Be aware: switching from LIBOR to SOFR danger

Phase-Out of LIBOR

This article is for advanced investors who wants to understand the impact on their stocks, funds, and preferred stocks.

I am for one who is concerning about my portfolio after switching to another stocks (and corresponding companies) valuation method. Will the value drop? Will the value remain the same, or even increase? 

I have extracted some paragraphs from the online articles that I present below. Your comments are welcome.

The uncertainty surrounding the use of LIBOR began long before the U.K. FCA made its announcement in 2017. In 2011, it came to light that certain banks had manipulated the LIBOR benchmark rate by decreasing the interbank borrowing rate, increasing the creditworthiness of banks, and consequently changing the rate for the individual traders to gain profits. Ultimately, this raised concerns over the future of LIBOR which primarily contributed to the reasons that led to the U.K. FCA’s deciding to phase it out.

SOFR is considered to be a market-driven, secured borrowing rate based on an established lending market with money market mutual funds, asset managers, securities lenders, and securities dealers, among others, being the principal participants in the overnight repurchase market.

The key difference between LIBOR and SOFR is that LIBOR is an unsecured rate and represents banks’ estimates as to their cost of funds, while SOFR is a secured, risk-free rate.

Another notable difference is that there is a significantly higher volume of SOFR-based trading and in the underlying nature of the rate itself. As such, the higher volumes make SOFR safer from manipulation than LIBOR.

Additionally, SOFR currently exists only as an overnight rate, whereas LIBOR has seven different forward-looking tenors (overnight, one week, one month, two months, three months, six months, and 12 months). To put this into context, a practical example in which SOFR can be used in place of LIBOR is when, for instance, replacing three-month LIBOR with a rate based on SOFR.

One of the setbacks foreseen with the use of SOFR is that not enough data history exists, which might lead to reliability issues for risk management and volatility models that rely on historical data, ultimately leading to increased complexity in valuing transactions. Refinancing challenges may also arise, since SOFR is an overnight rate and may not be sufficiently liquid.

However, it is conclusively assumed that SOFR is less susceptible to market manipulation and therefore preferred to LIBOR.

Taxpayers

The phasing out of LIBOR will undoubtedly have a significant impact on companies’ operations. It is also worth noting that the degree of change is so significant that companies need to take a fresh look at the entirety of their operating model and strategy as it relates to financing arrangements.

The changes and issues that companies/taxpayers should consider include the following:

Revision of Contracts

Because SOFR is a secured risk-free rate based on overnight transactions and does not incorporate a risk premium, it is expected that the transition from LIBOR to SOFR will result in different credit spreads over the selected reference rate. Companies will therefore be required to conduct a comprehensive review of all documentation of financial instruments where LIBOR is directly and indirectly referenced.

Consequently, contracts that are valid beyond the end of 2021 will need to be amended to deal with the phase-out of LIBOR.

Accordingly, accounting implications may result in the de-recognition of contracts or discontinuation of hedge relationships. By identifying their LIBOR exposure and outstanding hedge relationships, financial institutions can assess whether an amendment to their contracts is needed and evaluate how their existing hedges might be affected.

The wording of the contracts may also be revised such that it incorporates the new rate alternative as well as spread adjustments to minimize the difference between LIBOR and SOFR.

Risk Assessment

There is a need for companies to understand and mitigate risks and ensure the lowest impact on a fund’s net asset value. Companies may need to perform a post-transaction valuation and update their records to reflect the implications of the new rates across different business units, such as risk management, legal, portfolio management, accounting, finance, treasury, etc.

For example, updates to records are needed for multiple valuation and risk systems, such as credit adjustments and term structure updates, which may be a result of the alternative rates.

There is also the need to evaluate key risks arising from each of the transition scenarios and the respective transition strategy, and prioritize based on the risk assessment for each transition scenario. For example, a transition that will most likely change a bank’s market risk profiles will require changes to risk models, valuation tools and hedging strategies.

Tax Implications

The proposed alternative rates are calculated differently and payments under contracts referencing the new rates will likely differ from those referencing LIBOR. Therefore, companies may decide internally to add a fallback provision to handle the eventual future transition to an alternative rate (e.g., a provision stating the alternative rate that will apply to the instrument once the current LIBOR rate becomes unavailable).

Another practical example is where alternative rates may result in the parties to the instrument realizing gain or loss. This raises several tax questions, such as whether the alterations are treated as a taxable event. It is therefore paramount that taxpayers seek clarification from their tax authorities on how to handle such transactions from a tax perspective.

Impact on Financial Statements

Granted, the changes in the fair value measurement will impact the company’s balance sheet. The International Accounting Standards Board has proposed amendments to International Financial Reporting Standards (IFRS) to assist companies in providing useful information to investors about the effects of interest rate benchmark reform on financial statements.

The main proposed amendments relate to:

• Modifications—a company would not de-recognize or adjust the carrying number of financial instruments for modifications required by interest rate benchmark reform, but would instead update the effective interest rate to reflect the change in the interest rate benchmark;
• Hedge accounting—a company would not discontinue its hedge accounting solely because of replacing the interest rate benchmark, if the hedge meets other hedge accounting criteria; and
• Disclosures—a company would disclose information about new risks arising from the interest rate benchmark reform and how it manages the transition to alternative benchmark rates.

Advanced Pricing Agreements

Advance Pricing Agreements (APAs) could also be an avenue for taxpayers who may be significantly affected by the transition to enter into APAs with other jurisdictions to avoid future transfer pricing disputes. Taxpayers should discuss with their revenue authorities how arm’s-length interest will be calculated going forward on their loan products so that there is clarity on both sides.

There is something to scratch your head, right?

Do your DD, man!

Your Club Admin.