The LIBOR transition journey: Moving your transition plan forward

Similar to the ‘Program structure, governance, and project management office’ step, this is not a check-the-box activity. Your assessment process should be ongoing as you consider each product, project, and portfolio. Many companies built their products and systems with a simple enough proposition: if there was a floating rate involved, that rate would be LIBOR. As the LIBOR era ends, firms could face a fragmented market where they need to apply different standards to different products across different markets. This has implications for everything from technology and risk management to client communication and marketing. The way you manage portfolios — your own and your clients’ — could require a range of different customizations, you’ll want to continually assess the direct and indirect impact of this change.

We recommend you consider the following as you assess your transition impact:

• Continue to conduct qualitative and quantitative impact assessments across all business areas and functions.
• Complete your initial exposure analysis including multiple transition scenarios and sensitivities, if you haven’t already done so. Refresh your assessment at least quarterly, based on new information about market conditions and regulatory feedback..
• Perform an end-to-end assessment of how your core functions may need to change, including methodologies, models, and infrastructure. Don’t forget to consider potential shifts in balance sheet management strategies.

In the US, most LIBOR-linked contracts are expected to transition to the Secured Overnight Financing Rate (SOFR), a daily rate based on the cost of repos: collateralized overnight borrowing. The recommendation of SOFR, a rate based on a liquid market with a substantial volume of underlying transactions, aligns to the overarching goal to transition to benchmark rates that are robust and objective. As widely as LIBOR is used, there are other significant interbank offered rates (IBORs) that are also expected to give way to more objective benchmarks in different countries and currencies.

What does it mean for markets to now rely on SOFR and other ARRs? For one thing, contracts that reference LIBOR will need to be rewritten. Products that reference LIBOR will need to be updated. In addition to strategic considerations, the transition is bound to affect many aspects of your operations: from documentation to lines of software code.

The transition could prove especially complex because LIBOR and the ARRs recommended as replacements differ in some key ways. LIBOR contains a degree of bank credit risk; SOFR does not, as the collateralized nature of repo transactions make them nearly risk-free. LIBOR is a forward-looking term rate quoted in seven maturities up to a year. SOFR is an overnight rate, which is expected to be employed in the form of backward-looking averages. In other words, simply replacing LIBOR with SOFR would not result in economic equivalency. To compensate for the difference, alternative reference rate working groups have recommended a spread adjustment to be added to SOFR when replacing LIBOR in financial contracts.

Financial services firms can smooth the switch of products to SOFR by taking some practical steps now:

• If you haven’t already, create a business strategy for developing new products tied to SOFR before the end of 2021. (Many products may need to start the transition far sooner.) This strategy should take into account the effect of the changes on risk management, accounting and other systems.
• Be sure to clarify the approval process for new products that use SOFR, developing a new process if necessary. Set clear milestones for the launch of new products, while tracking changes to the needs and preferences of borrowers and lenders.
• Don’t forget to build a process to monitor exposure to LIBOR beyond 2021. You’ll want to update the reporting process regularly, including references to contract language and basic information on the borrower or investor.
• You should also develop a base-case scenario for the impact of the transition on such factors as liquidity and pricing, including expectations for each product.

For simplicity’s sake, we refer here to the SOFR transition, but the same principles apply to any ARR that replaces LIBOR or another IBOR. In fact, you may well have exposure to other new benchmarks, each of which has its own parameters.

Contract remediation is one of the most important and painstaking steps in the move to SOFR and other ARRs. You should inventory all LIBOR-linked contracts and the nature of existing fallback language. Then, identify terms that need changing. Any revision should be coordinated across different contract types, languages, jurisdictions, and file locations. You can speed contract analysis by using software tools that can assess vulnerabilities and organize contracts by how much remediation might be needed: it’s more involved than search-and-replace.

You may want to consider a three-step approach to updating contracts:

• First, find all of your contracts, identifying what data elements need to be collected by contract and product type. (We’ve found that this step is the most time-consuming and complex.)
• Then, analyze your contracts by first extracting and classifying data and then comparing contract data with data on LIBOR exposure and risk, as well as information on your clients and counterparties. Technology can be immensely helpful in accelerating processing and organizing large volumes of contracts, but these tools do not — and cannot — replace the need for manual analysis and expert legal judgment. Rather, they can help you use scarce legal and business resources more efficiently.
• Finally, make sure you have discussions with your clients and counterparties and alter your contracts — or create new ones if necessary. While there are some systemic attempts to address contracts that refer to an outdated benchmark, such as the ISDA Fallback Protocol for certain derivative trades, these are only intended as backup plans. Negotiations could take time, and you’ll want to gather intelligence on these contracts and start early to avert potentially costly deadlocks.

You’ll want to inform your clients, directors, staff, suppliers, and other stakeholders about the transition. You can limit liability and conduct risk by reaching out to your clients to discuss the changeover. Each audience should get a customized message describing the steps in LIBOR transition and potential risks.

Internal and external communications will probably need updating as your move to SOFR unfolds. You should also extend your outreach to regulators such as the Federal Reserve and SEC. Federal officials have repeatedly warned firms to show steady progress in adopting SOFR.

Here are some key steps to keep in mind:

• Plan a client communication strategy in phases aligned to steps in the LIBOR transition.
• Identify the product segments posing the highest conduct risk and needing the most attention.
• Categorize investors and counterparties based on factors such as product, conduct risk, and level of exposure to the SOFR changeover, tailoring communications to each group.
• Make sure you also stay on top of official guidance on the LIBOR transition, as regulators continue to clarify their expectations on what firms should do.

LIBOR is deeply ingrained in the internal data and operational systems at many financial institutions, and the challenges could extend beyond your company’s walls. Third party vendors such as administrators, custodians, and brokers may face their own challenges in switching to ARRs, or they may not be ready with certain capabilities when you need them to be.

By now, you’ll want to be well underway in implementing system enhancements — and that you haven’t missed anything:

• Continue to review the scope of impact from LIBOR transition on systems, processes, models, policies, and valuation methodologies. Each of these could be significant, and each could change as regulatory guidance evolves. Don’t rely on a static plan.
• You’ll also want to review your transition roadmap for changes to interest rate calculations, tools for calculating prices of ARR-linked products, asset/liability management and other systems and processes.
• Don’t forget to reach out to vendors to get regular updates on their progress in preparing for the coming switch to SOFR.
• Finally, make sure you can access all the market data you’ll need for SOFR and other ARRs, and that your systems and models can take and process the feeds.

We’ve found that many firms may be underestimating how the LIBOR transition affects modeling programs. This is especially true for valuation and risk models, including hedging strategies and risk management frameworks. You should expect some changes to your overall risk profile.

For example, use of ARRs may change the nature of basis risk in derivatives and cross-currency swaps. Different basis risks may make current hedging obsolete, prompting you to update your approach to asset/liability management. During the coming year — perhaps long before the planned end of LIBOR in December 2021 — liquidity in LIBOR-linked products may fall and market volatility may increase. Also, any financial instability during the sunsetting of LIBOR may crimp counterparty cash flows and push up credit risk.

Here are some suggested priorities as you move to curb risks: 

• You’ll want to start by updating risk limits and internal controls related to LIBOR, and considering whether changes are likely to affect capital requirements.
• Throughout the transition, you should monitor markets in LIBOR-linked instruments for any decline in liquidity or increase in price volatility, and be prepared to act quickly. (You’ll also want to stay on top of evolving liquidity in ARRs, which could also change as the new markets grow.)
• You’ll also want to identify changes needed in pricing and models used by the front office and market risk teams. To be clear, this transition will likely affect treasury, capital, loan pricing, asset and liability management (ALM), and other models, but trading models may see the greatest impact. Automation tools can be especially useful for standardized testing for models, enhancing documentation, and performing validations.
• Don’t forget to reset assumptions that underlie stress testing, risk exposure calculations, and risk appetite.
• Some risks may not always be clear at first. Be sure to consider as many second order risks as you can when you update models. For example, during the transition, you’ll want to estimate how shifts in market pricing could change funding, counterparty credit, and other exposures.

While adopting SOFR, you should track IRS tax guidance and changes to financial reporting requirements. The IRS has proposed a regulation that, in general, would consider changing a debt instrument and other financial contracts to an alternative rate as a non-taxable event. The SEC has said that you should view LIBOR transitions as a risk that should be disclosed if necessary.

The switch to SOFR may influence financial reporting regarding hedges, derivatives, fair value, cash instruments, and leases. The Financial Accounting Standards Board (FASB) has issued optional guidance saying that, under certain circumstances, hedge accounting may continue when a contract (derivative or hedged item) is changed. FASB has also simplified the accounting analysis for the high volume of LIBOR-linked contracts that will need modification. The guidance will expire in most cases at the end of December 2022.

You may want to consider these steps:

• If you haven’t already, you’ll want to start by setting up a formal workstream with a detailed budget, dedicated team, and clear channels for knowledge sharing. As we mentioned earlier in this article, you’ll want to revisit your budget during the transition and update it if necessary
• On an ongoing basis, you should evaluate the impact of LIBOR’s end on accounting and tax, using scenario analysis to help prioritize your transition efforts.
• Make sure you consider how SOFR market data will flow into systems and models, and any changes needed for pricing, including time series data generation.
• We recommend you create an audit trail of profit and loss stemming from the LIBOR transition to help in your assessment of business strategy and conduct risk.
• It’s also important to track proposals and guidance from regulators including the IRS, FASB, SEC, and other agencies and standard setters to stay current on clarifications and new rules.