Transition from LIBOR to SOFR: Primer for IFC Clients
Back to IFC's LIBOR-to-SOFR Transition
What is LIBOR?
LIBOR, or the London Inter Bank Offer Rate, is the most widely used interest rate benchmark to price or value a wide range of financial products, with underlying transactions of over $370 trillion across the globe. LIBOR is calculated based on the average estimates by a group of banks of the cost of their borrowings in five currencies (U.S. dollar, euro, British pound sterling, Japanese yen, and Swiss franc) with seven maturities of varying durations.
Why is LIBOR being phased out and when?
With LIBOR based on estimates quoted by a panel of banks, the rate became susceptible to manipulation. This issue surfaced during the 2008 global financial crisis and was exacerbated by a reduction in intrabank lending. Given the fundamental weaknesses of the rate, global regulators and market participants began a process of phasing out LIBOR identifying appropriate alternative benchmark rates.
- LIBOR will no longer be available for new financial transactions from Dec. 31, 2021;
- On March 5, 2021, the Financial Conduct Authority announced the dates that panel bank submissions for all LIBOR settings will cease, after which representative LIBOR rates will no longer be available as follows:
- Dec. 31, 2021, for all pound sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month U.S. dollar settings
- June 30, 2023, for all other U.S. dollar settings (including the most commonly used three-month and six-month settings)
For ongoing updates from Intercontinental Exchange (ICE)— the administrator of LIBOR, please go to this link.
What are the implications of phasing out LIBOR?
Given the quantum of financial products that use LIBOR, phasing out LIBOR has a significant impact on all participants in global financial and capital markets.
Moving from LIBOR to alternative reference rates (ARRs) is a massive undertaking across capital markets and includes several key elements:
- new benchmarks must be widely adopted by a variety of participants;
- technology must be upgraded to process products linked to the new benchmark(s);
- legal teams must amend trillions of dollars of existing contracts tied to LIBOR; and
- financial markets must model structural adjustments to integrate the economics of the new rate.
What are the key industry bodies stewarding LIBOR transition in the market?
For the U.S. dollar LIBOR market, the Alternative Reference Rates Committee (ARRC) has recommended an alternative benchmark rate described below. The ARRC is comprised of private market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York.
The UK Financial Conduct Authority (FCA) regulates and oversees LIBOR. To address LIBOR’s shortfalls as a funding cost benchmark for global financial markets, the FCA stated that all LIBOR settings will either cease to be provided by any administrator or no longer be representative beyond December 2021 for certain settings and beyond June 2023 for the rest of the settings including three-month and six-month LIBOR.
For derivatives markets, the International Swaps and Derivatives Association (ISDA) was mandated by the Financial Stability Board (FSB), a consortium of national and international regulators, to draft fallback provisions, select the fallback rates and mechanisms for the 2006 ISDA Definitions, and develop a plan to amend legacy contracts referencing LIBOR. ISDA published these proposed fallback provisions, fallback rates, mechanisms, and draft amendments on Oct. 23, 2020, in the IBOR Fallbacks Supplement and IBOR Fallbacks Protocol.
For the syndicated loan market, the Loan Market Association (LMA), a trade association for the Europe, Middle East, and Africa region, works with market participants, other trade associations, and regulators to represent the interests of the syndicated loan market, developing key compounding conventions and standard documentation for risk-free, rate-referencing transactions.
U.S. Dollar LIBOR Replacement
What is the replacement for U.S. dollar LIBOR?
In 2017, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as the rate to represent best practices in U.S. dollar derivatives and financial markets. SOFR is based on observable repo rates, or the cost of borrowing cash overnight collateralized by U.S. Treasury securities. On July 29, 2021, the ARRC further formally recommended the forward Term SOFR published by CME Group, Inc. (CME) for use in connection with business loans. As described below, IFC can offer SOFR Non-Cumulative Compounded Rate loans and is working to launch forward looking Term SOFR rates as soon as feasible.
What are the implications on the cash products market, including bilateral and syndicated loans?
LIBOR and SOFR benchmark reference rates are not economic equivalents. LIBOR has a term structure, is an unsecured rate, and contains a credit premium representing the credit risk inherent in interbank lending. SOFR, on the other hand, is an overnight, secured and almost risk-free rate and consequently is lower than LIBOR. Market participants, including IFC, clearly understand LIBOR transition should seek to minimize any transfer of economic value between lenders and borrowers in an existing transaction. As SOFR is inherently lower than LIBOR, certain underlying spread adjustments may be required to reflect both the term nature and interbank lending risk characteristics inherently contained within LIBOR.
Following consultations on the LIBOR transition, ARRC published recommendations on U.S. dollar LIBOR fallback language for syndicated and bilateral business loans that will convert to SOFR by June 2023 covering three main parameters:
- Triggers: Circumstances that would trigger the replacement of the reference benchmark rate (which have now come to pass);
- Benchmark replacement rate: The rate, or waterfall of rates, that will replace the current benchmark;
- Spread adjustment: Spread added to the replacement rate to account for difference with the current reference rate.
In its LIBOR transition, IFC has adopted ARRC’s recommendations within our process of designing the fallback mechanism and implementation of a new benchmark rate.
IFC’s LIBOR Transition
IFC is collaborating with partnering multilateral development banks and development finance institutions to track industry announcements and identify best practices for new loans, LIBOR fallback language, and benchmark replacement mechanisms for our legacy transactions.
As part of this process, IFC’s new LIBOR based loans issued during the remainder of 2021 include fallback language to ensure there is a mechanism to replace LIBOR with a successor benchmark rate. This language reflects approaches recommended by the ARRC and the LMA.
- Implementation of new benchmark
rate in new loan documentation
On Dec. 1, 2020, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued a statement strongly recommending the cessation of issuing any new LIBOR-based contract including loans after Dec. 31, 2021.
In anticipation of the cessation of new LIBOR based loans, IFC can now offer borrowers SOFR Non-Cumulative Compounded Rate Loans with a 10-Business Day Lookback and no Observation shift. In addition, IFC is monitoring market developments and working toward rolling out Term SOFR, a forward-looking rate based on SOFR with tenors including 3, 6, and 12 months. - The Trigger Event for the
cessation of LIBOR
On March 5, 2021, FCA announced the dates that panel bank submissions for all LIBOR settings will cease, after which representative LIBOR rates will no longer be available as follows:- Dec. 31, 2021, for all pound sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month U.S. dollar settings
- June 30, 2023, for all other U.S. dollar settings
This announcement was widely construed by the market as the Trigger Event for the cessation of LIBOR
- Implementation of new benchmark
rate in existing loan documentation
IFC intends to reach out to clients beginning in 2022 to propose specific amendments to loan agreements to incorporate the new benchmarks. This process will include other conforming changes to reflect appropriate data sources, calculation periods, and payment dates as required by the new benchmark. This loan portfolio amendment program provides IFC and its borrowers assurance that a process is in place for continuity, after the cessation of LIBOR in June 2023 - Implementation of new benchmark
rate in multi-lender projects
Similarly, beginning in 2022, IFC expects to amend the legal agreements in transactions involving multiple lenders, investors, and/or IFC loan participants after. - Basis risk inherent for loans
with related hedging products
IFC offers client risk management swaps to loan clients, helping clients manage their interest rate risks and foreign currency risks by synthetically converting their underlying floating rate U.S. dollar loans to fixed rate U.S. dollar loans or converting U.S. dollar loans to local currency loans. IFC will strive to offer the SOFR structure for overlay swaps and underlying floating rate U.S. dollar loans.
As loan market and derivative markets move into different SOFR variants and compounding methodologies, IFC is working on pricing, modelling, and hedging solutions to minimize interest rate mismatch between loans, and SOFR swaps.
Eventually all U.S. dollar LIBOR-based loans and hedging transactions between IFC and its clients will transition to SOFR. Given the varying groups involved and the timing of progress, it is not yet possible to determine whether the transition will result in the development of derivative and loan products with identical terms, as is currently the case in a LIBOR world, or whether divergences between LIBOR-based derivatives and loan products emerge.
This means there is the potential for a mismatch and some degree of resulting basis risk associated with differences between the structure of loans and related hedging.
LIBOR Timeline
Last updated: October 20, 2021
