January 04, 2019
In our blog Treasurers Prepare for Libor Replacement - Part I, I discussed how the markets will move forward with LIBOR and the ramifications for corporates of With the deprecation of LIBOR, corporate treasurers are faced with an uncertain future about how deals which would traditionally reference LIBOR are struck and what to do about deals which currently reference LIBOR. There is an increasing acceptance and usage of new LIBOR alternatives, so corporates can expect new reference rates to be used in new deals but what about older deals?
While ISDA has been slow in providing details of how agreements based on the 2006 ISDA definition may change or be adjusted, they have been actively promoting new agreements with references to the current list of alternatives. The group has also been actively endorsing the risk-free rate alternatives as replacements to LIBOR, and they have also been promoting the idea of adjustments to the risk-free rates, to accommodate old contracts. Agreements from 2016 and onwards should reference the agreed new reference rates and provisions on adjusting these to match or create a LIBOR equivalent.
For ISDA, the path forward needs to include a reference to both the LIBOR and new references rates, and adjustments to new reference rates are important to bridge any timing gaps and create quasi LIBOR settings. This of course depends on the market trusting the source and calculation of reference rate adjustments, which may not be simple or transparent in the absence of the underlying LIBOR publishing. Since April 2018 Bloomberg have been publishing adjustments to SOFR, but there is no collective agreement on the adjustments being a good market practice or an acceptable replacement to a LIBOR fixing. The pricing of adjustments can be a challenge and needs to include not only risk and price difference, but also basis and potentially liquidity adjustment, if the depth of market varies over time.
What would happen if there is a need to renegotiate contracts? There is certainly a clear move towards the new alternate rates, however because these are not perfectly established, there is a potential for a pricing difference. Even if we consider adjustments like those suggested by LIBOR, the LIBOR \ SOFR spreads still change over time, so timing could be important if renegotiation is required. Any actions towards renegotiation present significant changes to pricing, basis, and risk.
First, corporates should identify all the places they are exposed to LIBOR. This could be something as simple as a list of all contracts referencing the rate. In many cases, there may not be a direct reference to LIBOR, so deriving its full impact could require some work. Second, corporates should ensure they are familiar with the impact of a change. Understand the risk profile of LIBOR and its alternatives as it relates to your business, or to any counterparties on deals. Changes to agreements could impact everything from simple cash liquidity to the balance sheet. Third, if you are a buy side participant, start engaging with your sell side counterparty. In many cases sell side entities are required to have plans on how to transition to alternate references. Be prepared for possible contract or agreement changes or even renegotiation of deals. For older contracts, many things are likely to have changed, and this could have a significant impact on the options available.
Treasurers should begin strategizing today. The move from LIBOR could change the market quickly. The European Central Bank has warned about the ramifications of a failure to quickly move from LIBOR to new references. There could be significant impact on the market and pricing. The market has significant regulatory changes starting in 2020, leaving 18 months to reform one of the largest and most critical elements of financial markets.