By John Hintze
Clock is ticking as key components take shape without corporate input.
The derivative and cash markets in the US are heading toward the adoption of very different approaches to calculating the new rate to replace London Interbank Offering Rate (Libor), an outcome that could present borrowers with significant hedging and operational challenges. The lack of feedback from commercial borrowers is increasing the risk that the solutions regulators decide upon will not fit borrowers’ needs.
After 2021, major banks will no longer be obligated to submit their interbank lending rates used to produce Libor, potentially degrading further its already questionable viability as a benchmark to price floating-rate financial instruments. The precipitous drop in interbank lending volume in recent years raises concerns that Libor’s viability may end even sooner.
So far, however, commercial borrowers have provided little input on the development of the Federal Reserve’s Secured Overnight Financing Rate, or SOFR.
A dearth of corporate input. One of the key issues Libor users face is fallback language, which is a key transition element because it facilitates moving existing transactions priced over Libor to a new benchmark. The New York Fed’s Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA) have both proposed such language, the latter in contracts for derivatives referencing Libor and other key interbank offering rates (IBOR). ISDA’s proposal drew comments from 147 organizations, and according to association’s results published in December, only seven came from nonfinancial corporates.
The ARRC has issued four consultations addressing fallbacks in contracts for different corporate loan products. Comments received in early February for bilateral-loan fallbacks comprised 20 signed by financial organizations and a few vendors, and 15 anonymous comments written from lender perspectives, echoing the mixture of comments received on consultations for syndicated loans, floating-rate notes and securitizations.
The significant progress made so far in developing markets supporting SOFR has also largely excluded corporates. The major derivative exchanges launched SOFR futures in May 2018, and the CME reported the daily average volume of its SOFR futures reached nearly 40,000 in March, double January’s volume. The ARRC anticipates those derivative instruments enabling the creation of term versions of SOFR, providing borrowers with a forward-looking rate that resembles Libor’s term structure and enables better cash-flow forecasting. Furthering the effort, the Federal Reserve Board staff published a paper Feb. 5 titled “Inferring Term Rates from SOFR Futures Prices.”
However, participants in those developing markets have primarily been financial institutions, so it remains unclear how corporate borrowers will view any term SOFR rates that emerge. Participants in a recent NeuGroup meeting of corporate treasurers from large corporations were unaware of the ARRC’s fallback consultations and other SOFR-related developments. Most had yet to consider in detail the significant differences between Libor and SOFR, and how those differences could impact their firms’ financial operations and strategies.
Good for lenders, not borrowers? One of the few firms reflecting end-user concerns that commented on the ARRC fallback consultations was Chatham Financial, which offers hedge-related services to corporates. Eric Juzenas, director of global compliance and regulation at Chatham, said in an interview that borrowers’ dearth of input means one of the most important questions—whether SOFR or a different Libor-replacement rate will best fit market needs—has yet to be addressed.
“As we consider the steps necessary to build out SOFR and term SOFR, we need to be looking at how these rates will actually be used in the market, and for that we need more market participants to be involved in ARRC and ISDA processes,” Mr. Juzenas said. “It’s really something that we should be trying to figure out now rather than pushing it down the road, but we’ve seen little indication of discussions specifically addressing the needs of borrowers.”
Risking SOFR apathy. Mr. Juzenas added that the ARRC and ISDA have reached out to borrowers, but “most borrowers and end users are running their businesses day-to-day and don’t have time to keep up with and respond to ARRC and ISDA proposals.”
The ARRC did not respond to requests for comment on what input it has received from borrowers and end users, or whether it has plans to solicit their feedback more actively.
Mr. Juzenas added that whether the ARRC determines that a term SOFR rate is viable or not, or that a compounded rate is preferable, if a decision lacks broad input from borrowers, they may find the alternative rates do not fit their needs. The same holds true for important transition-related issues stemming from the significant differences between SOFR and Libor, the resolutions of which borrowers must be comfortable with to assure their buy-in.
Cash and derivative discrepancies pose challenges. SOFR is generated from literally thousands of overnight repurchase-agreement transactions, making it less susceptible to the manipulation that compromised Libor. That was a primary reason for the ARRC choosing it, but here’s the rub: SOFR is an overnight rate and most borrowers are accustomed to term rates, around which their systems, policies and procedures are built.
A company pricing a 12-month loan over SOFR will finalize its interest payment at the end of that period, after compounding each daily rate. Commercial borrowers, however, are accustomed to knowing at the start of each term what their payment will be—three-month Libor is the most common floating rate for commercial loans.
In the ISDA consultation’s final results published in December, however, the trade association noted that the “overwhelming majority of respondents preferred falling back to a ‘compounded setting in arrear rate’” for SOFR. The disconnect between the derivative and cash versions of SOFR has raised concerns about the impact on corporate borrowers—so far mostly from their bankers.
“The 2018 ISDA consultation on derivative fallbacks assumed that term rates will not be available, and thus proposed compounding approaches using overnight SOFR rates,” says Credit Suisse. “CS has communicated to ISDA that we believe forward-looking term rates to be a superior approach to compounding for derivatives, especially since it ensures consistency with other markets where contracts and clients heavily rely on such rates being available.”
Credit Suisse declined to comment on whether it has received a response from ISDA. The trade association told iTreasurer.com that the fallback issue is “separate from an industry wide initiative to transition from the IBORs to alternative risk-free rates for all contracts, including derivatives.”
Why corporate input is important. The compounded setting in arrear rate referred to by ISDA is set at the end of the term or reset period, whereas a term rate such as Libor is set at the beginning. Chatham Financial’s Mr. Juzenas said that the compounded setting in arrears rate “may be closer in behavior to a term rate.” However, he said, “it still presents operational difficulties in terms of cash management and the fact that the term and compounded rate structures are different.”
Mr. Juzenas added that the ARRC’s and ISDA’s fallback language proposed in consultations is voluntary, and that companies can individually negotiate fallbacks as well as the type of SOFR rates for their loans and hedges, whether term or compounded. To make those decisions, however, will require analyzing the practical impact.
“End users need to begin focusing on the practical implications of these rate choices and whether or not regulators are going to pressure dealers to support one rate over another rather than let the markets evolve,” Mr. Juzenas said. “SOFR has been created largely in response to regulatory pressure, it remains to be seen what Libor successors will best match market needs.”
Regulators have prompted risk-free rate initiatives (RFR), but so far the financial industry has played the primary role in choosing the rates and how to develop them. ARRC members, for example, are almost entirely financial institutions and associations, with the National Association of Corporate Treasurers (NACT) being the sole representative of corporate interests. And the chairs of the ARRC’s 10 working groups are almost entirely Wall Street executives.
Hedge accounting challenges. Nevertheless, bankers commenting on fallback language identified important issues that could significantly impact their corporate customers. One of those is hedge accounting treatment, which corporate borrowers seek when hedging their debt to reduce volatility in their financial statements. However, the derivative must closely offset the loan it is hedging, and pairing term SOFR for the loan and compounded SOFR for the derivative may be insufficient.
“Our view is that the language used to describe the fallback triggers should be identical as between loans and derivatives to ensure the lending and derivatives markets don’t move asymmetrically,” the Bank of Nova Scotia said in its comment letter.
J.P. Morgan (JPM) calls the hedging of loan interest a potentially “crucial component” of risk management for borrowers and lenders. The bank sees a modest mismatch as manageable, but its “anecdotal expectation” is that any mismatch between the loan and hedge rate could cause some borrowers to stop hedging altogether. Some, it said, may be adverse to any hedge-related earnings volatility, and some use the “critical terms match” version of hedge accounting that allows for zero ineffectiveness to be assumed.
“We believe this population has not had the need to set up the operational capability to deal with hedge relationships that have any rate mismatches,” the bank’s comment letter says, adding they could instead resort to economic hedges, increasing earnings volatility. “As such, it is crucial for borrowers and lenders to be aware of potential mismatches in advance of a transition, in particular to allow for time to review potential hedge strategies or mismatches with external auditors,” the bank said.
So much to do, so little time. The operational challenges are likely to be significant even if the cash and derivative markets both develop term versions of SOFR, and especially so if cash products and derivatives are instead priced off daily or compounded SOFR. For lenders the challenge will be formidable if there is no preapproved “hardwire” transition dictating the fallback procedure, and instead financial products must be individually amended.
“This will involve changes to lenders’ loan systems and legal and administrative resources to process the required amendments,” said a comment letter submitted by an anonymous author, most likely from a bank. “We estimate the process could take between several months to beyond one year to complete such a conversion.”
Larger banks have sizable IT departments, as do the third-party vendors that smaller banking institutions typically outsource their operations and technology needs to. And the highly regulated banks tend to be more accustomed to adapting to rule changes. Corporate finance departments’ resources, instead, tend to be sparser. And given Libor’s potentially perilous state, borrowers must become well acquainted with the new RFR and how to use it, and more importantly understand its impact on their companies’ finance functions.
“It’s easy to calculate these rates, but incorporating them into operations and figuring out the time periods to calculate rates and payments, and making sure the company has sufficient cash on hand, are the significant operational challenges,” Mr. Juzenas said.