Financial institutions, corporations, and their clients face an upcoming change that will disrupt how they execute existing and future contracts, emanating from scandals in which banks allegedly rigged Libor rates.
The scandals, and their subsequent exposure, triggered a crisis in confidence that forced a decision by the UK Financial Conduct Authority (FCA) to seek alternative risk-free rates (RFRs).
Complying will be a massive undertaking. More than $300 trillion worth of transactions, comprising loans, derivatives, and bonds that affect the entire economy, are based on Libor, which is set to be discontinued by the end of 2021. Additionally, contracts with family businesses, student loans, and more than 15 million retail customers reference Libor; all must be modified to transition to RFRs.
RFRs: Benefits and Challenges
RFRs have some benefits. Designed to alleviate risk, these rates will be based on underlying markets and actual transactions, rather than on perceived unsecured borrowing costs submitted daily by individual banks.
But making the transition presents challenges in assessing exposures and ensuring adequate preparation. Several functions must be considered, including valuation, pricing, accounting, budgets, forecasts, treasury, operating income, and tax situations.
Lack of clear regulatory guidance has encouraged many institutions to adopt a wait-and-see approach. However, delaying the transition is not a solution, as doing so could damage finances, customer relationships, and operations. Stakeholders who are ill-prepared should consider seeking professional guidance to ensure an orderly transition.
The time to act is now. The transition from Libor is not easy, given the many stakeholders involved. Any further delays in planning, testing, and implementation could have a significant impact on operations and financial reporting.
In December 2019, The New York State Department of Financial Services directed financial institutions to submit their plans for managing the risks of discontinuing Libor. Although these institutions will comply, their clients, as well as smaller organizations and companies, may not be prepared. These entities may not understand the scope of what’s involved and may lack the tools to make the transition.
A survey published in 2018 by the International Swaps and Derivatives Association (ISDA) contained some sobering statistics. Although 76% of the institutions surveyed had begun internal discussions on transitioning to RFRs, only 11% had budgeted for it, and just 12% had a project plan in place.
Two years later those percentages have improved, but still fall short, as a recent event indicates.
On March 3 of this year, several company treasurers participated in a call with David Bowman, senior staff liaison from the Federal Reserve Board of Governors to the Alternative Reference Rates Committee (ARRC). More than a third (35%) of them said their companies have teams in place to manage the transition, another 35% do not, and 30% have plans to do so.
Much remains to be done. For example, some businesses are still referencing Libor rather than new RFRs, suggesting many corporations remain uninformed as to how the changes will affect their risk profile.
Take Steps to Move Forward
A successful transition demands corporate focus, with clear, specific communication to explain what each functional department must do to effect a smooth transition.
Legal Department: Examine contracts and assess exposure to determine which contracts may be affected. The relevant information in the contract exists, but clarity should be highlighted.
In addition, the fallback contractual rate should be verified. If none exists, a replacement rate should be determined to ensure it is adequate to meet all circumstances. If it is not, then the contract should be either amended or, in some cases, renegotiated. Future contracts should contain the new fallback language specified by the ARRC.
IT Department: Involve this group early to ensure it has the correct information and processes necessary for an orderly transition. This includes reviewing systems integration functionality for accruing interest, budgeting, and disclosures. If systems are inadequate to make the required changes, begin now to make the technology upgrades necessary to accommodate new instruments and rates.
Accounting Department: Ensure adequate resources are available to address reporting, payments, and other business issues that could arise from transitioning to RFRs. Get the CFO’s office involved. ASC 815 has designated the Secured Overnight Financing Rate (SOFR) as the relevant benchmark.
If necessary, banks should adjust for credit and term differences, for example, as these two rates are not equivalent. In addition, hedging documentation may be required. Finally, plan for changes in accounts payable, as the value of underlying products could change.
Risk Management: Because risk valuation is a major concern for financial institutions, they must assess risk to assets and liabilities, assess the impact rate movements can have on borrowing, and determine when to enter into negotiations, if necessary.
Front Office: New rates are meant to be based on historic transactions (backward looking). Some niche users may rely on forward-looking, term versions of the RFRs for a limited time, but that will change by the end of 2021.
Changes will affect the valuation of loans, derivatives, and swaps (i.e., fixed rate versus variable options). Run models to measure the effect of these modifications. To mitigate risk, be prepared to renegotiate spreads and calibrate term rates in lieu of overnight rates. (Note that the ISDA’s protocol for converting legacy derivative contracts is expected in the third quarter, and a SOFR term reference rate is targeted for first half of 2021.)
Treasury and ALM functions: Be prepared for changes in cash management, liquidity, and cash flows, and plan accordingly.
External Vendors: Coordinate with them to ensure they are making the necessary adjustments and that those changes will meet the company’s needs.
Governance: Make sure controls are in place to properly manage the transition to RFRs.
The overarching message is to act now. Delay may prove expensive. Companies, clients, and affiliates should put a roadmap in place to manage the transition. Key components are:
- Establish governance.
- Appoint a task force to assess risk.
- Take an inventory of contracts and transactions.
- Identify alternative RFRs.
- Analyze the effects of converting to RFRs.
- Ensure operational readiness, including trading, technology, and support systems.
- Increase contractual robustness to accommodate new changes.
- Prepare and plan for potential new risks.
- Promote transition by getting affected departments on board.
- Seek guidance from experienced consultants when necessary.
Companies that are prepared for the changes mandated by the transition to RFRs will limit their risk, ensure adequate liquidity, and be positioned for a more orderly and seamless process.