There are few treasurers on the planet who are unfamiliar with LIBOR. After all, the London Interbank Offered Rate has been at the heart of intercontinental banking for decades. As a tried-and-tested benchmark for short-term interest rates, LIBOR measures the average rate at which banks are willing to borrow wholesale, unsecured funds – which is why it underpins around $300trn worth of financial contracts, derivatives, bonds and loans.
For years, the ICE-administered LIBOR has been published in five currencies, seven tenors and has been relied upon across the globe as a shrewd tool with which to make better-informed business decisions and help treasurers adequately gauge market expectations. Yet this institutional reliance upon LIBOR is rapidly dismantling. Regulators and industry bodies are now turning elsewhere, and that means treasurers and their teams have got to prepare accordingly.
In 2017, the UK’s Financial Conduct Authority (FCA) announced it would no longer require banks to participate in the LIBOR submission process by the end of 2021 – and regulators in various jurisdictions are following suit and delivering retirement dates for their existing LIBOR benchmarks. Market authorities are already working to designate alternative risk-free reference rates (RFRs) to replace LIBOR, and in several jurisdictions the new rates have already been launched.
So, why the big change?
It can’t be denied LIBOR’s credibility has slowly declined following the widespread rate manipulation scandal that came to light in 2012. Yet the move away from LIBOR is a bit more practical than a simple exercise in reputational management or self-preservation. At the end of the day, the underlying market LIBOR measures is no longer liquid, and there’s been a growing concern amongst both financial authorities and panel banks surrounding the total lack of underlying transactions and hard data actually being used to calculate LIBOR.
That’s why it’s not necessarily bad news for data-driven treasurers that LIBOR is on its way out – but because there are so many financial instruments tied to LIBOR, it goes without saying the rate is heavily embedded within the operating models of a huge number of organisations. Transitioning to alternative rates won’t be easy, and it’ll have serious implications on how contracts are priced and how treasurers manage risk.
Fortunately, there are tangible and decisive steps teams can take in order to navigate these changes and plenty of advice on how to mitigate the emerging risks associated with LIBOR transition.
What challenges need to be overcome?
Before delving into how treasurers can prepare for moving away from LIBOR, it’s worth highlighting the key areas that are set to be affected.
One of the most labour-intensive considerations treasurers must bear in mind will be necessary changes to fallback provisions across a range of documentation. This will place a particularly large impact upon derivatives, which may now require Credit Support Annexes (CSAs), material changes to ISDA Master Agreements or even new contracts that require additional collateral. In terms of lending, interest rate determination provisions will likely need to be amended, too. Meanwhile, the adoption of a new RFR could impact noteholder interests where debt is concerned.
Another key issue facing treasurers will be the ways in which transition from LIBOR to a new benchmark could impact internal and external treasury systems. Yet slightly more complex is the challenge of emerging risk in terms of hedge accounting. Not only could the introduction of new rates drastically disturb existing accounting treatments, but there’s also potential for new risks between derivatives and bilaterally-agreed loans.
Stack these concerns on top of tax considerations and the ways in which new benchmarks could create a change in terms of debt, and it’s fair to say that treasurers have got their work cut out for them in the run up to 2021.
What can treasurers do to prepare?
In terms of moving forward, the first port of call for treasurers working to prepare for the transition should be to delve into their organisation’s exposures and risks. That means looking at payroll loans, factoring, supply chain financing, in-house banking and asset-based lending for a start.
The Association for Financial Professionals has advised that teams should kick off the process by assessing the potential risks of LIBOR migration, developing mitigation processes and coming up with contingency arrangements in order to meet new (or existing) regulatory obligations where applicable. Treasurers have also got to place renewed focus on futureproofing their documentation.
According to the Alternative Reference Rates Committee (ARRC), more than 82% of all existing products that reference LIBOR should actually mature by the end of 2021. That means firms will need to engage in intensive contract renegotiation and product redesign as jurisdictions transition – and product redesign will need to be driven largely by downstream impacts on valuation and pricing models.
As part of contract renegotiation, counterparties should be looking for amendment provisions that offer clarity around calculations to minimise disputes and place serious weight on fallback language. For those in need of a springboard, the ARRC released guiding principles last summer outlining voluntary considerations organisations could bear in mind when drafting a contract that references an alternative reference rate in place of LIBOR.
More important still, it’s critical that organisations actively reduce their reliance on LIBOR and lessen legacy exposure by transitioning to a new RFR sooner rather than later. That means engaging with transition efforts, responding to regulatory consultations, setting up a transitional programme of internal governance and identifying or designating accountable executives.
In the UK, firms have already got an alternative rate to turn to in the form of the Sterling Overnight Index Average (SONIA), which is now being administered and published by the Bank of England. SONIA is calculated as a trimmed mean of rates paid on overnight unsecured wholesale funds, and regulators say it’s more robust because, unlike LIBOR, it’s anchored in liquid underlying markets.
It’s also worth pointing out SONIA doesn’t include a term bank credit risk component, and can also be compounded to be used in term contracts.
According to the FCA, an increasing number of businesses have already started to transition their portfolios over from LIBOR to SONIA. There’s been considerable growth around derivatives in particular, with an estimated £4.2trn worth of OTC derivatives having been cleared on a monthly basis across 2018 – while overnight transactions supported by SONIA are currently averaging some £50bn per day. As a result, SONIA has finally surpassed LIBOR in terms of cleared notional swaps.
Part of the reason so many firms have been able to transition to SONIA with relative ease is because many of the market’s leading TMS solutions like Salmon Treasurer are already being recalibrated in order to facilitate transitions from LIBOR to the new benchmark. Where unsupported, businesses that have yet to transition to a new RFR would do well to consider treasury management solutions that are designed to facilitate the move, or explore new modules that can be integrated within existing systems.
In the United States, firms are being encouraged to transition to the relatively similar Secured Overnight Financing Rate (SOFR) as a new benchmark. Last April, the US Federal Reserve of New York began publishing SOFR, and according to JPMorgan Chase it’s since risen to a transactional volume of over $700bn per day.
At the end of the day, while the methods that treasurers and their organisations choose to utilise to prepare for LIBOR transition may vary, what truly matters is that plans are put in to place and carried out as soon as possible. After all, at this point it’s crystal clear that LIBOR is on its way out – and the end of 2021 will be here much sooner than many care to realise.