Webinar reveals that organisations need to be prepared for LIBOR changes
Absa CIB-sponsored webinar unpacks the upcoming changes to LIBOR benchmarks.
At the end of this year, a significant number of London Interbank Offered Rate (LIBOR) benchmarks go on official retirement and are replaced by alternative reference rates. With mortgage rates, business loans, asset-backed securitisations, bonds, derivatives and many other financial instruments currently referencing LIBOR, this is a big deal, perhaps the biggest transition in financial markets, ever. Finance teams and treasury specialists in particular are in for a wild ride and need to get up to speed with the changes quickly.
On 1 July, CFO South Africa hosted a webinar, in partnership with Absa CIB, which unpacked why LIBOR is being replaced, how products will be impacted and which alternative benchmarks will be in place to provide more transparency.
Absa Group head of financial resource management and regulatory strategy Annelize Snyman explained that the volume in the market that underpins LIBOR has dwindled over recent years due to a number of reasons, one of which is the introduction of liquidity regulation in the banking industry that opens the rate up to conduct risk.
“If you contrast that against the fact that currently around $350 trillion of outstanding notionals is pinned to USD LIBOR, you can see why regulators are forcing this transition and trying to find alternatives,” she said.
Alternatives to LIBOR
Annelize said that most countries have been working towards finding alternatives, which are being set in terms of risk-free rates.
USD LIBOR will be replaced by secured overnight financing rates (SOFR). “These rates are underpinned by deep markets, therefore setting these benchmarks on transactions, and making them more credible and more resilient to any manipulation,” Annelize said.
She explained that, currently, LIBOR consists of different tenors, including overnight and three months. In contrast to this, SOFR is an overnight rate and term rates might only become available at the end of this year. “So in order to get an equivalent for that, you will have to compound your daily SOFR rate in arrears in order to obtain the term equivalent.”
The other important factor she noted is that SOFR is risk-free as opposed to adding that bank credit adjustment, which is currently the case with LIBOR.
GBP LIBOR will be replaced by the sterling overnight index average (SONIA), and EURO LIBOR will be replaced by the EURO short-term rate.
“We are seeing two trends around the world as people transition to the new alternative rates,” Annelize explained. The first is a hard transition, where regulators in jurisdiction like the US and UK have identified a date when the existing rate will cease to exist and will be replaced by the new single rates.
The other trend is a dual rate regime, where regulators in jurisdictions like Japan, Canada, Australia and Switzerland are focusing on strengthening existing benchmarks by adding more consideration for transactions, then developing a new alternative overnight or risk-free rate to replace it at the same time. “So you have a regime where you have two rates, and they’re not necessarily setting firm deadlines,” Annelize added.
What are the legal implications?
Annelize explained that there are a number of things that organisations need to think about before the changes come into effect, the most important being the impact on legal processes and what to do around contracts, specifically those that are currently referencing LIBOR rates, but will mature post the cessation of these rates.
Annelize explained that, if a contract matures beyond 2021 and the cessation date, organisations can embed appropriate fallback language that aims to allow for a smoother transition to one of the alternative rates.
“This is where there is a lot of work that needs to happen and legal preparation is critical,” added Absa Group head of treasury Parin Gokaldas. “It is critical to highlight that most legacy contracts don’t have any fallback language. That means that if they aren’t prepared, they could face problems when LIBOR disappears.”
Annelize said that another option is to completely change the contract so that, instead of referencing LIBOR, you reference SOFR without relying on fallback language. Organisations can also redeem the contract earlier, refinance contracts, or switch them out into a fixed rate contract.
Parin explained that regulators are already starting to drive pressure into markets and financial market participants to ensure that they are prepared for the change and recognise the need to move. “We are definitely on a firm path towards the discontinuation of LIBOR and we have timelines in place,” he said. “So it’s clear that risk-free alternatives will replace LIBOR.”
Along with the legal implications, Annelize said that organisations also need to consider a couple of other changes that come with the move from LIBOR to risk-free alternatives, including system and model changes.
“There is a big difference when you are going from a three-month rate to an overnight rate, and the certainty that gives you around your cash flow calculations,” she explained. “If you use a three-month term USD LIBOR, you have certainty for three months over that cash flow. Once you change to an overnight rate, that cash flow certainty only becomes available much later, depending on the agreements put in place around it.”
She added that organisations also need to consider how dual booking systems will change to accommodate the rates, as well as how hedge accounting will work and what effects it will have on tax.
Absa CIB head of trade finance product management Michelle Knowles said that the majority of banks will be communicating the cessation of LIBOR and advising on which alternative rate it will choose. She explained that, when these changes are communicated, it's important for clients to consider the impact of these changes on the pricing of their facilities, both drawn and undrawn amounts. “Your agreements with the bank will probably be amended to accommodate this.”