As of June 30, 2023, LIBOR will no longer be a viable reference rate for a wide variety of debt transactions. This change will have a significant impact on trillions of dollars of outstanding debt, as firms have used LIBOR for decades as the benchmark reference for determining interest rates for debt instruments and OTC derivatives, including structured securities, corporate debt, and municipal bonds.
Related: The "Secret Sauce" to Navigating the LIBOR Cessation
In July 2017, the UK Financial Conduct Authority (FCA) announced that LIBOR would cease to be published, citing concerns about the robustness of LIBOR, including its vulnerability to manipulation.
While the transition away from LIBOR is intended to enhance the integrity and stability of the financial system, it requires the financial services industry to address several data challenges ahead of the June 30th deadline. Any issuer of a security that matures after the LIBOR cessation date and relies on LIBOR to calculate interest rates will need to choose and communicate a fallback replacement rate to the investor community prior to the LIBOR retirement date.
In preparation for LIBOR cessation, industry-led groups have convened in various markets to identify alternatives to LIBOR. In the U.S., The Federal Reserve Bank of New York’s Secured Overnight Financing Rate (SOFR) was recommended by the Alternative Reference Rates Committee (ARRC) as the preferred LIBOR replacement benchmark.
The ARRC is a group of market participants focused on ensuring a successful LIBOR transition. In addition, DTCC, in collaboration with the ARRC, market data vendors, and industry participants, designed a workflow and several tools that can be used by bond issuers and their agents to assist with the capture and communication of the new fallback index that will replace LIBOR on outstanding debt.
With the cessation date rapidly approaching, it is crucial that the industry devote sufficient attention and resources toward ensuring an orderly transition from LIBOR. To do so, industry participants must have a clear understanding of the data challenges presented by LIBOR cessation and the resources available to help meet them.
Key Differences Between LIBOR and SOFR
There are several key differences in the underlying data and the methodologies used to calculate LIBOR and SOFR. These differences present certain challenges as the industry navigates the transition from LIBOR.
First, LIBOR is a forward-looking rate that relies on submissions from a panel of banks, while SOFR is an overnight rate based on actual transactions in the U.S. Treasury repurchase agreement (repo) market. This fundamental difference means that industry participants must carefully review and update their systems, processes, and models to accommodate the new benchmark replacement data.
Second, SOFR is a nearly risk-free rate, meaning it does not reflect ongoing unsecured credit exposure or forward expectation on the direction of rates. Therefore, a Credit Spread Adjustment (CSA) will be needed to underlie the SOFR rate in order to calculate the rate that will drive interest accrual once LIBOR ceases to be a functioning rate.
The CSA will typically be based on the trading of SOFR-linked interest rate derivatives products in multiple tenors and determined by benchmark administrators including CME Group, ICE, and Refinitiv.
In addition to examining systems and processes, market participants should also review financial contracts to determine whether their terms need to be updated.
A Massive Undertaking
The issues arising from the retirement of LIBOR are complex and are magnified by the sheer volume of bonds for which a replacement benchmark must be communicated. DTCC estimates that over 100,000 bonds will mature after LIBOR ceases to function as a benchmark rate.
As firms ramp up their LIBOR transition efforts, they can turn to their traditional data providers to gather the necessary information on bonds that reference the LIBOR rate. In addition, firms can take advantage of tools such as DTCC’s recently launched LIBOR Benchmark Replacement Index solution, accessible through the firm’s Legal Notice System (LENS).
Users of this solution can view information on securities whose rate is currently based on USD LIBOR and obtain the new benchmark rate that has been selected for such securities. DTCC also provides this information through an automated file delivery. Finally, several market data providers will disseminate benchmark rate information collected by DTCC through their existing products and distribution channels.
Significant work still lies ahead for the industry, as the June 30th deadline nears. However, the ARRC, DTCC, data vendors and issuers, and their agents have shown their ability to collaborate and remain committed to working together to support market participants as they prepare for LIBOR cessation.
This article was originally published to FTF News on June 13, 2023.