The end of USD LIBOR is looming…but it ain’t over ‘til it’s over.
2023 will see the final steps in the journey towards the end of USD LIBOR. Most LIBOR panels (non-USD) have ended, and rate settings have ceased, but US dollar LIBOR settings have continued under a panel bank methodology. On December 16, 2022, the Federal Reserve Board (FRB) adopted the final rule that codified the replacement of LIBOR in certain financial contracts after June 30, 2023. This rule identifies replacement benchmark rates based on SOFR to replace overnight, one-month, three-month, six-month, and 12-month LIBOR. However, the UK Financial Conduct Authority (FCA) still requires the IBA to continue publishing one-month, three-month and six-month US dollar LIBOR on a non-representative and synthetic basis (‘synthetic US dollar LIBOR’) for a short period after the end of June 2023, until end-September 2024.
The synthetic settings are intended for use in legacy contracts only to help ensure the orderly wind-down of LIBOR. The FRB and FCA has prohibited the use in new transactions with effect from January 1, 2022, except for specific activities (risk management or reduction of pre-January 2022 exposures). However, from July 1, 2023, after the US dollar LIBOR panel ends, all new use of synthetic US dollar LIBOR will be prohibited under the Benchmarks Regulation, overriding the January exemptions.
The scale of remaining action
With just a few months remaining until cessation, market participants continue to grapple with the complexities and challenges of transition. Although the efforts to transition the stock of USD LIBOR legacy contracts ahead of the June deadline have accelerated, the scale of the remaining action is significant. Over half of the outstanding institutional LIBOR-based loans have fallback language included in the loan agreements, requiring a modification to be executed for the fallback language to trigger the transition to a new benchmark rate. The graph1 below outlines the covenant amendment challenge’s scale and the amendment types’ distribution.
Cost logjam to transition by investors?
Some industry sectors, such as CLO (Collateralized Loan Obligation) buyers, are particularly focused on the transition from LIBOR. Many CLOs use LIBOR as a benchmark for determining interest rates on their underlying loans. The switch to alternative reference rates could impact the cash flows and returns of CLOs, potentially costing investors significantly in potential returns.
These CLO equity investors (who can’t vote on deal amendments) have been stepping up efforts to understand the implications of the transition and have been proactively advocating for CLO managers to reject proposals and other critical terms contained in deal amendments, tied to loans, to ensure that they are well-positioned to protect their investments and minimize any potential losses.
Economic negotiations continue proactively, but the extent to which the cost logjam may have been broken is unclear.
Additional challenges for market-participants
Despite varying market views, strategies, and risk assessments, participants generally prepared to transition to alternative reference rates and refinance their LIBOR book during the previous low-interest rate environment. Interest rates have risen, which could make it more expensive to refinance.
The fluidity of regulations, best practices, and other industry developments around LIBOR make it critical for market participants to ensure that their contract portfolios are up to date by analyzing them under the lens of the latest requirements. It’s possible for contract portfolios and LIBOR data sets to become stale, necessitating regular updates using the most relevant and reliable data sources.
There may be an underestimated resistance level from borrowers and buyers to transitioning, as the transition from LIBOR to alternative benchmark rates has added a layer of complexity to the refinancing decision, with borrowers needing to consider the potential impact of the transition on their existing loans and future borrowing costs.
Until June, there may be a market-participant acceleration to analyze LIBOR contract portfolios for relevant language (as outlined in the table below) as part of their legal remediation strategy, which will influence their client outreach and communication approach. They will also need to consider operational readiness in the above context, ultimately working towards a product transition strategy to amend and replace the contracts.
What questions do market participants need to answer regarding their LIBOR contract portfolios?
Cimplifi can help you answer these questions about your contract portfolio and simplify many other aspects of support for the USD LIBOR transition.
To learn more about the CALM™ practice at Cimplifi, our regulatory impact assessment advisory competencies, or our expertise in table data extraction, contract analytics, and lifecycle management, click here. #keepCALMandcontracton