By Tal Reback Oct 26, 2020
As we look ahead to 2021, we are keenly aware that the LIBOR transition will be a milestone event for our investors and our portfolio companies. We sat down with Tal Reback, who is a member of the KKR Credit team and represents KKR on the Alternative Reference Rates Committee (ARRC), a group of private market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from LIBOR to SOFR. Below Tal shares her thoughts on what this change means for investors, the biggest challenges faced during this transition and describes how affected parties can plan for something of this magnitude.
Is LIBOR really going away at the end of 2021? What products will be impacted by the change?
Tal Reback (TR): Yes – it’s true, LIBOR is due to be phased out by December 31, 2021. There has been a lot of discussion on whether this date would be extended due to COVID-19. As it currently stands, there has been no extension and banks will no longer be compelled to submit LIBOR after December 31, 2021. So what does this all mean? Long story short, LIBOR is like salt – it is almost in everything: mortgages, business loans, consumer loans such as student and auto loans, and derivatives. Essentially anything that references the global benchmark is in scope for the transition, which is a lot globally!
You mentioned this is a global change…are all LIBOR currencies transitioning to new alternative reference rates?
TR: Yes, LIBOR is currently published in five currencies: USD, GBP, EUR, JPY, CHF and they will all likely transition to new rates for their respective jurisdictions.
Why transition away from LIBOR now?
TR: As the old adage goes, if not now, when? Most people don’t realize that the transition away from LIBOR has been years in the making. In fact, people have been talking about LIBOR reform for over a decade! For background, LIBOR is the most widely used interest rate benchmark globally and is meant to reflect the cost at which large banks can borrow from one another on an unsecured basis in wholesale markets. Over time - in response to both the global coordinated effort to reform LIBOR regulations post the Global Financial Crisis, banks have changed how they fund themselves. As a result, wholesale funding now plays a much smaller role representing approximately $500 million of transactions vs the over $200 trillion it aims to represent. LIBOR has become an inverted pyramid and today LIBOR is mostly determined by expert judgement rather than eligible funding transactions. That is why the ARRC selected a replacement rate that is deep and robust where there is sufficient volume and diversity of transactions to be the foundation of the trillions of dollars of financial contracts that will reference it.
What is SOFR and how is it different than LIBOR?
TR: SOFR - which stands for Secured Overnight Financing Rate - is a daily transaction-based rate that measures the cost of borrowing cash overnight collateralized by U.S. treasuries. SOFR is considered a risk free rate as it does not contain a credit sensitive component. What does that mean? In times of market stress and volatility, LIBOR would typically rise to reflect increased credit risk and reflect marginal funding costs. SOFR does not have that characteristic and typically declines in times of market stress. Unlike SOFR, LIBOR is an unsecured credit sensitive rate with multiple forward looking term rate tenors.
What do you foresee as some of the big challenges as we head into 2021?
TR: Given we are less than 450 days away from LIBOR cessation, there is a lot of work to do in a short amount of time. We need all hands on deck and everyone will play a role. This is definitely not a one size fits all solution and will vary by party. I try to think about it as one long zig-zagged relay race where the moment you get your sparkly baton – it’s game time. Some of the key milestones when I think about the transition in 2021 are: amending existing contracts to incorporate fallback language, operationalizing the rate change across a myriad of products, systems, and infrastructure, providing enough leeway for the market to digest SOFR-linked issuance in various products, and ensuring financial market stability. We are all in this together and each step of the transition is an important one.
What are the common misconceptions about the LIBOR transition?
TR: Oversimplification. On the surface, this may seem like a rate change – swap out one, swap in another, but it is truly much more complicated than that. Not only are LIBOR and SOFR not apples to apples reference rates, but this is the global movement away from a widely referenced rate across hundreds of trillions of contracts that rely on it to calculate interest payments and future cash flows. The transition reminds me a bit of a Monet – you really do need to take a step back to see the whole canvas and understand how all the brush strokes come together. Don’t underestimate the value of one stroke, but also don’t dismiss that as the whole story.
How do you plan for something like this? What can you do today? And what is your advice to others?
TR: Block and tackle – we are in execution mode. Focus on what you can control today and make sure to continue to move the ball up the court. Understand your dependencies, know your exposure and fallbacks, and form a point of view. As we head into year end, it’s a full court press into 2021.