As banks and corporates tackle the impact of an economic crisis, the issue of transitioning away from the London Interbank Offered Rate (Libor) still simmers away – with legal, financial and resource challenges gathering for those that drop the ball.
Switching to a new risk-free rate (RFR) requires careful consideration. As does timing.
“The risk is not the mark to market (MTM) switch, the risk is that you do the switch at the wrong time because those Libor versus Sonia spreads are moving and recently, they have been moving a lot due to the coronavirus. There’s a risk of the timing for that, and that’s where it’s complicated,” says Xavier Pujos, managing partner at Sionic.
Sarah Jordan, head of knowledge for the projects, real estate and finance at Osborne Clarke, says banks haven’t allocated the right amount of resource to the transitioning process.
“They are not prepared. We know from talking to our banking clients that there has been poor resource in finding a strategy to deal with the task. Our bigger clearing bank clients have dedicated global transition teams and they are trying to deal with a two-fold task. On one side, they have teams that are looking at devising new products to sell to the market that are based on risk free rates,” she says. “On the other, they are also figuring out how to go about amending this huge number of legacy contracts that mature after the 2021 deadline.”
The “legacy book” – that vast number of outstanding contracts, debts, derivatives, trade finance instruments and lease agreements – all need provisions to incorporate a new RFR. But market participants and lawyers are still seeing huge numbers of contracts based purely on Libor.
“All the loans that are coming to us, when a bank gets in touch with us and says ‘we’ve got a new deal to do, can you be our lawyers and document it,’ almost all of those are predominantly still based on Libor,” says Jordan.
Given the lack of preparedness, some are pushing for a delay in the transition deadline.
In a statement published on March 25 and updated on May 1, the UK’s Financial Conduct Authority (FCA) announced that firms will not be able to rely on the publication of Libor after the end of 2021.
However, a major concession by the regulator came in the form of a delay to interim milestone in loan markets, with the deadline for cash markets to stop issuing Libor-linked loans pushed from the end of the third quarter this year to the end of the first quarter 2021.
That said by the end of the third quarter this year, lenders should still be in a position to offer non-Libor-backed products and contractual arrangements must be in place to allow for the conversation by the end-2021 deadline.
The delay was crucial, says Joshua Roberts, associate director at Chatham Financial.
“The transition was already a complex undertaking – now, finding an orderly transition path is likely to be far more challenging. The pandemic will likely divert focus, resources, manpower, and budget from the Libor transition effort,” he says.
“It has also made the markets function rather abnormally, further complicating the transition effort. Without a proper and orderly transition, we could see further market disorder, consumers and small businesses disadvantaged, the reputation of banks damaged, and potential for litigation.”
The FCA’s latest update has been welcomed, he says, particularly with firms struggling for cashflow.
“That was always a very aggressive timeline, and it was always going to be very difficult to meet,” says Roberts. Amid a pandemic and an unfolding financial crisis, “access to liquidity really needs to take centre stage and needs to be prioritised.”
Risks to consider despite pandemic
Roberts says the $300 trn worth of Libor-based contracts present a “major risk” when the interest rate will no longer be in use.
Some contracts contain fallback mechanisms in place in case of the benchmark’s unavailability, but contracts will need longer term provisions.
“There’s a very wide variety of these fallback provisions, some of them are not appropriate for long term use, and the contract could function in a way that was not originally intended,” says Roberts.
Vigorous fallbacks are crucial with the new RFRs diverging from Libor in terms of value. The UK’s new rate – Sonia – produces lower rates than Libor.
The FCA has warned banks and insurers that they should “assess and work to manage their customers’ exposure to Libor” to protect “customers’ best interests.”
“Banks are managing most of their contracts with either a mark to market or some form of reserves. They know what their rates are, so they’re very close to the market of those contracts. Any change in the value will affect their profit and loss. On a non-bank basis, it might not be the case because you might have a hedge, an interest rate hedge of an asset and you matched the payments,” says Pujos.
“In theory, at the time when you do the transition, that should be at a zero mark to market difference because when you trade or have an agreement on the change in rates, that should be mutual for both parties.”
In Europe, the ECB announced that the Euro Overnight Index Average (Eonia), the old reference rate set to be replaced with the Euro Short-Term Rate (€str), will become “€str plus a fixed spread of 8.5 basis points, from the first publication date of the €str (October 2, 2019) until the discontinuation of Eonia on January 3, 2022,” – easing the swap between the two rates.
In the UK, the spread between the two rates is a serious concern.
“There’s a huge risk. Sonia rates that are available in the market are now against the Libor rates that are running about eight to 10 basis points cheaper,” says says Ian McNaughton, head of product, UK at TreasuryXpress.
For McNaughton, the process is straightforward.
“It’s about the preparation. Treasurers face similar challenges that affect market participants – the primary problem is identifying where in their contracts and treasury management system is Libor being used and trying to quantify what their exposure is to it. The next step is to start agreeing amendments on those contracts and make sure that they behave as they are intended to when Libor goes away, and they’re using Sonia instead. The final point is to stop signing new contracts based on Libor, if possible,” he says.
However, Pujos suggests there could be unforeseeable hurdles.
“There are contracts where the Libor element could be hidden,” he says. “If you have a corporate using one of their banks to do cash management for them, the bank will have said ‘if you have a residual balance for a certain period of time, we’ll pay you Libor plus,’ and that has to change as well. Even if you have never been short on cash and your corporate treasurer is running on lots of cash flow, you’ll need to change that contract just in case,” explains Pujos.
Safety in tech hands
To safeguard the continuity of contracts, technology vendors are looking to provide solutions to facilitate the switch, with some suggesting those with artificial intelligence capabilities will go to the front of the queue.
“It is a task that lends itself well to the use of AI because it’s a huge number of contracts. AI can be an extremely helpful tool to identify which contracts need to be changed,” says Jordan.
Technology will also be vital to calculate new rates and swap contracts under Sonia.
“If they have loads of contracts, the big banks will have to automate that process using software solutions,” says Pujos.
According to Manish Chopra, global risk and analytics leader at Genpact, using AI for the Libor transition allows firms to review a large volume of contracts faster than any process and enables users to identify Libor clauses in the data. The use of AI can also permit “traceability” that makes “archival data available so banks can see what changes had been made” whilst “minimising the risk of human error.”