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LIBOR Is Going Away—How Do We Transition $350 Trillion of Debt and Derivatives? - Graham A.D. Broyd

Treliant Industry Insights
March 26, 2018
Graham A.D. Broyd

A transition in one of the world’s most widely used interest rate benchmarks is set to begin in the coming year. The global financial system’s move away from the London Interbank Offered Rate (LIBOR) to a new standard will have far-reaching impact—not just on short-term, interbank lending, which is LIBOR’s mainstay, but also affecting mortgage banks, credit card issuers, corporate lenders, traders in interest rate derivatives and futures, and others.

Nearly all financial services companies have debt linked to LIBOR, which is embedded as a reference rate in trillions of dollars’ worth of outstanding contracts. Over time, the transition’s ripple effect could become more of a deluge for companies that have not monitored developments and taken the necessary steps to review, revise, and communicate changes in the millions of legal contracts that are today pegged to LIBOR.

LIBOR, an interest rate benchmark that is designed to represent the cost of certain banks lending to each other—specifically, those banks that are active in the London interbank money markets. LIBOR is administered by the Intercontinental Exchange (ICE). Post the financial crisis and, in particular, the failure of Lehman Brothers, those markets became illiquid and inactive, and the process of finding a replacement benchmark has been underway. U.S. dollar LIBOR is the most significant and widely used benchmark, but LIBOR also covers euros, British pounds, Swiss francs, and Japanese yen, and many countries also have an equivalent, but separate, “IBOR-type” benchmark, such as SIBOR in Singapore. All are in various stages of identifying and implementing a replacement for their IBOR.

The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve and with representatives from the major participant banks, industry utilities, and client sectors, announced in June 2017 that LIBOR will be replaced by a broad Treasuries “repo” financing rate, the Secured Overnight Financing Rate (SOFR), reflecting the cost of banks borrowing cash secured against U.S. Treasuries.1 The rate would be published by the Federal Reserve Bank of New York in cooperation with the Treasury Department’s Office of Financial Research.

What’s at Stake
The transition could impact an estimated US$350 trillion of contracts and exposures benchmarked to LIBOR, including all loan types as well as interbank trading and interest rate derivatives.

Much of this figure is in the areas of interest rate derivatives and futures trading, a business not renowned for transparency or easily understood by outside parties. An early identifiable trading issue will be that unsecured LIBOR is to be replaced with a secured repo financing rate backed by U.S. Treasuries, and this will fundamentally change how interbank and interest rate derivatives traders manage risk, collateral, and margins for themselves and for clients. Adjustments will be needed to banks’ trading and valuation systems, as well as financial reporting.

Then, more broadly, trading impacts on interest rates could have impacts across the landscape of bank lending, as well. Consider that every time a personal or commercial mortgage interest rate currently resets, for example, there’s a good chance it’s resetting against the LIBOR reference rate.


Changes to SOFR are already underway, and will occur in managed stages. It will be published on a daily basis by the Federal Reserve Bank of New York on April 3, 2018, and will be introduced initially for use in derivatives trading for the largest banks, and over time moving towards use in the consumer debt and with retail clients.

Interest rate derivatives and futures trading activities are expected to be impacted by changes to the new rate as early as the end of 2018. The paced transition plan anticipates that Overnight Index Swaps (OIS)—a core risk management product in the interest rate management business—will reference the new Secured Overnight Financing Rate by the end of 2018. Trading in centrally cleared derivatives will reference SOFR by the end of the first quarter of 2019, and Central Clearing Parties will permit the use of SOFR for variation margin reset and calculation by the end of the first quarter of 2020.

A term market will have to be developed, since Treasury Repo is largely an overnight market, and LIBOR has traditionally had benchmark rates for terms at one month, three months, and even one year. This will require more extensive use of the futures market and an anticipated SOFR derivatives market.

The Bank of England announced in June that banks will have to be prepared to use a LIBOR replacement rate by the end of 2021. Note that the UK’s Working Group on Sterling Risk Free Reference Rates is expected to substitute Sterling LIBOR, not with Treasury Repo, but with SONIA (Sterling Overnight Index Average)—an index inconsistent with the U.S. replacement selection—further complicating the transition and the risks. The European Central Bank (ECB) recently advised that it would develop a new unsecured interest rate benchmark before 2020 to serve as a backstop to private sector benchmarks.

From there, the ARRC says the transition plan will be executed over several years, which is when the new benchmark is also expected to supplant LIBOR as a key reference rate for corporate loans, residential mortgages, and credit cards and touch thousands of corporations and businesses and millions of individuals in all parts of the U.S. and internationally.

Making the Transition
When LIBOR goes away, what happens? This is actually a bigger question than many financial services companies may think, with implications at multiple levels. These “levels” can be defined by type of client, as in institutional, commercial, and consumer. They are also defined by activity, as in trading, risk management, financial reporting, legal, documentation, or technology.

Particularly in complex organizations, significant preplanning and coordination will be required, because addressing a single question in the course of this transition is likely to raise five more.

Now is the time for banks to begin identifying and documenting their exposure to this benchmark change, name a project team, and put an implementation plan in place, covering all the different areas that this change will impact across the organization.

The first and most obvious question to ask is—what products and services do I have that are linked or reset by LIBOR? Can I document those commitments? Do I understand the risks of transition as LIBOR disappears (e.g., do I have to re-document every contract and re-price every transaction?) Can I plan and manage the change?

Communication with clients will be key throughout the transition. Bankers should begin soon to identify every client potentially affected by the transition. They cannot treat communications as an afterthought, but should integrate a communications strategy into the implementation plan from the start.

Examples of Challenges Include:

Identification and documentation. Many banks may lack a clear line of site to all contracts implicated in the LIBOR change. A big global bank might have derivatives contracts, structured products, consumer debt, mortgages, student loans, credit cards—all operating in different divisions that may rarely coordinate risk management and systems. The same bank may also conduct corporate and investment banking, as well as trading—via international as well as domestic operations. So the first hurdle is determining how to identify and locate every piece of business that has a link to the LIBOR benchmark, in order to manage the change.
Structure. Organizational challenges could arise in trading, as risk management moves from an unsecured to a secured product. Unsecured interest rate risk tends to be managed in a global bank by a different group of people, with different trading and risk management systems, than those managing secured, collateralized interest rate risk. That can be difficult to change, and potentially disruptive.

Internal Transfer. A bank, from its central treasury or finance function, has to value all the lending done across the bank before money goes out to clients. The same goes for borrowing. How does the changing benchmark affect a bank’s internal treasury transfer rate?

Accounting. Many of the financial results that a bank reports to investors and securities agencies are now valued against LIBOR. If they will be based on a different benchmark, going forward, what is the potential impact on the bank’s results? On its clients’ results?

Communications. Consumer banks may have to change the documentation, processing, and consumer notifications for tens if not hundreds of millions of circumstances, re-documenting off the new benchmark. Actual rate changes could be necessary; at a minimum, questions could be raised in the future about whether a contract remains valid if its rate is still linked to LIBOR. Could there be litigation if the replacement rate increases the costs to a client? When and how do banks speak to consumers about this issue? The earlier bankers begin thinking through such challenges, the better.

The Final Analysis
The ARRC is proceeding gradually, so that the LIBOR changes do not disrupt companies, clients, and the market. The other international bodies have a tendency to await ARRC announcements before convening and concluding their next steps. Still, with the extent of change in question, there are risks to be managed.

Financial services companies across the board need to identify and document their exposure to these risks. Particularly during the transition, pricing, liquidity, internal treasury transfer risk, accounting treatment, and margin and collateral agreements are among the many areas to be assessed. Planning should begin now, before it becomes urgent and impossible to execute. Client communications will be paramount throughout—to the culmination of a process that will undoubtedly see some hitches but ideally work smoothly enough to keep the global banking system on solid footing.

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Graham A. D. Broyd
Graham Broyd, Senior Advisor at Treliant Risk Advisors, leads Treliant’s Financial Markets Conduct and Compliance practice, working with regulators, large international banks, and law firms on preventing, remediating, and investigating conduct and compliance issues stemming from banks’ trading floor activities.