understanding & addressing the libor to sofr …
TRANSCRIPT
May 7, 2020
BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK
company limited by guarantee, and forms part of the international BDO network of independent member firms.
BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK
company limited by guarantee, and forms part of the international BDO network of independent member firms.
UNDERSTANDING
& ADDRESSING
THE LIBOR TO
SOFR TRANSITION
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3
With You Today
Matthew Goldberg
Partner
646-957-4285
Sudip Chatterjee
Managing Director
212-404-5598
4
Learning Objectives
Identify the events and rationale that have led to the present day
efforts to eliminate LIBOR
Recognize the more relevant exposures that require analysis and
remediation during an IBOR transition project
Discuss the skillsets and capabilities required in order to successfully
transition from LIBOR to SOFR (or other reference rate)
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What is LIBOR?
Stands for London Interbank Offering Rate (also
referred to as an IBOR)
Meant to reflect the rates that the world’s largest
banks charge each other for short terms loans
Most widely used benchmark interest rate today
Presently published across 5 currencies and 7
maturities
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Currencies and Tenors
Currencies:
CHF – Swiss Franc
EUR – EURO
GBP – British Pound Sterling
JPY – Japanese Yen
USD – US Dollar
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Let’s Talk Some History!
LIBOR was
created
1980 BBA published BBAIRS
(British Bankers Assn
Interest Rate Swap)
1985
1986
First LIBOR rates
were published
(USD,GBP, JPY)
Financial crisis
hits and we see
LIBOR rates spike
2008LIBOR was firmly
entrenched as the
benchmark
interest rate
1990
LIBOR
scandal is
uncovered
2012
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Why Did the Manipulation Occur?(CAUSE AND EFFECT)
First, because LIBOR became a vital reference rate for
interest-rate derivatives
The Banks' derivatives traders pushed their LIBOR submitters to
manipulate LIBOR, up or down, depending on their positions
Then, LIBOR became a proxy for the health of the
banking system
During the financial crisis, the banks' executives pushed
their LIBOR submitters to understate LIBOR, to make
them look healthier than they were
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LIBOR Scandal!
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1. Manipulation was possible because of the way
LIBOR submissions were made. Banks were asked to
estimate the rate at which they COULD borrow
from other banks, not rates at which they
ACTUALLY borrowed.
2. At the same time, the way banks fund themselves
has changed. The unsecured London interbank
market, which LIBOR was designed to measure, was
active when LIBOR was created, but that isn’t how
banks finance themselves any more.
The Main Reasons Behind
Changing LIBOR
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The Fed estimates that on a typical day there are
currently around six to seven actual market
transactions—totaling about $500 million— that
could underpin one- and three-month U.S. dollar
LIBOR across all of the panel banks.
For the six-month tenor, there are only two or
three transactions per day.
At the one-year tenor the average is one
transaction per day, and on many days there are
none.
That means that the majority of panelist
submissions each day are based solely on “expert
judgment.”
What was the Actual Activity?
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What was the Actual Activity?
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To Put in Perspective
Although actual transactions underlying LIBOR have diminished, its use as a
benchmark has become ubiquitous. The gross notional value of all financial
products tied to U.S. dollar LIBOR is around $200 trillion—about 10 times U.S. GDP.
That includes $3.4 trillion of business loans, $1.8 trillion of floating-rate notes and
bonds, another $1.8 trillion of securitizations, and $1.3 trillion of consumer loans
held by about four million individual retail consumers, including around $1.2
trillion of residential mortgage loans. The remaining 95% of exposures are
derivative contracts, which we learned in the financial crisis have consequences
for both Wall Street and Main Street.
So, every day, the payments on $200 trillion of exposures are calculated based
on a handful of transactions worth a few hundred million dollars at most.
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STEPS TAKEN:
Reforms were put in place.
UK Financial Conduct Authority would regulate
member banks from 2013 onward.
One of the primary goals was to anchor LIBOR
submissions and rates to the greatest extent
possible to actual transactions. This is to ensure the
rate is genuinely representative of market
conditions.
The Aftermath
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Beginning of the Transition
JUNE 22, 2017 - the Alternative Reference Rates Committee
(“ARRC”) selected the Secured Overnight Financing Rate
(“SOFR”) as their final choice to replace USD LIBOR past
calendar year 2021
JULY 27, 2017 – Andrew Bailey, Chief Executive of the UK
Financial Conduct Authority (“FCA”), gave a speech whereby he
stated that member banks would no longer be required to
provide LIBOR submissions past Dec 2021
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Beginning of the Transition
EXISTING HURDLES:
Developing a market based approach that would be ready to replace LIBOR as of
the end of 2021
Picking a replacement Alternative Reference Rate for each of the primary LIBOR
currencies
Member banks were reticent after the LIBOR scandals that had occurred
LIBOR submissions were not based on actual underlying transactions (banks were
concerned about the exposure based on the subjectivity)
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In the major currency areas, authorities have already
started publishing rates intended to eventually replace
(or complement) the IBOR benchmarks.
The initial focus has been on introducing credible,
transaction-based overnight (O/N) RFRs anchored in
sufficiently liquid money markets.
Selection of Alternative
Reference Rates
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An Ideal Reference Rate
1. Provide a robust and accurate representation of interest rates in core money markets
that is not susceptible to manipulation
o Benchmarks derived from actual transactions in active and liquid markets, and subject to best-
practice governance and oversight, represent arguably the best candidates in terms of this
criterion
2. Offer a reference rate for financial contracts that extend beyond the money market
o Such a reference rate should be usable for discounting and for pricing cash instruments and
interest rate derivatives
3. Serve as a benchmark for term lending and funding
o Given that financial intermediaries are both lenders and borrowers, they require a lending
benchmark that behaves not too differently from the rates at which they raise funding
An ideal reference rate would have to:
At present, LIBOR fulfills the 2nd and 3rd criteria but lacks the first.
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Selection of Alternative Reference Rates
Working groups were set up in each currency to define the new risk free rates
(“RFRs”). The determined rates are as follows:
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LIBOR vs. Fed Funds Rate Comparison
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Where do the Exposures Lie?
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Where do the Exposures Lie?
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Where do the Exposures Lie?
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Where do the Exposures Lie?
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Where do the Exposures Lie?
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IBOR Transition Approach and Skill Sets
What are the steps to performing
an IBOR transition project?
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IBOR Transition Approach
STEPS TO IBOR TRANSITION:
1. Organize a formal IBOR steering committee or task force
2. Perform an entity wide risk assessment
3. Prepare a comprehensive transition roadmap
4. Transitioning contract approaches (monetizations, renegotiations, fallbacks)
5. Methodology for new products
6. Establishing valuation methodology (approaches, model validation)
7. Updating Systems
8. Addressing accounting and reporting
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1. GETTING BUY-IN FROM SENIOR MANAGEMENT AND
THE ORGANIZATION
Executive management need to be engaged in the
project to help make decisions and drive the
transition across the organization
Frame the issue properly – how it fits into a larger
picture
Involve others - building a coalition is the easiest
way to obtain organizational approval on a larger
scale
What are the Hurdles?
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2. ASSESSING THE OVERALL IBOR EXPOSURE
Inventorying and categorizing products that are
associated with LIBOR at the outset
Depending on the form of the contracts (hard copy,
electronic, physical location, etc.) this may be
difficult
Sorting through contracts for relevant features
(digitization of contracts, search applications, etc.)
Outlining a roadmap to serve as the guide
throughout the project
What are the Hurdles?
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3. RENEGOTIATING OF CONTRACT TERMS
Each asset class is going to have separate concerns
Derivatives – International Swaps and Dealers
Association (“ISDA”) will provide protocols (sheer
volume of contracts, OTC contracts may have
differing requirements)
How willing are the counterparties to renegotiate?
Depends on current position, triggers,
contingencies, etc.
What are the Hurdles?
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4. TECHNOLOGY AND INFRASTRUCTURE
Systems will need to be analyzed in order to assess
the magnitude of the changes to be considered
Changes to systems that are off the shelf, tailored
and internally developed
Data sources will need to be reconfigured to feed
into current systems such as risk management, front
office, valuation and financial reporting systems
What are the Hurdles?
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5. MODEL RECONFIGURATION AND VALIDATION
Models are going to require reconfiguration to
address the changes that will be implemented such
as the basis for new curve projections (average
historical pricing, bootstrapping or an offshoot of
futures pricing)
What are the Hurdles?
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6. LITIGATION, RISK AND COMPLIANCE
Involvement of the general counsel’s office
regarding renegotiation of contracts and fallback
language
Revising existing control processes so as to
incorporate the administration and management of
the changes to be implemented
Establishing new risk procedures to enable the
transition and to ensure compliance within an
acceptable risk framework
What are the Hurdles?
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7. ACCOUNTING AND FINANCIAL REPORTING RISKS
Impact on valuations that are performed (new or
existing positions)
Impact will be felt either directly or indirectly
Hedge accounting, recognition of gains/losses
What are the Hurdles?
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What Has Happened Recently?
MARCH 16 - the U.S. Federal Housing Finance Agency extended the deadline for
federal home loan banks including Fannie Mae and Freddie Mac to cease
entering into LIBOR-based instruments that mature after the end of 2021.
Originally slated for March 31, the lenders have been given a further three
months to comply.
MARCH 25 - the UK Financial Conduct Authority (FCA), Bank of England and
members of the working group on sterling RFRs confirmed the end-2021 target
date remains in place, though recent events are “likely to affect some of the
interim transition milestones.”
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What Has Happened Recently?
At the end of September 2020, when the FCA has called for an end to LIBOR-
linked lending in sterling markets. Just a handful of loans have to date been
linked to the sterling overnight index average (Sonia) – LIBOR’s successor for UK
markets. For corporates, making the leap to a compounded-in-arrears version of
an overnight rate requires systems updates. With a crisis raging through the real
economy, it’s unlikely to be at the top of a treasurer’s to-do list.
The secured overnight financing rate (SOFR) – U.S. dollar LIBOR’s heir apparent
– has decoupled from other lending benchmarks such as commercial paper rates
and LIBOR itself, exacerbating worries over its appropriateness as a lending
benchmark.
37
Current Timeline
Source: Federal Reserve Bank of New York
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With COVID-19, How do We Proceed?
1. Proceed forward with the established timelines
Until a definitive statement is released changing the milestones
2. Keep working on fallbacks and transition plan
3. Make sure to address new products in the interim
4. If there is an extension, use the time to plan and continue executing
5. If a pause is warranted, make sure to get to a good stopping point
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Recent Happenings
JULY 2019 - SEC staff published a statement to encourage market participants—
to commence or carry on the following two action items in connection with the
LIBOR transition: (1) appropriate disclosures of material exposure to LIBOR; and
(2) the type of activities that market participants should engage in to manage
such risk.
DECEMBER 30, 2019 - the SEC published a public statement on the role of audit
committees in financial reporting. It encouraged “audit committees to
understand management’s plan to identify and address the risks associated with
reference rate reform, and specifically, the impact on accounting and financial
reporting and any related issues associated with financial products and
contracts that reference LIBOR.”
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Recent Happenings
DECEMBER 17, 2019 - Three divisions of the U.S. Commodity Futures Trading
Commission (“CFTC”) issued no-action letters on granting temporary relief from
regulatory requirements when amending swap contracts to include sufficient
fallback language and risk-free rates that will address the end of the use of
IBOR.
DECEMBER 23, 2019 - The NYDFS published a letter requiring that entities
prioritize the transition away from LIBOR.
Other regulators have also been emphasizing the importance of a timely
preparation by requiring regulated market participants to disclose in public
filings, or report to regulators directly, the manner in which they are preparing
for LIBOR’s demise and the progress that they have made so far.
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Recent Happenings
Beginning on March 2, 2020, the New York Fed, in cooperation with Treasury’s
Office of Financial Research (OFR), began publishing 30-day, 90-day and 180-day
SOFR Averages, as well as a SOFR Index
The SOFR Averages and Index will employ daily compounding, in line with the
ISDA methodology for use of overnight rates in swap contracts
The SOFR Index will measure the cumulative impact of compounding the SOFR
on a unit of investment over time and can be used to calculate custom period
averages between any two business dates
Publication of accessible and reliable SOFR Averages and a SOFR Index, for
reference in financial contracts, is an important step in encouraging widespread
adoption of SOFR and supporting the LIBOR transition
The averages and index could be referenced in a variety of products, such as
consumer loans and floating rate notes (FRNs)
42
Alternative Reference Rates
Committee (ARRC) Actions
NOVEMBER 2019 – Summary of ARRC’s LIBOR
fallback language
JANUARY 21, 2020 - ARRC consultation on spread
adjustment methodologies for fallbacks
MARCH 6, 2020 – U.S. ARRC proposes a New York
state legislative “solution” for legacy LIBOR
contracts without adequate fallbacks
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Questions?
MATTHEW GOLDBERG
Partner, Valuation & Business Analytics
646-957-4285 / [email protected]
SUDIP CHATTERJEE
Managing Director, Valuation & Business Analytics
212-404-5598 / [email protected]
44
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