1. A Little Context
Within the next two and a half years, global financial markets will see lasting changes made to some of their oldest interest rate benchmarks. These benchmarks will be either retired or reformed, replaced either by a series of nearly risk-free rates (RFRs), or reformed benchmarks. We are of course talking about Inter-Bank Offered Rates (IBORs), the most common of which is LIBOR, a rate which has existed for some 70 years as a cornerstone of the loan market. The move away from these benchmarks is partially due to conduct scandals arising from historic abuse of quotation-based benchmarks, but it is primarily due to a dramatic shift away from unsecured overnight borrowing as a main source of funding by banks. Over 18 months have passed since Andrew Bailey, Chief Executive of the FCA, announced the need for financial markets to transition away from LIBOR before 31st December 2021. More recently, during Q1 2019, European regulators deferred the transition timeframes for Euro interest rate benchmarks (EONIA, which is being replaced, and EURIBOR, which is being reformed) to match those of LIBOR. It is easy to view this timeline as being rather distant and hence preparation for it not of immediate priority. However, our view is that this is not the right conclusion to draw for most firms.
2. Why is this Important for Corporates (and other benchmark users)?
Potential Value Transfers
Each RFRs may differ considerably from the benchmark that it is superseding. Although the impact is likely to be much less with reformed benchmarks (eg EURIBOR), the impact to benchmarks which are being replaced (eg EONIA, LIBOR) are material. Take the case of LIBOR. LIBOR is a forward-looking term rate set at the start of an interest charging period. But it is not a risk free rate; it contains a “credit spread” and a “term premium” to compensate the lending bank for the credit risk of making a loan to another bank over a given term – thus it effectively reflects the funding costs of the lending bank. SONIA (and all other RFRs, see Table 1 above) is an overnight rate determined by looking back across historical data. As it has no term element and no real credit spread, it is a nearly risk free rate and will be lower than LIBOR. There is therefore an economic difference between the two rates which will need to be accommodated within the pricing of future transactions to ensure there are no unfair value transfers from “winners” to “losers”. Transparency in this process will be paramount – this is something that Corporate Treasurers should keep a close eye on and engage with their bankers sooner rather than later.
Windscreen vs Rear View Mirror Rates
IBORs are forward-looking rates with regular agreed resets: they are “windscreen” rates. These allow borrowers, such as corporates, to have a good view of their future payment obligations and hence the ability to manage cashflow and any associated financing in advance and with a good level of certainty. Conversely, RFRs are “rear view mirror” rates. They are calculated daily and, as such, parties to a trade cannot calculate obligations in advance with certainty. This is of particular importance to corporates who tend to use more cash market products such as loans and bonds, and potentially interest rate derivatives to hedge those positions. Uncertainty of future obligations will almost certainly lead to corporates holding higher levels of liquidity than before. This will need to be baked into cash management processes, controls & systems, along with corresponding interest rate compounding calculations and reports.
Regulators are of course aware of these issues and are actively trying to find solutions for them through a series of Working Groups. One approach is compounding the RFRs over an equivalent LIBOR tenor (eg 3 months). In itself this is still a rear view mirror approach. However, it may be possible to adjust the interest rate period slightly so that borrowers such as corporates have a short but feasible period of time in advance of the interest rate payment date where they know their upcoming payment obligations with certainty and can lock in their financing requirements. How might this work in practice? Details are to be agreed, but options include agreeing to fix the rate (say) 1 week before the payments are due, or agreeing to start the reference period (say) one week before the actual interest rate term begins and ending it one week before the actual interest rate term ends. A second approach is to develop a forward-looking term rate based upon RFR derivatives markets. The current problem with this approach is that regulators are fearful that it will be the harbinger of a return to the current situation with term benchmark rates being quoted (and traded) more extensively than the underlying overnight benchmarks. As such, there is emerging “guidance” that any forward-looking term rates will be largely restricted to cash markets and derivative cash product hedges, wider derivatives markets will have to use RFRs.
Any fragmentation of the market between RFR overnight rates and RFR-derived term rates introduces basis risk, which is why regulators will allow forward-looking term rates to be used for derivatives with the express purpose of hiding cash positions (i.e. managing risk). A further problem with basis risk is that it may impact hedge accounting treatment. If cash products and their hedges reference different benchmark rates, the hedge may be deemed ineffective. This would mean that businesses cannot use hedge accounting, which may result in larger than desired PnL swings. Of course, differences my also occur across currencies. This will particularly impact multi-currency facilities – scenarios may emerge whereby the same agreement references LIBOR for some currencies and RFRs for others. The general message from these considerations is that corporates should ensure that cash products, and derivatives they use to hedge them, both reference the same benchmarks – unless and until a liquid market in basis risk products evolves.
3. What Major Asset Classes are Impacted?
For corporates, the key asset classes are bonds, loans and derivatives hedges. In all of these cases, the key questions are what is the benchmark strategy for new issues and what is the benchmark fall-back strategy for legacy trades, in case publication of the existing benchmark rate ceases?
Bonds – there have been several bond & FRN issuances referencing new RFRs, especially SOFR in the US and SONIA in the UK. Most of these were issued by financial institutions and exclusively adopt rear view mirror RFR rates (averages or compounding) over the term of the bond issuances. Although liquidity is building, it remains open whether bond markets will adopt a “compounded RFR” term rate (as per the derivatives markets) or a genuine “forward-looking” term rate (as sought by the loan markets). In terms of legacy trades, there is no single “protocol” to deal with fall-backs. Arrangements are typically bespoke and range from reverting to the last published benchmark fixing (so that the rate in effect becomes “fixed”), to bespoke agreement of amendments to existing contracts to reference a new benchmark rate. The former solution may result in significant value transfers, the latter is difficult and time consuming to implement.
Loans – unlike the bond market, there have been no new loans referencing RFRs as a benchmark rate and there is currently no agreement on fall-backs. The loans market more than any other is lobbying for regulatory approval of forward-looking term rates. The focus of Working Groups has bifurcated between (a) proposing definitive fall-backs for immediate inclusion in all legacy loans transactions (this is particularly the line taken by ARRC in the US), and (b) reducing the “consent threshold” required to implement replacement benchmarks if existing benchmarks are discontinued (the line taken by UK & European Working Groups).
Derivatives – following regulatory guidance, derivatives trades are already referencing new RFR benchmarks (especially SOFR & SONIA) extensively. Unlike bonds and loans markets, derivatives markets are largely bound into the use of protocols, which greatly facilitates amendments across all participants that have signed up to these protocols. ISDA is currently working to amend the 2006 ISDA Definitions to implement fall-back language for key benchmark rates.
4. What is the Current View of Regulators?
The biggest fear that regulators have to a smooth transition to new benchmarks is lack of engagement on the part of market participants, as exemplified by the following two quotes:
“We have only a little over 2.5 years until the point at which LIBOR could end. The transition needs to accelerate; the private sector needs to take on this responsibility, and we expect you to do so.”[Randal K. Quarles, Chair, FSB, April 2019]
“The biggest obstacle to a smooth transition is inertia – a hope that LIBOR will continue, or that work on transition can be either delayed or ignored.”[Andrew Bailey, FCA, July 2018]
In response to these fears, the UK FCA issued a “Dear CEO” letter to major financial institutions in the latter part of 2018, asking them to respond with analysis of their exposure, plans to transition, state of readiness and to appoint a Senior Manager to be accountable for the Benchmark Transition. The responses to this outreach are expected to be released during May 2019. But outside of the large financial institutions, which were catapulted into action by the Dear CEO letter, our experience is that preparations seem to be very immature. From our conversations with Tier 2 and Tier 3 banks, it is clear that not everyone is prepared and ready. Many of the buy side firms, insurers and corporates represented at our own IBOR transition briefings also seem to be treading water – a considerable disparity in the state of readiness clearly exists across the industry landscape.
5. What Should Corporates Do Now?
Our sense is that the prevailing attitude of most (but not all) UK corporates is to “wait and see what happens”. This is based on view that a typical UK corporate will have relatively light exposure to LIBOR and it will be simple to deal with when the industry has reached its conclusions and progressed the transition. This is certainly one approach. However, we caution against it and suggest the following steps that your Corporate Treasury function should be carrying out now. There is an inevitable time, effort & cost demand but action now will put your firm in a far stronger and safer position.
Firstly, appoint a specific executive with responsibility for leading IBOR transition. It is really important to coordinate activity across the organisation to ensure that transition is managed holistically.
Secondly, educate and train. It is really important to be aware of what is coming. Already the transition process is introducing less often-used vocabulary, leading to challenges around transparency and understanding. We recommend research and learning, via the IBOR transition lead, using the regulatory and trade association outputs. What is LIBOR? How is it calculated? What does it impact? Who are the users? Use these materials internally and ensure they are spread through the organisation in a coordinated fashion. Carry out training sessions internally, or seek external help. This will put your firm in a great position where all stakeholders will understand if their activity is driven or affected by IBOR transition. Questions to consider include: What are our current products which may have a tie to an IBOR? How are they financed and funded? Are suppliers or clients be affected and, if so, how? This is a really important foundation as will drive many commercial considerations going forward.
Thirdly, carry out an audit. The education and training will allow your firm to put together your laundry list of exposures. What is your exposure to IBORs? What products are impacted? How many clients or suppliers are impacted? How and where is the reference benchmark documented? When do impacted exposures mature? How can we reduce out exposures that do not expire before 2022? If for whatever reason contracts are being amended for other purposes, seek to include benchmark transition provisions at the same time. This step will allow you to assess your impact, and hence how material this transition will be for your organisation.
We expect the typical corporate to have low impact and be exposed predominantly through loan facilities where the borrowing rate is linked to an IBOR, and in some cases through derivatives where they have hedged their interest rate risk with a swap. This is the good news but still requires work. What will the new loan product offered by banks look like? IBORs are good in the eyes of a corporate as they are transparent, forward-looking and provide certainty. But new products may have a reference rate that have some or none of these features. It is important to understand what the impact will be for future business, as well as for legacy business if fall-back arrangements have to be invoked.
For derivatives we advise that you assess exposures and, if possible, execute now. Pay particular attention to existing accounting hedges and keep up to date with IASB notifications on hedge accounting. We are of the view that as we move closer to the end of 2021, many banks will already have moved to trading RFRs. This will lead to less liquidity in IBOR linked products and higher execution costs, which could have a financial impact on your business. Prudential financial planning is critical and firms should have a view on any potential shocks to revenue to manage the expectations of, and communications with, shareholders, rating agencies and debt holders.
Finally, understand what you need to do around systems and technology. This is particularly important in the Finance department and with your loan booking models. Will they be able to change and transition to new rates? What control gaps will arise or what operational risks will be introduced if you rely on spreadsheets or journal entry book-keeping? Above all, keep updated through industry associations such as ACT, LMA and ISDA. Participation brings knowledge, an opportunity to help shape the outcome and a great deal more comfort about the adequacy of your own preparations.