In this month’s blog I thought I’d take the opportunity to answer a few of the questions most frequently asked by corporates about LIBOR transition.
Please drop a note to technical@treasurers.org if you have a specific question not addressed here and we’ll see if we can help.
1. Remind me what is happening, and when?
2. What’s going to change?
From the end of 2021, the majority of the panels originating LIBOR will cease to operate (with a few USD exemptions) this means that EVERYWHERE that currently references LIBOR in some way will need to be reviewed and an alternate reference benchmark rate identified.
This includes contracts with banks, intercompany contracts, commercial contracts and other places where LIBOR may be referenced (e.g. accounting valuations). LIBOR is endemic.
Appendix A in this briefing note suggests where one might look: Briefing Note Transition to risk free rate benchmarks February 2020.
3. What are the replacement benchmarks?
The various working groups broadly agreed that it was most appropriate to transition away from a forward-looking term rate (LIBOR) based on very few actual transactions, to a (near) risk free rate based on the actual overnight borrowing costs for financial institutions. (For example, SONIA is based on the actual rates paid by banks to borrow in sterling overnight on an unsecured basis from other financial institutions.)
These Risk Free Rates (RFRs) are overnight and backwards-looking, so whilst they are very suitable for the derivative market (which accounted for over 80% of LIBOR referencing transactions,) it is more problematic when applied to the lending market.
It’s worth bearing in mind that contracts referencing LIBOR do not have to transition to reference RFR; it may be more appropriate to reference bank base or a fixed rate.
4. Is there an RFR term rate that I can use?
Slightly confusingly, the answer is ‘yes and no’.
It depends on the jurisdiction.
For example, there is no CHF term rate at all; in GBP, the term rate is limited to a relatively few fairly tightly defined use cases; in USD, the Alternate Reference Rates Committee (ARRC) announced a SOFR term rate early in August – and the use case for that seems to be much more loosely defined. Looking at loans specifically, it looks as though, in general, the loan can’t reference term in CHF or GBP but may do in USD... (there are exceptions for products such as trade finance).
However, the regulators are very keen to make sure that a term RFR is not widely used as a percentage of the total market (in part because the liquidity (number of transactions) underpinning the rate falls the longer the maturity and the regulators are determined to avoid a repeat of the issues that arose with IBORS). They will therefore be watching regulated entities (the banks) very closely to ensure they minimise the use of term rates.
From a corporate perspective, the cost of borrowing against a term reference rate is likely to be greater than against the overnight rate, particularly if there is a requirement to hedge the underlying in the derivatives market and there will be an additional cost as the bank manages the basis risk (between overnight and term RFRs).
Obviously, it depends on the particular circumstances, but as a general rule, transactions referencing the most liquid end of the market are likely to be cheaper (particularly if there are derivatives involved) – as long as they suit the organisation...
5. How far are people in their LIBOR journey and when did they start it?
There is not a straightforward answer to this - it generally depends on the scale and complexity of the business. Some organisations started thinking about this some time (years) ago, others have waited until relatively recently when there was greater clarity about what the post LIBOR environment was likely to look like.
However, irrespective of when corporates started on the journey, the vast majority (irrespective of scale) are now aware of LIBOR transition and are actively working on plans for transition, especially given the looming deadline of 31 December 2021 for all (new and legacy) GBP contracts and all new USD contracts.
6. Are banks, advisers, TMS providers and the market generally ‘ready’ for transition?
Generally, in the UK, yes, they are.
Banks should have already approached you about how they recommend transitioning any existing contracts you have with them. (Do make sure that if, for example, you have a loan and a hedge with different banks, that their solution is consistent and doesn’t result in unintended consequences such as loss of hedge effectiveness.)
TMS providers are stating that they are ready to support transition – but this might be impacted if you’re not on the latest version of their software...
Other advisers (such as audit firms, consultancies and lawyers) are generally up to speed on transition. But, we are already hearing of resource constraints given the tight timelines (who knew that there would ever be too few lawyers...?) so don’t wait before engaging with them.
In other jurisdictions, things are not as far progressed, but this should not preclude you from approaching your bank and advisers proactively.
7. Where do I go for the latest information?
Particularly in markets other than the UK, there seem to be new developments almost every day and it’s hard to keep up with the latest developments.
For the latest markets data, we’d recommend ‘going to the source’, so the RFR WG in the UK; the ARRC in the USA etc.
By currency, the ‘source’ information comes from:
GBP: Risk Free Rate Working Group (RFR WG)
USD: Alternate Reference Rates Committee (ARRC)
JPY: The Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
CHF: The National Working Group on Swiss Franc Reference Rates
EUR: Working group on EURO risk free rates
The RFRWG also publishes a monthly newsletter offering a one-page summary of the latest developments. Sign up for this but the latest (July) version is here.
If you are looking for suggested ways of approaching the transition project, the ACT website has resources.
Other useful resources include relationship banks, advisers, trade associations such as UK Finance and the FICC Markets Standards Board (FMSB).
