Demystifying value transfer: A critical consideration in the transition away from LIBOR

The publication of the London Interbank Offered Rate (LIBOR) is set to cease in little over a year.¹ Markets and financial firms are preparing for the transition away from this widely used reference interest rate to alternative benchmark interest rates, known as alternative reference rates (ARRs).² Regulators around the world have reiterated the importance of the LIBOR transition, affirmed transition dates, and recommended transition activities and milestones. To minimize the impact of shifting from LIBOR to ARRs, regulators and market participants are addressing the important issue of “value transfer” — the potential inadvertent transfer of economic benefit among counterparties to a LIBOR-based financial contract resulting from the cessation of LIBOR and/or the adoption of an ARR in that contract. Regulators have offered particular guidance and recommendations on how to address potential value transfer in cash and derivative products. In this article, we explain the concept of value transfer, provide an example, and highlight what is being done to address the issue at Invesco.

What is value transfer?

Financial instruments that reference LIBOR sometimes include contractual language (referred to as “fallback language”) that defines the process to identify and implement a replacement interest rate if needed. For example, once LIBOR is permanently discontinued or declared to no longer be representative, a LIBOR-based instrument’s fallback language will govern the selection and implementation of the replacement interest rate, including identification of the replacement rate and the spread adjustment that will be applied to that rate to calculate the new interest rate for the instrument. This is where the issue of value transfer could arise: the robustness of the fallback language, the difference in terms and characteristics between LIBOR and the replacement interest rate, and the suitability of the corresponding spread adjustment could lead to adverse outcomes for one of the counterparties in the contract. Additionally, value transfer gains or losses could also occur with respect to a LIBOR-based security from the widening of bid/offer spreads on the security due to concerns over contract terms and the robustness of the fallback language. In general, poor fallback language can negatively impact an instrument’s pricing and liquidity (especially as the expected LIBOR cessation date draws closer), resulting in value transfer. For example, broad market observations have shown that certain LIBOR-based securitized products with poor fallback language have begun to experience downward price pressure.

There may also be a value transfer impact on the net asset values (NAV) and fees of investment funds. Value transfer could negatively affect a fund’s NAV if the pricing of LIBOR-based instruments held by the fund is affected by the factors mentioned above: suitability of spread adjustment, the widening of bid/offer spreads, reduced liquidity, or poor fallback language. In turn, advisory and performance fees payable to the fund’s adviser or general partner could also be impacted, since fees are calculated as a percent of NAV or positive investment return.

The potential economic impact of value transfer can arise from a variety of sources and is a significant factor in addressing and preparing for the LIBOR transition.

How are regulators addressing value transfer?

The issue of value transfer is a key priority for working groups tasked with helping to prepare the financial industry for the transition away from LIBOR. The Alternative Reference Rate Committee (ARRC) in the US and the Bank of England Working Group on Sterling Risk-Free Reference Rates (RFRWG) in the UK have provided guidance and recommendations on how to address value transfer in cash products. The International Swaps and Derivatives Association (ISDA) has similarly offered guidance for derivative contracts globally. For example, ISDA, the ARRC², and the RFRWG³ all have recommended the use of specified ARRs and fallback language and a historical five-year median spread adjustment methodology when calculating the spread adjustment to be applied to an ARR when it replaces LIBOR in a financial instrument. Generally, to account for the fact that ARRs are inherently different from LIBOR, this methodology analyses the historical spreads between LIBOR and the relevant ARR over the five-year period preceding the official announcement of LIBOR’s discontinuance, selects the median spread over that period, and adds that spread to the ARR to determine the new ARR-based interest rate. Despite these coordinated efforts, we believe value transfer risk remains a concern.

Example: How value transfer can happen

The example below shows how value transfer could occur, even when working group-recommended fallbacks are utilized and triggered:

For cash and derivative instruments that reference LIBOR, each of the ARRC and ISDA recommends a historical five-year median spread adjustment to quantify and account for the difference between LIBOR and the ARR. However, this spread adjustment could result in value transfer at the trigger date for both cash and derivative instruments, since the historical five-year median spread adjustment is unlikely to be equivalent to the at-market spot spread (the difference between LIBOR and the ARR at the time of conversion to the ARR).

While the historical median approach is meant to account for how LIBOR and the ARR have differed in the recent past by analyzing the difference in the two rates over this period and selecting the median difference as the static spread adjustment, it gives limited indication of how LIBOR and the ARR will differ at the time of the fallback trigger, or whether the static adjustment will remain appropriate in all future market conditions. This is worsened by the fact that some ARRs, such as the Secured Overnight Financing Rate (SOFR), have historically diverged from LIBOR during times of market stress, moving in opposite directions from LIBOR due to differences in the implicit credit risk of each rate: While LIBOR is intended to represent unsecured bank funding rates and risks, many ARRs, such as SOFR, are fully secured, mitigating credit risk. Thus, during times of market stress, the implementation of fallback language could inadvertently cause value transfer from lenders to borrowers in cash instruments and from fixed-rate payers to floating-rate payers in derivative instruments.

What is Invesco doing to confront the impact of value transfer?

Invesco is working to understand the implications of value transfer and seeks to act in the best interest of our clients while maintaining transparency. Invesco is inventorying and reviewing outstanding financial contracts with LIBOR exposure and analyzing fallback language, and is happy to discuss any concerns or questions clients might have about the impact of value transfer on their portfolios. As LIBOR cessation nears, we believe value transfer will be an important topic for regulators and the broader industry. In the meantime, we believe engagement with global working groups is critical to ensuring that the interests of all parties are considered in working group recommendations and that the transition of markets away from LIBOR is fair and orderly.