Hedging your bets: preparing for the cessation of Libor
The deadline for transitioning from the London Interbank Offered Rate (Libor) to risk-free-rates (RFRs) is fast approaching, with the process due to complete at the end of 2021 and no sign of the UK’s Financial Conduct Authority (FCA) extending the deadline as a result of the pandemic.
With the transition presenting a widescale and complex change, it’s crucial for financial services organisations to ensure they are fully prepared prior to the deadline.
With interbank offered rates (IBORS) being common practice for a long period of time, firms might be asking: why change at all? The fundamental reason behind the transition is the decline in IBOR market liquidity, along with public scandals of bank manipulation and IBOR rates increasing credit risk during times of financial crisis. As a result, the recommendation was made in 2017 that a more robust method was required.
In addition, the recent global financial uncertainty caused by the pandemic has further highlighted the vulnerability of IBOR rates, which are set based on a combination of the expectation of central bank policy rates and bank credit risk. This means that in times of enhanced financial market instability, credit spreads increase and borrowers can see their interest rates rise. In these situations, borrowers linked to RFRs will get the full benefit of the central bank policy rate cuts, while IBOR referenced contracts do not due to the offset with the increase in credit risk.
The transition to RFRs means shifting to a system that is less volatile. RFRs come from actual transactions and ultimately, the central bank in each jurisdiction will be the guardian of the RFRs. Borrowers linked to RFRs during a time of financial market instability would have access to central bank policy rate cuts, making it a much more attractive proposition. The new system won’t include a term bank credit risk component and will therefore be a better measure of the general level of interest rates compared to IBORs.
As with any change, there are risks that come with moving from IBORs to RFRs, and a number of steps that need to be taken to mitigate such risks.
Contractual language needs to be revised. For example, in the UK there will come a time soon when referencing Libor for new contracts is no longer permitted. The International Swaps and Derivates Association (Isda) announced that in those cases where a legacy contract maturing after 2021 has been initially negotiated to reference a discontinued IBOR, adjustments will need to be made to the RFR going forward to ensure the contracts align to the original agreement as much as possible and the adjusted rate is fair for both parties.
Isda is also updating its definitions in respect to fallback rates and has announced that Bloomberg will be the adjustment services vendor. Therefore treasurers need to make sure they have a Bloomberg license and if they don’t, should contact a treasury advisory house like Rochford to manage the transition.
These contractual alterations will create a significant workload for many firms, so it is vital that resources are allocated to carry out the amendments required. For cash products, this is likely to mean long and complex negotiations, however this could also present an opportunity to secure better deals.
Financial business entities and treasuries will also need to assess their hedging strategies and documentation. To aid in the IBOR transition, accounting standards regulators are permitting specific provisions that will, under most circumstances, mean the hedge relationship will not be required to be de-designated should an entity need to rebalance the hedge relationship. Nonetheless, borrowers may find that a reference rate used in their loans doesn’t match that of the reference rate used in their interest-rate hedges. This needs to be monitored to ensure any change made during the transitional period will continue to allow them to effectively hedge their borrowings.
The transition will also have an impact on financial reporting. The International Accounting Standards Board (IASB) has proposed significant amendments to the official standards, allowing companies to provide useful information to investors about the impact of the IBOR reform.
The most notable change to financial reporting will be to the International Financial Reporting Standard 7 (IFRS 7), a regulation requiring companies to disclose information about any new risks coming from the IBOR reform and how they plan to manage the transition to the alternative benchmark rates. Compliance will need supplementary resources allocated and a strong internal and external communications plan to ensure limited legal, reputational and conduct risks.
While the changes coming into effect will impact financial business entities and treasuries, by making key preparations ahead of time, anticipating potential risks and putting mitigation processes in place, they can put themselves in the best position possible to take on the transition. It is vital that companies evaluate their operations to ensure every element of their treasury that currently relies on IBORs can run when they are no longer available.
The process will start with building an inventory of legacy contracts and then developing a plan to transition these contracts away from the respective IBOR. In many cases, the best outcome will be to convert these to the new RFRs before the IBOR discontinues. In some cases it will be relying on a fallback rate, signing the Isda protocol or similar. But by creating a robust plan of action, financial services organisations will be set in good stead for the future transition.