Background: LIBOR Loses Its Status as the “World’s Most Important Number”
With over $200 trillion of financial contracts pegged to LIBOR as of 2018, the reference rate has played one of the most critical roles in the financial industry for over 50 years. However, significantly reduced volumes of interbank unsecured term borrowing coupled with recent revelations of manipulations in LIBOR rates have undermined LIBOR’s ability — as well as its capacity — to continue playing the “world’s most important number.”
When Will the Transition from LIBOR Occur?
On July 27, 2017, the United Kingdom’s Financial Conduct Authority (FCA) announced that it will no longer require banks to submit quotes for LIBOR rates after 2021. The FCA also recommended that the market stop using LIBOR as a benchmark.
The global transition away from legacy short-term financing rates is a massive undertaking for the financial industry. Regulators, market participants, exchanges, and clearing functions all share a consistent set of priorities – the avoidance of market disruption, liquidity “gaps”, and the degradation legal or contractual terms.
While some market participants believe that the Covid-19 pandemic will delay the transition, postponement of LIBOR cessation seems unlikely. The Alternative Reference Rates Committee (ARRC) recognizes that near-term, interim steps may be delayed but continues to pursue its 2020 objectives. Segments of the market that remain reluctant to adopt in-arrears, SOFR-based instruments continue to advocate for alternative rates and an in-advance methodology (e.g., middle market corporate borrowers, consumer products). Certain market segments may receive extensions and relief. However, current expectations are that any delay will have a small impact and represent a small portion of contracts, collateral and assets.
Accordingly, the ARRC continues to expect that the financial system will complete the transition by the end of 2021. The current operating assumption remains “full speed ahead” toward 2021 cessation, contract remediation and pre-cessation trigger events.
What Will Replace LIBOR? There Is Likely No “One Size Fits All” Solution
While multiple alternatives are being considered, the most commonly cited replacement rate is the secured overnight financing rate (SOFR), a broad Treasury repo financing rate. The Alternative Reference Rates Committee (ARRC) has recommended SOFR as an alternative to LIBOR in the United States.
Voya Investment Management believes that, regardless of the ultimate size and scope of the SOFR market, SOFR alone will not replace the LIBOR index. An obvious rationale for this conclusion is the conceptual difference between SOFR and LIBOR, particularly with regards to credit risk and term structure. More likely, multiple alternatives will address various segments of the market. For example, secured overnight financing, averaged historically and compounded, may not be an appropriate reference rate for certain floating rate notes. The mortgage, commercial and consumer loan markets may be structurally incapable of facilitating an “in-arrears” methodology, and end-borrowers may reject such an approach. In addition, options markets may conceptually reference an underlying instrument that is not specifically SOFR based.
How is Voya Investment Management Preparing?
Voya Investment Management has taken proactive steps to ensure that, as a market participant, fund manager, and counterparty, we are well-positioned to adapt to evolving market conventions, norms, and benchmarks.
In 2019, we established a comprehensive LIBOR transition program and governance structure, headed by the Voya Financial Risk Committee, with executive sponsorship from Voya Financial’s CFO and Voya Investment Management’s CEO.
The LIBOR transition program includes dedicated workstreams for contract remediation, product transition, system and operational readiness, finance, and client communications. Through the end of 2021, the program will continue to track industry milestones and optimize activities and resources based on our understanding of market developments across different asset classes.
In addition to our ongoing analysis and implementation of LIBOR alternatives, we have conducted a comprehensive review of credit agreements and contracts with inadequate floating-rate language:
- Most credit agreements typically provide a “market disruption event” clause as a fallback, which includes a trigger event entitling lenders to suspend making loans at interest rates calculated with reference to LIBOR.
- Where possible, current fallback provisions need to be updated with clear guidelines for converting LIBOR to the new reference rates.
- For investments where Voya IM is a direct lender, Voya legal teams are reviewing and amending existing credit agreements, in order to accommodate LIBOR cessation, with appropriate “fallback” language.
- For LIBOR-sensitive investments in which Voya IM is not a direct lender, our project team is working to identify, prioritize and remediate contracts with inadequate floating-rate language. This undertaking will be part of a larger industry initiative, to ensure continued transparency and liquidity for contracts referencing LIBOR.