Market awareness of the impending shift from Inter-bank Offered Rates (IBORs) to new risk-free rates (RFRs) is strong, but corporates are yet to kick their preparations into gear. Businesses will need to identify the full extent of their exposures and adjust their contracts and infrastructure to accommodate the new rates. But they will also need industry consensus on the specifics of the transition in order to be confident in their measures, as Treliant’s Graham Broyd, Shell’s Frances Hinden, RTL Group’s François Masquelier, and Deutsche Bank’s Vanessa Manning explain.
Inter-bank Offered Rates (IBORs) across the globe are broken. They no longer represent a true benchmark – and have not done so for a long time. In fact, as Graham Broyd, Principal at Treliant, points out “In the first six months of 2019, an average of merely one transaction per day underpinned the 12-month LIBOR dollar rate.”
As such, in 2013 the Financial Stability Board (FSB) was tasked with reviewing the widely used IBOR benchmarks. Since then, there have been a number of developments, with a series of new, alternative risk-free rates (RFRs) based on overnight transactions developed in five key currency markets: the UK, US, Japan, Switzerland and Europe.
The Financial Conduct Authority’s (FCA) plan to phase out the publication of the London Inter-bank Offered Rate (LIBOR) by 2022 is driving a transition away from IBORs and towards these RFRs. The decision has set in motion a chain of events that will have a profound impact on the value of tens of millions of contracts, worth in excess of US$370tr. This leaves the industry facing a ticking clock to orchestrate an orderly transition.
The stakes are high.
Awareness has certainly improved over the past year, but as the 2022 deadline nears, corporates still have a long way to go. So, what can they do to get ahead, safeguard their position and ensure a smooth transition?
Currently, the biggest challenge is proving to be the ability and willingness of corporates to prepare for the transition. For a start, there is concern among many businesses that they simply don’t have the time or manpower to devote to determining their exposures, understanding the impacts, and then formulating and executing a plan for adoption.
Many of these companies appear to be hoping that the IBOR transition will simply go away – with smaller businesses particularly hamstrung. Shell’s Vice President of Treasury Operations, Frances Hinden, who is also Vice-chair of the Bank of England risk-free rates working group, says: “There is a growing concern that the long tail of smaller companies, who probably feel they do not have the time or resources, are not beginning to implement the change. But it is imperative that they do. If they believe they can ignore the problem, then they are wrong.”
Meanwhile, even for those with greater resources, there remains considerable uncertainty around the nature of the transition, slamming the brakes on any potential decisions. For instance, the precise way in which RFRs correspond to different variations of LIBOR has yet to find consensus. Hinden explains: “While we know that LIBOR is going away, and we are aware of its replacement, what we don’t know is whether there is going to be an industry standard.” For instance, will a three-month LIBOR be replaced with a term rate, a compounded overnight rate or an average overnight rate? As these variations on the RFRs are still in development, nobody wants to go ahead and create new contracts only to find out their model is at odds with the rest of the industry.
The new RFR markets are also at different stages of their liquidity life cycle. In the UK, for instance, SONIA is already an active market-place and has been for a number of years. In contrast, the US RFR, known as SOFR, was released only last year and is yet to reach sufficient liquidity, while Europe’s RFR, known as ESTR, will not be released until October. The lack of maturity among certain markets contributes to a general reluctance to commit ahead of time.
Nevertheless, corporates need to act. François Masquelier, Treasurer of the RTL Group, Chairman of ATEL, and Vice Chairman of the European Association of Corporate Treasurers, believes that “corporates are generally a reactive rather than proactive breed” and that they continue to “either wait for the banks to knock on the door when it is time to move or await a Brexit-esque extension to the LIBOR deadline”. The truth is, he explains, that this is the year for action and corporates should begin addressing the myriad technical issues that lie ahead.
In recent months, the FCA has confirmed these sentiments, stating that corporates “need to be prepared for a LIBOR end-date in 2021. Whether your exposure is to sterling LIBOR or one of the other LIBOR rates, you will hear the same message from central banks and regulators in other jurisdictions”.
For the industry at large, it is therefore essential to minimise the uncertainty surrounding the nature of the transition. Education and agreement on the rates will be an important first step – making recent measures, such as the Alternative Reference Rates Committee (ARRC)'s recent white paper on how market participants can use SOFR in cash products, a welcome intervention.
Vanessa Manning, Managing Director, Global Liquidity Management Head, Corporate Bank at Deutsche Bank GTB, explains that three primary transition models are being discussed for LIBOR. The first model predicts that regulators will ramp up their involvement. If so, the switch to an RFR could occur at a defined point in time as part of a structured legal and regulatory framework – akin to the recent SEPA migration. Manning explains that “while this solution would reduce timing uncertainties and legal risk for all market participants, regulators are yet to indicate such an enhanced role”.
As a result, it is possible that the transition will be led by a market initiative. This would require a number of companies to proactively make the move to RFR – adding liquidity to the nascent market. Once critical mass and scale is achieved, it is hoped that all other participants would follow suit ahead of the 2022 deadline.
A further possibility for the phase-out is the proposed “multi-year transition”. In this scenario, any contract written after a prearranged date will automatically be benchmarked to RFR, while contracts including LIBOR will be phased out following their maturity. This solution supposes that LIBOR will continue to be published post-2022, even after it is no longer mandatory. Manning explains, however, that “central banks have made it clear that the continued publication of LIBOR in the UK is extremely unlikely. Companies should therefore look to drive the transition themselves”.
What is clear is that, by 2022, corporates will need to have identified all reference to the IBOR benchmarks in their existing contracts. This is no simple matter. In most companies, the benchmark is used by multiple departments, across various systems, and in a wide range of financial products. From her experience of mapping Shell’s exposure and talking to other corporates, Frances Hinden explains that “banking-linked contracts are a tiny percentage of the total number of documents that refer to LIBOR. It is not simply used for futures, mortgages and securitisations, it is used all over the place – for example, for ship leases, real estate rental agreements and late payment clauses too”. As such, the vast majority of a company’s exposure to LIBOR may involve counterparties that have little knowledge of the upcoming change – further exacerbating the challenge ahead.
Once the exposures have been identified, the legacy contracts will need to be renegotiated, replacing IBORs with the new RFRs. Given the fundamental differences between these rates – with the new RFRs based on overnight transactions – it will not be straightforward to derive an economically equivalent contract or model.
Many contracts will have fallback provisions that dictate what should happen in case an IBOR is unavailable, but these are not the solution in this case. These terms typically assume that the lack of availability is a short-term issue, but if an IBOR becomes permanently unavailable, these terms will, by default, stand for the remainder of the contract – often creating a clear winner and loser. In order to address these difficulties, complex loan structures will need to be assessed and agreed on a bilateral basis. Having an industry-wide solution in place to convert legacy rates to new alternatives will be paramount to a successful market-wide transition.
Some of the biggest, and potentially catastrophic, unanswered questions exist within hedge accounting. If you read the international accounting standards literally, given LIBOR will not exist post-2022, it is arguable that hedges will be made ineffective. Hinden describes this as an “eyes shut moment”. She continues: “If a company were to do their hedge accounts for year-end 2019 they need to be able to know that their cash flows are reasonably probable in the next five years. But if they are linked to LIBOR these cash flows are no longer probable.”
The International Accounting Standards Board (IASB) has acknowledged this issue and produced a board paper and a research project in an attempt to address this challenge.
The transition will likely result in major projects to address functional and technical changes, alter impact assessments, and overhaul testing models. Against this backdrop, it is important that companies understand the magnitude of the task ahead and take robust steps of their own to shield themselves from the risks. RTL’s Masquelier suggests that “the issue should particularly resonate with providers of IT services linked to LIBOR, yet the conversation has not yet begun”. As such, corporates should look to ignite this discussion to avoid a rushed, last-minute IT transition.
Technology, of course, is also a source of solutions: notably in aiding companies with the sheer volume of work required to gather together and review all their outstanding contracts and the associated fallback language. Recent developments such as natural-language processing and machine learning, for instance, could be used to mine data from contracts across the business – and not just those tied to banking contracts – categorising them according to common types of terms and conditions.
In order facilitate a smooth migration, Manning outlines clear steps a business can take: “Companies must look to implement an integrated workstream – ensuring the move is fully co-ordinated and centralised across the entire business.” With this in mind, she suggests that it is important that corporates nominate an individual responsible for overseeing the entire transition – something that is already mandated for banks in the UK.
Defining a company-wide approach will require establishing a clear transition roadmap, which will help clarify the bigger picture in terms of infrastructure adaptations, financial exposures and costs. This last point is important: corporates will need a budget to carry out necessary adaptations to IT tools, valuation models, hedge accounting, tax, collateral management and pension models.
Finally, Manning suggests that with the nature and timeline of the industry-wide shift still unclear, it is critical that corporates keep abreast of the latest developments and adjust their strategies accordingly.
While their own transitions are crucial, corporates can also play a valuable role in fostering dialogue and encouraging a harmonised industry approach. Working together, there is no reason why we cannot overcome the challenges of this transition and ring in a new era of RFRs.