The cessation of LIBOR represents a significant challenge for the buy-side. Navigating this transition will affect firms in many ways. The buy-side needs to understand that they now have a new risk in their portfolios – the fallback language in their LIBOR-based instruments.
Although the Fed is pushing for firms to convert their USD LIBOR positions to SOFR before the end of 2021, there are many complicating factors. LIBOR fallback language is highly inconsistent from one deal to the next. Even if a deal has fallback language for temporary disruptions in the setting of LIBOR, many do not anticipate a permanent cessation. This creates unintended consequences, including fallbacks that effectively turn a floating rate note to fixed at the last LIBOR setting if there are no banks willing to set a LIBOR level. Given the historically low level of LIBOR, this disincentivizes issuers to alter their fallback language.
Another potential landmine for the buy-side is that some states require 100% consent in order to modify a deal. This means that a single investor could hold up the conversion of a deal to an alternative reference rate if they do not give their consent to the new terms. This is already happening1 and has the potential to create a wave of litigation throughout the industry.
The cessation of LIBOR does not only affect certain parts of a buy-side firm. It affects the entire organization – portfolio management, trading, marketing, operations, technology, risk management, etc. The entire organization needs to be engaged in the process through a top-down governance structure established by senior management.
1See “CLO Libor fallback language proposal fails as investor balks at change”, https://www.reuters.com/article/clo-liborammcrefi/clo-libor-fallback-language-proposal-fails-as-investor-balks-at-change-idUSL2N26S16P, Reuters, October 8, 2019.