For treasurers, regulatory challenges and changes are a way of life. But few are causing as many headaches as the upcoming LIBOR transition. In a nutshell, the London Interbank Offered Rate, which has been at the heart of intercontinental banking for decades, is being replaced by a raft of alternative benchmarks by the end of 2021.
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, but there are undoubtedly worries about the transition.
“I think there are two main concerns to worry about,” says Peter Seward, GTreasury Vice President, Market Development, Risk. “Firstly, it’s a big change and it’s quite slow moving. It still has two years to run, which inevitably means a lot of things are going to change. Then, secondly, certainly in the longer term, the effects are going to be far-reaching.
“The US and UK are good examples. The US and UK indexes have been around a while, and some financial institutions have started issuing floating rate bonds against the new SOFR and SONIA indexes respectively, which is all good. I think they’re doing a public service and helping the market. However, questions remain around the market conventions for these new instruments, such as whether it’s daily compounding interest, daily rate sets, the business day lags for the rates they set, whether it’s four days or five days (versus LIBORS’s two day lag), whether they have lockout periods and so on. The little nuances of the indexes are changing because people are still figuring it out.”
Keep a close watch
Peter suggests that this means everybody involved with LIBOR replacements need to keep a close watch on what’s happening as market conventions evolve – including systems providers like GTreasury.
“GTreasury is keeping on top of the changes to build capabilities that can handle all the nuances of the indexes,” he explains. “Replacement rates are going to be different from country to country. Even though the G20 proposed the initiative, every country has its own administrator or own organisation which will select its LIBOR replacement and then administer the implementation of it. As a vendor, our role is to provide systems for our clients that meet the market standards.”
When asked if treasurers therefore have to watch and work with their system solution providers to ensure they in turn are watching the LIBOR replacement developments, Peter answers: “Treasurers have got to ensure now that their systems providers are on top of it, so that by the end of 2021 they’ll have a seamless transition.”
“Even though it will be a couple of years before the end of LIBOR, some of the changes are very large, and accommodating for them is not going to be done in three months or six months – they’ll have to be done in a year to 18 months, so vendors need to be on top of it now, not in a years’ time.”
Impacts on treasury
To highlight Peter’s point, GTreasury has launched a new whitepaper on the topic at this year’s AFP Conference in Boston. The whitepaper goes into impressive detail and is well worth a read, especially as there are some major impacts on treasurers.
“There are really three main impacts on the treasury function,” says Peter. “A whole host of currencies are affected and any organization that has interest rate products in any of those currencies are going to be affected. Wherever they have floating rate instruments, whether it’s an interest rate swap, a swaption, the cap, collar or floor, a credit facility with term loans referencing LIBOR, floating rate notes, even inter-company loans that reference LIBOR that are not external with the world, they are most likely going to change after 2021.
“There won’t be a LIBOR so they’re going to have to look internally at all of their contracts to see where the word “LIBOR” is referenced. And then they’re going to have to physically review it and change it and make sure there’s wording that allows for the replacement of it with something else, preferably the new replacement index. That’s a big task for corporates. The fall-back language – ‘what do you do if that index is not available, what do you fall-back to?’ – needs to be updated or replaced.”
Peter suggests a couple of examples where this will need to happen. Derivative contracts are generally governed by ISDA agreements, so treasurers are going to have to check their ISDA agreements, as well as derivative contracts. Also, inter-company loans written by in-house lawyers will need to be checked. Essentially, where the party is external they’re going to have to negotiate the changes per contract.
The next thing treasurers need to look at is the fall-back plan. Peter explains: “These plans have three parts to them. Firstly, it needs to define what the event is that is going to cause or trigger a change to the index – it has to be a very specific definition to constitute LIBOR not existing. Then you’ve got to say what you’d replace it with, so presumably in the US it would be SOFR and in the UK it would be SONIA. The last thing it’s got to explain is whether any adjustment needs to take place because of variations in the indexes – in the US the difference between SOFR and LIBOR is between 10-12 base points, because one’s secured, and one’s not.”
The third challenge Peter emphasises is the impact on regulations.
“The regulatory issue could be a big one. If your debt transitions to SOFR or SONIA and your swap transitions from LIBOR to SOFR or SONIA do you have to change your regulatory reporting? Many regulatory boards have issued exposure drafts so to help, but the point for corporates is that if you do hedge accounting you need to look at these exposure drafts and just check that things are going to be ok for you.
“And the very last point to mention is valuation and stress testing. Corporates will often stress test the market and say, ‘well, what happens to my interest costs or the value of my derivatives if FXrates went up or down 10%, or if interest rates went up and down 1%?’ and then they’re required to report it. Come 2021 they will be shocking SONIA or SOFR, rather than LIBOR, so they need to be able to have systems to do that. Zero coupon valuation curves will all be based on non-LIBOR instruments.”
Systems to support treasurers
Peter continues on to say that this work by the treasurer needs to be supported by the system vendor in order for LIBOR transition to be smooth.
“From a corporate perspective, all of their documentation needs to handle the change and it goes without saying that their system needs to handle it too. I may have a three-year LIBOR loan and then, all of a sudden, someone now tells me it’s SOFR, plus the margin’s changed so, ‘go out there and trade and make sure everything is working’. The vendor needs to make sure their systems flow.
“When this happens you need to be able to identify all of this and make all the adjustments, which is potentially awkward as it may not be the same for every currency on the same day. There may even be a floating rate debt that’s being hedged with an interest rate swap, and the fall-back on that debt is different to the fall-back on the swap, and it may mean that they don’t transition from LIBOR to SOFR on the same day because the definition of the transaction is not met or the trigger is different. It’s complex and systems need to handle this. System flexibility is therefore vitally important.”
All of this raises the question of whether systems vendors will be ready for the LIBOR deadline.
“This isn’t a simple or quick fix so while LIBOR won’t be going away for a while yet – GTreasury, for one, is busy preparing now.”
GTreasury’s LIBOR transition whitepaper is available to download here.