Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer leads the global Libor transition effort at KKR
As the demise of Libor rapidly approaches, US companies really need to stop the default use of the one-time borrowing benchmark for the global financial system.
What might seem a safer option to stick with the status quo is actually far from that. Borrowing now in Libor adds unnecessary complexity and long-term risk in exchange for the temporary comfort of doing what is familiar.
The US loan market’s sluggish adoption of the new benchmark, the Secured Overnight Financing Rate (Sofr), is making Libor’s death seem like an exaggerated rumour. But the end is coming for the origination of loans in Libor as 2022 approaches.
Given Libor was once tied to more than $300tn worth of financial contracts, this transition has been no small feat. It is arguably one of the most complex events that market participants have witnessed in the past decade, with a shift from a benchmark rate set by a panel of banks to one more directly based on market prices.
Much of the focus to date has been on the $200tn market for “over the counter” or privately traded derivatives, given its critical mass in setting rates.
However, the much smaller but significantly more complex $2.5tn loan market is critical to the Libor transition and is also the most behind. Out of 173 loans totalling $154bn that have been issued since October 1, only 14 (totalling about $9.5bn) have been in Sofr, according to the S&P LCD database.
Thousands of small and mid-sized borrowers depend on the loan market to provide funding for their day-to-day operations, and, unlike large financial institutions, many of them do not have access to the capital markets.
These borrowers are facing significant risks as it becomes difficult to predict what Libor liquidity will look like in 2022 and beyond.
Debt contracts can include some near-term protection with “hard-wired fallback” clauses that ensure that loans can automatically convert to a successor rate without additional negotiation. But this also creates cash flow, accounting and reporting risks as legacy Libor loans and new Sofr issuance are managed together.
Longer term, that added risk will become even more uncomfortable as the market shifts and Libor becomes a memory of the past.
Once new origination of loans based on Libor ceases, trading volumes will undoubtedly decrease, contracts will expire or “roll off”, and demand for Libor-linked derivatives will drop precipitously.
Though designated banks will still be on the hook to submit quotes for US dollar Libor through June 30 2023, dealers will probably retreat from making markets in Libor-linked products as it becomes riskier, less efficient and costlier for them to execute trades.
The resulting decrease in volumes will affect liquidity and lead to increased transaction costs for both borrowers and lenders. This will have a domino effect on derivatives and asset pricing that could be highly disruptive and costly to companies.
Adopting Sofr now and with resolve will help borrowers control their destinies and avoid potential pain further down the road, not only potential financial costs but also operational and legal risks.
Given small and mid-sized borrowers make up much of Main Street and a large concentration of jobs are tied to the success and growth of these companies, it is critical that the lending markets proactively embrace the transition.
By increasing direct Sofr issuance, the market can begin to digest the change in capital structures and portfolios as it prepares for the Herculean task of converting legacy loans to the new benchmark.
In Europe, the Sterling Overnight Index Average (Sonia), sterling Libor’s successor rate, has had significant adoption as regulators compelled market participants to cease entering into new sterling Libor facilities and contracts after March 31 this year.
Although the sterling segment of the market is smaller compared with US dollar, the uptick in Sonia liquidity has been critical to the UK market and has been a positive development for the US market, prompting transitions in multicurrency debt facilities and cross-currency derivatives.
In the dedicated US market, participants have the tools they need to be successful in the transition to Sofr — but the slow adoption rate of the new benchmark calls for a close look at the risk of procrastination. It is time to let go of the past and move forward.
KKR and its funds are borrowers, investors and arrangers of corporate loans