The decade-long reform of global interest rate benchmarks is coming to its conclusion as alternatives to the London Interbank Offered Rate (LIBOR) are rolled out globally. Overnight interest rates based on actual transactions, the alternative or risk-free rates (RFRs) are considered to be more robust than the various LIBOR-based rates. Initially greeted with scepticism, financial institutions and corporate treasuries have accepted the reality that RFRs will replace USD, Sterling, CHF, Euro, JPY and other currency LIBORs.

While much of the transition for Sterling LIBOR has been done, this is only a small (albeit important) part of the overall picture. LIBOR was a key global interest rate benchmark across a number of financial products including derivatives, securities, loans and mortgages, and was widely used by corporations ranging from the smallest to the largest multinationals as a reference rate, a fallback or in a late payment clause.

For corporate treasuries, doing nothing is not an option as the benchmarks for other currencies come up for transition and the impact on contracts must be assessed. The lessons learned from the Sterling LIBOR transition can be applied to other currencies, however.

The benchmark reform was initiated in June 2013 by the Financial Stability Board (FSB), which coordinates financial regulation for the G20 economies. It was responding to allegations of market manipulation and false reporting of LIBOR. Among the first regulators to act was the UK Financial Conduct Authority (FCA), which discontinued LIBOR from 31st December 2021, no longer compelling banks to contribute to it.

Speaking at a conference in July 2022, Nikhil Rathi, Chief Executive of the FCA said the Authority’s strategy to replace LIBOR, which was announced in 2017, was “greeted with much scepticism at the time”. Five years on, less than 1% of contracts reference LIBOR “so the transition is possible and necessary”.

He added that the New York Federal Reserve had made “encouraging progress” towards the goal of winding down USD LIBOR for its June 2023 deadline.

“The transition away from Sterling LIBOR is to all intents and purposes complete,” says Sarah Boyce, Associate Director, Policy and Technical at the Association of Corporate Treasurers (ACT). “There are a couple of minor areas, such as in the bond market for financial institutions, that have to be worked through but no one anticipates any problems.”

The more complex, sophisticated treasury operations have migrated to the Sterling Overnight Index Average (SONIA), the Sterling LIBOR replacement. Smaller corporates that either only borrow or have limited requirements have moved to fixed rates, or bank-based reference rates that give similar characteristics to forward-looking term rates but don’t require hedging, she adds.

The transition to RFRs is agnostic of line of business or balance sheet size for a given corporate. Longer-dated exposures required repricing ahead of maturities using the alternative RFRs pricing methods.

The consensus among ACT members, says Boyce, is that by the time LIBOR is finally phased out, “it won’t be missed”.

LIBOR transition has touched on multiple areas, including:

• Legal – identifying affected contracts and documents that reference LIBOR.
• Interest rate curve creation – IBORs are forward-looking pricing mechanisms, whereas RFRs are backward-looking.
• IT – the transition could impact internal and external systems, which may need to be updated to handle new benchmark rates.
• Risk – pricing gaps and volatility may arise from the change in reference rates and new hedging/insurance mechanisms may be required.
• Tax – changes in certain jurisdictions may require new contracts for tax purposes.
• Accounting – there could be impacts on discounted cash flow valuations (from property, leasing, pensions, etc) and on hedge accounting for fair valuation of securities.

In August 2022, the FCA strongly encouraged issuers and bondholders of outstanding LIBOR-linked bonds to take the “necessary action to transition outstanding LIBOR-linked bonds to fair alternative rates.”

Acknowledging that many LIBOR-linked bonds (including securitisations and similar structures) had been converted by mutual agreement through processes such as consent solicitation – the FCA noted that the relevant RFR plus the industry-agreed spreads that have been used in successful consent solicitation exercises “provide a model for such conversions. Responsibility for initiating this process lies with the bond issuer.”

In addition, the FCA encouraged bondholders without robust fallbacks or another mechanism to remove reliance on LIBOR to engage with the relevant issuers or their agents and request that they initiate these conversion processes.

Publication of one and six month synthetic sterling LIBOR will cease at the end of March 2023, after which the synthetic settings – a derived rate based on panel submissions and term RFRs to which a fixed spread adjustment is added – will permanently end. Three-month synthetic Sterling LIBOR setting will be published until the end of March 2024, after which they will be ceased permanently. Synthetic IBOR for different currencies were designed to help mitigate the risk of widespread disruption to legacy LIBOR contracts that had not yet been transitioned.

While the hurdle of Sterling LIBOR transition has been all but cleared, the next hurdle – transition away from USD LIBOR – will require a much greater leap. An estimated US$200trn+ of derivatives, loans, securities and mortgages reference LIBOR in the US markets alone.

Marcus Burnett, Chief Executive of US-based SOFR Academy, a financial education and market information organisation focused on LIBOR transition, says that the transition to the USD LIBOR replacement, the Secured Overnight Financing Rate (SOFR), is going “extremely well on the derivatives side and by and large is where it needs to be”.

When it comes to loans, particularly for corporates, “a lot of work still needs to be done”, he adds. There are a number of reasons for this, including the later start to transition in the US by corporates and the many thousands of corporates involved, many of whom may not have been as “looped in with the transition” as they could have been, he observes.

“Some corporate treasurers that operate outside financial services may not have a strong familiarity with LIBOR transition. Also, some corporates have small treasury functions. For these types of organisations, USD LIBOR transition has been more challenging.”

Synthetic one, three and six month USD LIBOR settings will continue to be published by LIBOR’s administrator, ICE Benchmark Administration (IBA) until the end of September 2024. In announcing this, the FCA said it considered synthetic LIBOR a “fair and reasonable approximation of what LIBOR might have been”. The synthetic settings are intended for use in certain legacy contracts only, the FCA stressed.

The FCA added that “any” synthetic LIBOR settings are only a bridge to appropriate alternative RFRs, not a permanent solution. “As such, market participants should continue to prioritise active transition and focus on converting their legacy contracts to risk-free rates as soon as possible,” it said.

The ACT’s Boyce agrees with Burnett that USD LIBOR transition is more problematic. “USD LIBOR is in a very different place – the scale is much larger.” She identifies three distinct entities involved in USD LIBOR transition: ‘main street’ companies, large multinationals and emerging markets.

“The emerging markets are the least advanced and many corporate treasurers in these markets are not aware of what is happening or are not sure how to transition. The majority of these emerging market large loans will move to some type of term SOFR because of the requirements of borrowers and currency control rules,” she says.

In general, large multinationals, which during the Sterling LIBOR transition have moved to overnight SONIA are likely to move to overnight SOFR as this is the “cheapest and most liquid market and derivatives will be available for hedging, which won’t be the case with term SOFR.”

The smaller, main street companies seem to be moving towards a term solution, says Boyce. “Our view is that because these companies do not have hedging requirements and their loans tend to be small, they will move to term-based rates. It also looks like banks are persuading them that this is the appropriate solution.”

Royston Da Costa, Assistant Group Treasurer at Ferguson plc, whose business is exclusively North American focused, says the company is considering using SOFR when USD LIBOR is phased out. However, he says he is not certain if SOFR will be the main replacement for the USD LIBOR rate used by corporates. “For now, the banks we are dealing with seem to favour it,” he says. In fact, he believes it is increasingly apparent that term rates are being favoured by corporates that are turning to data providers such as the Chicago Mercantile Exchange (CME), which is offering LIBOR replacement term rates for a fee.

The Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by the Federal Reserve Board and the New York Fed, has noted that SOFR is the predominant rate across cash and derivatives markets. However, “no one should underestimate the scale of work left ahead of 30th June 2023 – the cessation date of the remaining USD LIBOR tenors,” it says.

Burnett says one of the main challenges in the USD LIBOR transition is the amount of contracts that are yet to be transitioned. “There are many different types of loans that still need to be transitioned – leveraged, syndicated, bilateral – and there are corporates on the other side of those loans. Some type of negotiation is needed and we are seeing frictions in those discussions, particularly in connection with the credit spread adjustment.”

Some corporate borrowers are also balking at the fixed spreads applied to the SOFR base rate which were frozen pre-covid for some USD LIBOR contracts. For three month contracts, for example, the spread is 26 basis points which is higher than market based spreads. “The historical fixed spreads can be problematic, particularly in the leveraged loan market,” says Burnett. “We recommend that corporates proactively have a conversation with their contract counterparty and reach an agreement on how to transition to SOFR at fair value – in either direction.”

The Academy has operationalised USD Across-the-Curve Credit Spread Indexes (AXI) as an add-on to SOFR in collaboration with asset manager Invesco’s subsidiary, Invesco Indexing. AXI is a weighted average of the credit spreads of unsecured US bank funding transactions with maturities ranging from overnight to five years, with weights that reflect both transactions volumes and issuances. It can be added to term SOFR (or other SOFR variants) to form a credit-sensitive interest rate benchmark for loans, derivatives, or other products. A recently published New York Federal Reserve research paper found that a credit sensitive supplement such as AXI can reduce the cost for corporates of obtaining credit lines from banks by up to 25bps.

Burnett argues that referencing AXI as a static spread can also help corporates transition legacy contracts in a way that will minimise negotiation disputes by providing a fairer and more transparent compromise between counterparties in any contract. “AXI could be snapped on the date of the amendment to ease transition negotiations and presents a fairer market-based compromise for borrowers and lenders. AXI always reflects the marginal contemporaneous cost of bank funding over the near-risk free rate, so it will move up and down over time.” He notes that LIBOR transition is coming at a time when corporate treasurers “have a lot on their plate” – workforces are shrinking and interest rates are moving higher, making for a challenging environment.

One of the biggest “wrinkles” in USD LIBOR transition is the impact of contract jurisdiction, says Boyce. “Under US law, contracts have a regulated fall back which will automatically come into play if you still have USD LIBOR referenced contracts on cessation. It is a very big piece of work for corporate treasurers to make sure they understand what will happen to their contracts when USD LIBOR ends.”

Boyce’s advice for treasurers is simple: “Try to get ahead of the game. Don’t sit back and don’t put your head in the sand, because this is happening and you need to address this problem. The longer you leave it, the more difficult it will become as other companies access scarce legal and advisory resources.”