When the UK voted in 2016 in favor of Brexit, it upended the balance of the European Union. More than two years on, Brexit talks are still dominating the news. Far more quietly, another source of major economic uncertainty from England has slowly been rearing its head: LIBOR.
Arguably, LIBOR is the most important number in finance. The London Inter-bank Offered Rate refers to the benchmark at which international banks lend to each other on a short-term basis. Financial institutions use LIBOR as the basis for swaps, corporate debt, and other financial and commercial contracts. The UK’s Financial Conduct Authority is set to phase out LIBOR by the end of 2021, and according to the Federal Reserve, more than $35 trillion of the $200 trillion in cash and derivatives transactions that reference LIBOR will have yet to mature by then.
And then, as with Brexit, no one is quite sure what happens next.
Securities and Exchange Commission (SEC) Chairman Jay Clayton is getting antsy about LIBOR’s imminent demise. At a speech in December, he said that “[a] significant risk for many market participants—whether public companies who have floating rate obligations tied to LIBOR, or broker-dealers, investment companies or investment advisers that have exposure to LIBOR—is how to manage the transition from LIBOR to a new rate . . . particularly with respect to those existing contracts that will still be outstanding at the end of 2021.” He noted that the SEC, Federal Reserve, and Treasury Department would be keeping close tabs on the LIBOR risk, and encourage market participants to “plan and act appropriately.”
Clayton isn’t the only one shaken by the LIBOR uncertainty. The number of companies mentioning the phase-out as a risk factor in annual 10-K reports increased more than 600 percent in the last year, per the Intelligize platform. And it isn’t just banks and investment houses that are concerned about the transition. As an example, Valero Energy Corp. noted that if the San Antonio, Texas-based petroleum manufacturer needs to restructure its debt load in the future, a new benchmark could negatively affect the terms.
“In addition, the overall financial market may be disrupted as a result of the phase-out or replacement of LIBOR,” the company said in its Feb. 28 10K. “Disruption in the financial market could have a material adverse effect on our financial position, results of operations, and liquidity.”
Companies in other industries echoed Valero’s sentiments in their 10-Ks, including pharmaceutical manufacturer Pfizer Inc. and American Airlines Group Inc. In some cases, the disclosures are coming at the behest of the SEC. For instance, in a Comment Letter that became publicly available in January 2019, the agency directed Great Elm Capital Corp. to amend its registration statement risk factors to include a discussion of the LIBOR issue.
“To the extent that the phaseout of LIBOR is material to a company, we would definitely expect a company to disclose that fact and describe the implications of the phaseout, including any associated risks, to investors,” said Kyle Moffatt, chief accountant at the Commission’s Corporation Finance Division, last year.
The LIBOR-rigging scandals of this decade illustrated legitimate concerns about its value as an interest-rate benchmark. Something else is coming in its place, most likely the so-called Secured Overnight Financing Rate. Regulators should hope that it proves to be worth the costs of the transition.