LIBOR Transition to SOFR
By the end of 2021, the commonly used London Interbank Offer Rate (LIBOR) is set to transition to a new interbank lending rate, the Secured Overnight Financing Rate (SOFR). This change is to be made on the heels of a decision by the UK Financial Conduct Authority (FCA) that no longer requires banks to lend on LIBOR, which calls into question the viability of LIBOR in 2021 and beyond.
Many business owners and individual investors are worried as to how SOFR will affect them, especially coming out of the COVID-19 pandemic. US Capital Solutions has put together some frequently asked questions that can help you, and your business, to better traverse this transition.
When is LIBOR going away, and how does COVID affect this?
There is no set date, other than the end of 2021, for the official transition to SOFR, and there seems to be no effect of COVID on the cessation of LIBOR, but here are some important milestones that you should be aware of:
- Updated ISDA Documentation: In 3Q20, ISDA released revised definitions and documentation protocol to better facilitate the transition from LIBOR to SOFR.
- Clearinghouse “big bang”: In 3Q20, LCH and CME, the largest central clearing houses, will begin using SOFR when valuing positions held against them.
What is SOFR and how is it different from LIBOR?
The New York Fed calculates SOFR based on the volume-weighted median of transaction-level data based on the following three sources:
1) Tri-party repo data
2) GCF Repo (General Collateral Finance repurchase agreement) transaction data
3) Bilateral Treasury repo transactions cleared through FICC’s DVP Service (Fixed Income Clearing Corp)
The primary difference between LIBOR and SOFR is that SOFR is solely based on transaction data, therefore making it less susceptible to market manipulation. More specifically, there is roughly $90 billion of actual market transactions supporting SOFR, whereas LIBOR relies only on the judgement of the LIBOR panel’s submissions.
While spot SOFR is published daily, developing market convention is supporting the compounding, or averaging, of these daily settings.
What are the main issues when transitioning a loan, or derivative, from LIBOR to SOFR?
1) Fallback triggers: what will give rise to a transition from LIBOR?
2) Fallback rates: what exact rate will replace LIBOR?
3) Spread adjustment: how will the loan spread be adjusted to reflect any difference between LIBOR and its replacement?
How will debt and loans be impacted?
When a debt contract is modified it must be analyzed to determine whether the change in cash flows indicates that the modification is in substance an extinguishment of the old contract. In other words, if the rate increase or reduction drastically changes the future cash flows of the loan, the loan contract as a whole must be renegotiated.
If deemed extinguished, any unamortized debt issuance costs must be recognized in current period earnings. Topic 848 provides relief in this area and waives the requirement to assess modified debt if the only modification is to reference rate reform related changes.
As your business is traversing these turbulent times, it is always helpful to have someone to talk to about your business, loans, future opportunities, and other areas of concerns. This especially plays a major role, currently, as business owners are looking to capitalize on their tax deductibles on spending through Section 179. US Capital Solutions provides free consultation to speak about potential loans and capital expenditures. Contact one of our Account Executives today to schedule a free consultation!
