LIBOR: The Transition Ahead
last updated on Wednesday, May 15, 2019 in Advances
The financial markets have commenced preparations for the expected phase out of the London Interbank Offered Rate (LIBOR) by the end of 2021. Currently the most widely used reference rate in the world, LIBOR is referenced in more than $200 trillion in financial contracts, from student loans to car loans to adjustable-rate mortgages. While we prepare for this transition, Federal Home Loan Bank of Des Moines (FHLB Des Moines) also wants to ensure that you, our members, are as prepared as possible. Given the large dollar volume of contracts tied to LIBOR, you may experience changes in your operations, financial management strategy, or product offerings as a result of the phase out.
To better prepare for the impending transition, the Federal Reserve formed the Alternative Reference Rates Committee (ARRC) to identify an alternative index rate and create a transition plan for the U.S. market. The Secured Overnight Financing Rate (SOFR) was selected in mid-2017 as the recommended alternative. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. First published in April 2018, the rate is determined based on transaction data comprising tri-party repurchase agreements, General Collateral Finance repos, and bilateral Treasury repo transactions cleared through the Fixed Income Clearing Corporation.
LIBOR vs. SOFR – Key Differences
LIBOR is a forward-looking rate that is published for multiple terms and includes a bank credit risk element for the term selected. LIBOR rates are fixed at the start of the interest period. LIBOR is based on a very small number of transactions between banks. It is mostly a model-determined index.
SOFR is a backward-looking rate with only one term, overnight, and is based on transactions in the Treasury repurchase market. Therefore, it does not have a term credit element embedded into it. Unlike LIBOR, SOFR is a secured rate, collateralized using U.S. Treasuries. It is based on known interest payments at the next interest payment date. SOFR is based on several hundred billions of dollars of transactions daily.
In late April 2019, ARRC released a white paper to help explain how to use SOFR in cash products. The paper also incorporates ARRC’s Paced Transition Plan, which outlines the steps for an effective shift to SOFR.
The Paced Transition Plan identifies milestones to help facilitate a smooth transition from LIBOR to SOFR through the end of 2021. Currently, the industry is pacing ahead of the timeline – SOFR debt issuances have occurred and the futures market is growing.
So what can you do to prepare your financial institution for the LIBOR transition? First off – don’t wait – 2021 may seem far away, but taking the time to understand your next steps and be fully prepared is imperative. LIBOR as an index will go away; do not plan on its continuation. The Federal Home Loan Bank (FHLBank) System suggests starting with the framework below to begin your transition planning.
Create a team to oversee the transition
Convene a structured team led by a senior executive and comprising representatives from treasury, loan operations, accounting, legal, information technology, risk management, communications, and others as needed to develop a transition plan, oversee its execution, and report regularly to the board of directors.
Inventory existing LIBOR transactions
Quantify all financial exposure to LIBOR and estimate the impact that a LIBOR phase out may have on hedge effectiveness, interest-rate risk, basis risk, and valuations.
Evaluate existing fallback provisions in legacy transactions
Review legacy LIBOR contracts that extend beyond 2021 to determine if current fallback language is adequate to provide a smooth transition to another reference rate. A primary consideration will be the calculation of interest in adjustable-rate instruments in the absence of LIBOR. Amend contract language for those agreements as needed, in compliance with banking, securities, and consumer protection laws. In addition, determine if changes to contracts require consent of various parties named in the agreements.
Develop language for LIBOR transactions going forward
In addition to addressing fallback language in legacy contracts, develop fallback language for new transactions going forward, providing for a smooth transition to a new reference rate. Again, prepare this language for compliance with banking, securities, and consumer protection laws.
Review accounting, tax, and systems implications
Assess changes to systems, models, and other operational processes that will be triggered by the LIBOR phase out. Accounting systems, loan systems, pricing models, risk models, and other management information systems will likely require changes.
Mitigate risk of disputes and create mechanisms for handling disputes
When amending contract language or developing language for new transactions, keep an eye on mitigating risks of disputes with borrowers or other parties to the financial contract. Create procedures and mechanisms to handle any disputes that may arise.
Develop a communications plan
Determine how to communicate changes to customers and other relevant parties.
Stay informed of industry developments and best practices
Create processes to stay up to date on developments in the industry on the LIBOR phase out and transition to SOFR, and take advantage of industry best practices around contract language and operational processes as they become available.
Next Steps: FHLB Des Moines Support and Preparation
We recognize that a smooth transition is critical to the financial markets, the operations of each regional FHLBank, and the operations of our members. FHLB Des Moines is coordinating our transition efforts with other FHLBanks as well as industry working groups. Recently, we completed a multi-year plan to prepare our own operations for the LIBOR phase-out and have taken steps to begin implementing that plan. Those steps have included participating in SOFR-indexed debt issuance and issuing SOFR-indexed advances to our members.
As part of that plan, we’ll be adjusting our offering of advance products that increase the Bank’s LIBOR exposure beyond December 31, 2021. These changes will be implemented on June 3 and will remain in place until the Bank believes the risks of the transition can be mitigated. LIBOR transition poses uncertain risks to FHLB Des Moines, and our transition plan identified key mechanisms to hedge this risk and remain a reliable, transparent source of liquidity for our members. As a result, we are adjusting certain advance products to:
- Limit term exposure to LIBOR by limiting maximum advance maturity terms
- Limit price exposure to LIBOR by increasing advance rates to adequately compensate the Bank for LIBOR transition risk uncertainty
We are committed to being your strategic partner in navigating the transition away from LIBOR. Our members’ success is our success. Look to us to provide resources over the next several months to help ease the uncertainty and support your financial institution’s transition. As always, we’ll remain your trusted source of liquidity and continue to provide funding solutions that support and reflect the changing markets.