(Editor’s Note–published November 29, 2019)
Treasurers aren’t too happy about the fallback language for the Libor-to-SOFR switch.
Members at a recent NeuGroup meeting used some colorful language in discussing the challenging issue of changing fallback language in contracts that currently use Libor, the benchmark rate that’s scheduled to disappear after 2021.
- The wording needs to specify what rate will replace Libor when it’s gone, what triggers the switch, and the pricing spread adjustment between Libor and the successor rate to account for differences between the two benchmarks.
Prepare for battle? One treasurer bemoaned the fact that regulators seem to “hope that people can agree” on the terms of fallback language and warned, “At worst, every contract could be hand-to-hand combat.”
- Behind that potential battle, of course, is the proposed transition in the US from Libor to the secured overnight financing rate (SOFR), a so-called alternative reference rate recommended by the Alternative Reference Rates Committee (ARRC). SOFR is a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities—the repo market.
- A report from consultant EY describes issues that could fuel the combat: “The transition to [SOFR] may require renegotiating the spread due to the differences between LIBOR and [SOFR], such as credit and term premiums. If a bank comes up with its own approach for redefining the spread for its variable-rate instruments, the counterparties may find themselves on the losing end of the transition—which could lead to legal challenges and reputation damage.”
No term rates—yet. As an overnight rate, SOFR is not a direct replacement for Libor, which is typically quoted for one-, two-, three-, six- and 12-month terms. And one treasurer at the meeting said the biggest issue in his mind is the lack of SOFR term rates. He said when that issue is resolved, corporates will get serious.
- But another treasurer noted that the ARRC has warned market participants not to wait for forward-looking term rates to develop before transitioning from Libor to SOFR.
Give your feedback. In early November, ARRC welcomed the release of a proposed publication of SOFR averages and a SOFR index. The New York Fed is requesting public comment on this so-called consultation by Dec. 4.
- The consultation proposes the daily publication of three backward-looking, compounded averages of SOFR with tenors of 30, 90 and 180 calendar days. It also proposes a daily SOFR index to help calculate term rates over custom time periods. It plans to initiate publication of the averages in the first half of 2020.
SEC disclosure. In a final point about Libor’s demise, one treasurer noted that the Securities and Exchange Commission this summer gave guidance on responding to risks associated with Libor’s end. The statement says, “The risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate is not completed in a timely manner. The Commission staff is actively monitoring the extent to which market participants are identifying and addressing these risks.”