Writer leads global Libor transition effort at KKR
As the demise of Libor quickly approaches, US companies really need to stop using the single borrowing benchmark for the global financial system by default.
What might seem like a safer option for sticking to the status quo is actually far from it. Borrowing now from Libor adds unnecessary complexity and long-term risk in exchange for the temporary comfort of doing the familiar.
The slow adoption by the US loan market of the new benchmark, the Secured Overnight Financing Rate (Sofr), makes the death of Libor seem like an exaggerated rumor. But the end is approaching for the origination of Libor loans as 2022 approaches.
Given that Libor was once tied to more than $ 300 billion in financial contracts, this transition has not been easy. This is arguably one of the most complex events that market participants have witnessed over the past decade, with the shift from a benchmark rate set by a panel of banks to a more directly based on market prices.
To date, much of the focus has been on the $ 200 billion “over-the-counter” or privately traded derivatives market, given its critical mass in rate setting.
However, the much smaller but much more complex $ 2.5 billion loan market is critical to the Libor transition and is also the furthest behind. Of 165 loans totaling $ 148.5 billion that have been issued since Oct. 1, only 11 (totaling about $ 8 billion) have been made to Sofr, according to the S&P LCD database.
Thousands of small and medium borrowers depend on the loan market to fund their day-to-day operations and, unlike large financial institutions, many do not have access to capital markets.
These borrowers face significant risks as it becomes difficult to predict what Libor liquidity will look like in 2022 and beyond.
Loan contracts can include some short-term protection with “hard-wired recourse” clauses that ensure loans can automatically be converted to a successor rate without further negotiation. But it also creates treasury, accounting and reporting risks, as old Libor loans and new Sofr issues are managed together.
Over the longer term, this added risk will become even more uncomfortable as the market moves and Libor becomes a memory of the past.
Once the new Libor-based loan arrangements cease, transaction volumes will undoubtedly decline, contracts will expire or “get canceled” and demand for Libor-linked derivatives will drop rapidly.
While designated banks will still be required to submit quotes for Libor in US dollars until June 30, 2023, dealers will likely stop creating markets for Libor-linked products as it becomes riskier, less efficient, and more expensive. expensive for them to execute transactions.
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 which could be very disruptive and costly for businesses.
Adopting Sofr now and with determination will help borrowers take control of their destiny and avoid potential pain down the road, not only potential financial costs but also operational and legal risks.
Since small and medium borrowers make up a large part of Main Street, and a high concentration of jobs is linked to the success and growth of these businesses, it is critical that credit markets proactively adopt the transition.
By increasing Sofr’s direct issuance, the market can begin to digest the change in capital structures and portfolios as it prepares for the Herculean task of converting existing loans to the new benchmark.
In Europe, the Sterling Overnight Index Average (Sonia), the successor rate to the Libor sterling, has been widely adopted as regulators forced market participants to stop entering into new Libor sterling facilities and contracts after March 31 of this year. .
Although the sterling segment of the market is smaller than the US dollar, Sonia’s increase in liquidity has been critical for the UK market and has been a positive development for the US market, causing transitions in multi-currency debt facilities and multi-currency derivatives.
In the dedicated US market, participants have the tools they need to successfully transition to Sofr, but the slow adoption of the new benchmark calls for careful consideration of the risk of procrastination. It’s time to let go of the past and move on.
KKR and its funds are borrowers, investors and arrangers of business loans