LIBOR’s Demise Means Changes Are Coming
The London Interbank Offered Rate (LIBOR) is a staple of the financial industry. LIBOR is a calculated average rate that participating banks estimate they would be charged by other banks. As brought to light in a significant rate-rigging scandal from a few years ago, British regulators who oversee the rate calculation have determined that there are not enough actual transactions to support the estimates made by the banks, and so the estimates will no longer be required after 2021. This spells the end of LIBOR.
While an obvious issue is that LIBOR is used in many lending arrangements and interest rate swap agreements, it can also be referenced in leases, purchase contracts, and as a payment penalty provision in many types of contracts. It is imperative to begin identifying these contracts now, as updating them will require coordination among various departments within your entity and could require information technology system changes. In addition to coordination within the entity, communication with counterparties may be necessary, which could result in an opportunity for counterparties to seek other contract amendments.
Alternative Reference Rates (ARRs) are being developed, and in the U.S. this may be the Secured Overnight Financing Rate (SOFR). However, there are differences, as LIBOR is a forward-looking rate which implicitly includes bank credit risk, while the SOFR is backward-looking and collateralized. These differences could necessitate business changes, as interest payments on some SOFR debt are not set until the end of the period while LIBOR is known at the beginning. Also, for debt and derivatives used to hedge that debt, basis risk could arise if they are not migrated to SOFR at the same time.
As the end of 2021 nears, trading volume of LIBOR-linked products will likely reduce, making it potentially harder to exit these positions. This could also impact where on the fair-value hierarchy certain instruments fall. A further uncertainty is how LIBOR-based assets and obligations that extend past the end of 2021 will be valued after that point. Additionally, contracts that refer to the last available published rate, could effectively lock in a fixed rate.
Standard setters and regulators have proposed financial reporting and tax relief for certain transactions falling within stated parameters. However, other contract changes made by companies or their counterparties could impact this relief.
The impact of LIBOR’s end will be far-reaching and entities should not wait to begin assessing the impact and making necessary changes. For questions on how to these changes could affect your entity, please contact your KSM advisor.
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