Most everyone who has grown up with Walt Disney classic films will recall the valiant Prince on his noble steed slashing his way through the Forest of Thorns to reach Maleficent’s castle and rescue Sleeping Beauty. While the transition from Libor to SOFR (or more generally from IBORs to Risk Free Rates or RFRs) is hardly as inspiring as the Prince’s quest to rescue Sleeping Beauty, we practitioners of the financial arts might do well to emulate his determination and singlemindedness. For in many significant respects the transition from Libor to SOFR will present very formidable obstacles, particularly for those who are approaching it in a lackadaisical manner.
First of all, there are countless thorns in the forest, they seem to be everywhere, they are sharp and dangerous, and if you are not careful, you might get seriously hurt. Oliver Wyman, in a February 2019 article entitled “Libor Transition Roadmap for Investment Managers”, itemized three different ways in which Investment Managers currently use Libor, each of which will require rigorous management throughout the transition process. These applications are so familiar that it is easy to take them for granted and neglect to imagine just how integral they are to the everyday functioning of investments as we know them. To extend the Sleeping Beauty analogy a bit further, the Prince was quite taken aback when he first confronted the forest of thorns, because it was so forbidding and unexpected. It should not have been unexpected, and fortunately he regained his determination quite rapidly. Marshalling the resources of a large organization might take considerably longer and be less decisive.
The first way in which investment managers will be faced with the Libor transition challenge is in the number, variety, and complexity of Libor-based products that are likely to be in their investment portfolio. Furthermore, they will be faced with the sheer magnitude of the problem of identifying all of those instruments, the timing and impacts of the transition, and the start of a meaningful process of changing the portfolio composition to one that will have predictable, sufficient, and competitive returns so that the investors will not suffer either outright losses or reduction in assets under management.
For banks, conversion from Libor to SOFR might cause significant reduction in income and compression in net spreads against traditional funding sources, unless assets can be converted from Libor-based to SOFR-based at considerably higher spreads. In industries where profitability is scrutinized at least quarterly by investment analysts, mismanagement of the transition could result in some very unpleasant surprises. Some of the many instruments that now use Libor as a basis for returns would include Floating Rate Notes (FRNs), Residential Mortgage Backed Securities (RMBS) and other Asset Backed Securities (ABS), large Syndicated Loans, Interest Rate Swaps, Interest Rate Caps and Floors, and many other types of derivative instruments (which are also Libor-based). Libor rates are written into the documentation of all such instruments, and likely are used in different ways (e.g., fallback rates, penalty clauses, damages and the like). All will have to be inventoried, amended, agreed, and signed before the effective change dates. Hardly a trivial task!
A particularly tricky problem may be fallback language such as when Libor ceases to be available. Many loans or securities may have provisions to the effect that if Libor ceases to be available, the rate may be fixed to maturity at the last available Libor. That fixed rate for a long period may not be profitable in a different rate environment.
A second problem for investors also comes with the use of Libor as a benchmark or target for different funds and mandates. For instance, a floating short-term instrument fund may invest in a variety of different instruments, but have as its target return a certain spread over Libor. When Libor ceases to exist, that fund will no longer have a measurable performance target, and may suffer substantial withdrawals as a result, or even suffer withdrawals before then as investors withdraw funds to put them with competitors who have earlier offered an understandable alternative and had salespeople explain the conversion to those investors. An investor slow in that process stands to see AUM diminish.
Finally, and perhaps most important, operations and administration rely heavily on Libor for valuation, in model calculations, accounting, and myriad other applications. One of the most pervasive and important to this writer is the use of Libor in the valuation of derivatives, not only in the short term, but also in the projection of a forward Libor curve for determination of long-term fixed swap rates. One-month and three-month SOFR futures have been introduced, but currently lacks liquidity to build yield curves for valuation purposes. In addition, it remains to be seen how that market will develop for use in longer maturities. Libor-based curves are used in a wide range of models, systems, and calculations currently in applications such as accounting, risk measurement, asset allocation, and contracts with service providers.
So let us be like the intrepid Prince and attack the Forest of Thorns with vigor, determination, and optimism. We are likely to encounter many unexpected obstacles along the way, and will certainly be more successful the sooner we get started in earnest.