The transition away from LIBOR towards the USD’s alternative reference rate, the Secured Overnight Funding Rate (SOFR), that we foreshadowed in our recent blog is underway. The Chicago Mercantile Exchange began offering SOFR futures in May and liquidity is growing, in fact more than 100,000 contracts have traded. More and more large Financial Institutions (FI’s) are taking proactive steps, such as initiating new product approvals, which will give rise to a new ecosystem of over-the-counter SOFR-based derivative products.
The Alternative Reference Rates Committee (ARRC) held their second roundtable in New York last week where they announced that the world’s largest derivatives clearinghouse, the London Clearing House, is now clearing SOFR derivatives. The ARRC’s sub-working groups also began sharing preliminary language for fall backs so that contracts underpinning financial instruments are still effective in the event that LIBOR is discontinued or that transactions volumes underlying LIBOR fall so low that LIBOR becomes unreliable. Regulators and industry groups are urging FI’s to act immediately.
We recommend taking the following 5 actions to prepare for this significant change:
- Engage in Industry Forums – FI's should engage with their respective industry groups and associations to monitor news, developments and publications on best practice. Certain aspects of the transition are yet to be determined so firms can advocate for their position. For example, the International Swaps and Derivatives Association (ISDA) has initiated a consultation on benchmark fallbacks through October 2018 where firms have the opportunity to provide their views on the calculation methodology for the creation of term rates - likely to be called Secured Average Financing Rate (SAFR) - as well as the spread adjustment that will be applied to SOFR to emulate the credit risk and other factors that were embedded in LIBOR.
- Raise Awareness Internally – Raise awareness within your organization now. This could take the form of education and information sessions and through communications from senior management. This will help to begin identifying key stakeholders and impacted products and businesses. Depending on the nature of the FI’s business mix, preliminary communications to affected clients could also be considered at this time.
- Establish a Project Management Office (PMO) – Formalize a PMO to organize and coordinate the LIBOR transition. Install a senior management sponsor and establish a governance structure. The PMO should begin production of a preliminary transformation program that can eventually be shown to regulators. Organizational change management and associated communications and training can also be run out of the PMO.
- Identify an Inventory of LIBOR-Based Products and Systems – Quantify your LIBOR exposure by identifying all products that reference LIBOR and their associated systems across the full trade lifecycle. Categorize LIBOR-based products by product type and by maturity to create a roll-off profile.
- Review Fallback Language in Contracts – Review the fallback language in contracts underpinning financial instruments. Assess whether or not the contract language provides for an event involving the permanent cessation of LIBOR publication. We will explore assessment of fallback language in greater detail in our next blog.
Industry surveys indicate that awareness of the move towards SOFR and the uncertainty surrounding LIBOR’s continuation is high amongst the largest FI's, however there is much more to be done. We echo calls by global regulators and industry groups in urging FI’s to take action on this historic change now.