Perspectives

SEC staff issues statement on LIBOR transition

This issue discusses the SEC staff’s recently issued statement on the expected discontinuation of the use of the London Interbank Offered Rate (LIBOR) as a benchmark or reference rate in contracts such as derivatives and how the transition from LIBOR may significantly affect financial markets and market participants (including public companies, investment companies and advisers, and broker-dealers).

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The SEC staff recently issued a statement (the “Statement”) that:

  • Discusses the expected discontinuation of LIBOR use and how the transition from LIBOR may significantly affect financial markets and market participants (including public companies, investment companies and advisers, and broker-dealers).
  • Lists questions and considerations for market participants related to new or existing contracts and other business risks.
  • Provides specific guidance from the SEC’s divisions of Corporation Finance, Investment Management, and Trading and Markets and its Office of the Chief Accountant.

Although the Statement focuses on LIBOR, its guidance is also relevant to market participants that may be affected by a transition from other reference rates.

 

Volume 26, Issue 16 | August 6, 2019

Background

The use of LIBOR is pervasive in today’s markets as a benchmark or reference rate in contracts such as derivatives (e.g., interest rate swaps), corporate and consumer loans and mortgages, and corporate and municipal bonds. LIBOR is calculated daily by the Intercontinental Exchange for five currencies, including the euro, the British pound, the Japanese yen, the Swiss franc, and the U.S. dollar, and for seven maturities or tenors including overnight/spot next, one week, one month, two months, three months, six months, and twelve months, resulting in the daily reporting of 35 LIBOR rates that are used in various financial products and instruments worldwide. The Statement notes that “[i]t is expected that a number of private-sector banks currently reporting information used to set LIBOR will stop doing so after 2021 when their current reporting commitment ends, which could either cause LIBOR to stop publication immediately or cause LIBOR’s regulator to determine that its quality has degraded to the degree that it is no longer representative of its underlying market.”

To prepare for the possible discontinuation of LIBOR, certain jurisdictions in which the use of LIBOR is prevalent have formed working groups to develop possible successor alternative reference rates (ARRs). In the United States, the Alternative Reference Rates Committee (ARRC) has designated the Secured Overnight Financing Rate (SOFR) as the recommended alternative rate for U.S. dollar–based LIBOR. The Statement notes that “SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions.” Some market participants, however, may continue to explore whether other U.S. dollar reference rates would be more appropriate for certain instruments. (For example, a reference rate that offers tenors longer than an overnight rate may be appropriate for certain longer-term contracts.) The Statement notes that the SEC does not plan to endorse any single reference rate; however, the SEC staff will monitor transition efforts and assess “whether the adoption of a variety of replacement rates for USD LIBOR instead of the emergence of a dominant successor could limit the effectiveness of all replacement benchmarks.”

Although there are still some questions about the ultimate resolution and timing of the transition from LIBOR, the SEC staff strongly encourages market participants that have not already done so to begin assessing their risks associated with the transition. Furthermore, the staff notes that it is actively monitoring participants’ progress with their risk identification and risk management efforts related to the LIBOR transition.

General Guidance

Existing Contracts

The SEC staff encourages market participants to assess their exposure to LIBOR in existing contracts that extend beyond 2021 in a timely manner to avoid potential market or business disruptions. The Statement notes that many such contracts “did not contemplate the permanent discontinuation of LIBOR and, as a result, there may be uncertainty or disagreement over how the contracts should be interpreted. In addition, in circumstances where the contractual interpretation is clear, the adjustment may be inconsistent with expectations of the affected parties” (e.g., a floating-rate contract would become fixed-rate). Since renegotiating contracts with counterparties can be time-consuming, it is important for market participants to be timely in their assessment of LIBOR exposure. The Statement provides a list of questions to help market participants identify and manage risks associated with the LIBOR transition. The questions outline actions that market participants should consider taking, including the following:

Type of Assessment Actions That Market Participants Should Consider
Identification of LIBOR exposure - Identify contracts that extend beyond 2021 that contain references to LIBOR.

- Assess the materiality of such contracts individually and in the aggregate for risk management and disclosure purposes.

- Determine the effects of LIBOR discontinuation on contract operation.
Analysis of contractual fallback provisions - Determine whether contracts have fallback provisions that are triggered by the unavailability of LIBOR.

- Assess whether there is a need to mitigate risks (e.g., determine whether there is a need to renegotiate with the contract counterparty).
Analysis of alternative reference rate (ARR) ramifications - Identify the ARR that would replace LIBOR in the affected contracts (e.g., SOFR).

- Assess whether there are fundamental differences between LIBOR and the ARR that could affect contract profitability or costs (e.g., different counterparty credit risk).

- Assess whether there is a need to adjust the ARR (e.g., by adding or adjusting the credit spread) to maintain the same economics for affected contracts.

- Determine whether the ARR introduces new risks that must be addressed (e.g., assess whether LIBOR-based contracts that were entered into to provide an economic hedge will still be effective under the ARR).
Analysis of hedging implications - Assess the effect of LIBOR discontinuation on the effectiveness of hedging strategies in which a LIBOR-based contract was used to hedge floating-rate investments or obligations.

New Contracts

The SEC staff encourages market participants that enter into new contracts to assess whether those contracts should refer to an ARR instead of LIBOR or should incorporate fallback provisions that take into account the LIBOR transition. The Statement notes that the “ARRC has published recommended fallback language for new issuances of floating rate notes, syndicated loans, bilateral business loans, and securitizations” (footnotes omitted). The Statement also acknowledges the efforts of the International Swaps and Derivatives Association to develop “robust fallback language” for derivative contracts.

Other Business Risks

The Statement notes that the discontinuation of LIBOR may affect other aspects of a market participant’s business, including “strategy, products, processes, and information systems.” Accordingly, market participants should assess their own facts and circumstances to determine whether they will need to undertake mitigation efforts to address these broader business risks. The Statement indicates that “prudent risk management may necessitate the establishment of a task force to assess the impact of financial, operational, legal, regulatory, technology, and other risks.”

Next Steps

The LIBOR transition could have a pervasive impact on the financial markets and significantly affect market participants’ systems, operations, and financial reporting. All entities should gauge their potential exposure to LIBOR, identify potential risks associated with the LIBOR transition, and determine whether action is necessary to mitigate those risks. In particular, entities should assess whether existing contracts that refer to LIBOR and are expected to extend beyond 2021 have effective fallback language so that the entities have sufficient time to take corrective action if necessary. Also, market participants should consider the impending LIBOR transition when they negotiate the terms of new contracts and ensure that such contracts either refer to ARRs or incorporate sufficient fallback language if LIBOR is used. SEC registrants also need to be mindful of their disclosure obligations under SEC rules and regulations and ensure that their disclosures are transparent and timely. Further, market participants need to continue to actively monitor the actions of standard setters and regulators to ensure that they comply with financial reporting requirements and avail themselves of any relief that is offered.

Deloitte may be able to help entities with their LIBOR transition efforts. For more details and contact information, see Deloitte’s LIBOR transition Web site.

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