substitute in the eventual replacement benchmark, and ISDA is working on future transition plans alongside the central banks.
For the balance sheet assets or liabilities that reference the LIBOR benchmark, many of the governing documents contemplate the lack of availability of LIBOR and allow for its successor. Clearly, given the wide variety of language that can potentially appear in a loan agreement, any broad example will not be relevant for all circumstances. Chatham can help clients prepare for this process and assist with your specific circumstances. Given that the recent news places a ticking clock on the long awaited process, it will be important to proactively prepare for the transition.
At this juncture, we would advise market participants to review the language in existing financial contracts (loans and derivatives) for any contemplation of a replacement rate, or the specific process that takes places if LIBOR rates become unavailable. For new contracts, we would recommend working with your advisors to craft language that contemplates the eventual shift away from LIBOR.
We can take comfort in the fact that yesterday’s announcement from the FCA considers how LIBOR based contracts can exist, even after banks stop quoting the rate.
“In the context of that requirement to have contingency plans for the scenario in which current LIBOR could no longer be produced, we have discussed with industry participants models such as calculation of a one-off set of term credit spreads, which could be added to the dynamic base of the risk free rates.”
Mr. Andrew Bailey, Chief Executive of the FCA
Given the uncertainties, and the considerable amount of global risk priced off of LIBOR, Chatham would advise end users to adopt a systematic approach to manage the process. As more information on the transition comes to light, Chatham will be working to develop tools to assist our clients in managing the risk associated with any change to a new benchmark.
What is on the horizon?
The ARRC meets again in August, and given the accelerated timeframe initiated by Mr. Bailey’s speech, there may be more information available soon. Chatham is acutely aware of the importance of this transition to end users and will keep you apprised of any developments as they unfold.
It is too early to know how the replacement to LIBOR will price and how quickly liquidity in the derivative markets will develop, and accordingly how quickly commercial risk will begin to price off this new reference rate. Financial technology firms and capital market participants will need time to develop the technology and infrastructure necessary to support the transfer of risk based on this new index.
Finally, there are still outstanding questions relating to the hedge accounting relationships when LIBOR is the hedged risk. Chatham will update you with our perspectives and action plans as they develop on this front.
For near term discussions on implications to your specific portfolio, please contact your Chatham relationship manager to talk through what this means for your firm.