The IBORs are in danger of disappearing
The London Interbank Offered Rate – or LIBOR – faces an existential threat because, after 2021, submitting banks will no longer be compelled to participate. Although ICE may continue publishing LIBOR rates submitted voluntarily by banks after 2021, it is likely that at least some banks will leave the LIBOR submission pool.
The loss of participants threatens to further undermine LIBOR and increase the risk of remaining banks. Regulators, particularly in the US and UK, have said that this presents a systemic risk to markets. Therefore, market participants need to transition to IBOR alternatives. If markets do not transition voluntarily, regulators could declare that LIBOR is unworkable or impose capital charges on LIBOR-based instruments. To facilitate transition, working groups sponsored by central banks are developing new risk-free rates and transition plans.
It is time to start preparing for what happens if LIBOR goes away. Here is what you need to be doing now:
Step 1: Evaluate Hedging Strategies
It is critical to begin thinking through LIBOR alternative hedging strategies. Term rates for LIBOR alternatives are proposed to be used only for cash instruments, not derivatives. This presents a difficulty for hedging. You may need to transition using only a compounded rate or be prepared to manage a mismatch between cash instruments and derivatives.
The USD LIBOR alterative, the Secured Overnight Funding Rate – or SOFR – is more volatile than LIBOR and it does not contain a credit component, meaning it behaves differently than LIBOR in times of financial stress.
Step 2: Review Documentation for Fallbacks
Discuss with your Chatham team how you can manage the risk of LIBOR’s unknown future. The fallback language in your debt and derivatives documentation determines what happens if LIBOR is unavailable. Get familiar with yours if you have not already as yours might fall back to a Prime rate, or it may not address LIBOR unavailability at all.
Chatham Financial can help you review your documentation and assess the benefits and drawbacks of the different fallback alternatives being considered by the industry.
Step 3: Consider Operational Impacts
Finally, the LIBOR transition may have a significant impact on your operations. By familiarizing yourself with replacement risk-free rates – such as SONIA, SOFR and ESTER – you can begin to evaluate impacts on systems and operations.
If term rates are not available for derivatives, consider how you will use compounded rates instead. You may need to modify treasury systems or adjust payment approval processes to address the fact that payment amounts may not be known at the beginning of a period. Begin these internal conversations now and follow market working groups as they consider the transition.
Completing these three steps – evaluating hedging strategies, reviewing your documentation, and considering impacts on systems and operations - will leave you as prepared as possible for the coming transition.
Chatham Financial is committed to supporting debt and derivatives markets and our clients as we transition to risk-free rates.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit https://www.chathamfinancial.com/legal-notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 19-0052
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