It’s estimated that the London Interbank Offered Rate (LIBOR) underpins around US$300trn of financial contracts. The 2008 LIBOR scandal revealed that some panel banks had been collaborating to ‘fix’ the rate by submitting artificially low or high numbers to benefit their derivatives traders, leading to investigations by US, UK and European regulators. This kickstarted the change that is currently under way.
When it comes to whether businesses are ready for the transition or not, one only has to look at the June 2019 audience poll at the European Money Market Fund Forum. Fifty-seven percent of delegates at the event believed that LIBOR wouldn’t truly disappear – a soberingly low number that suggests almost half of businesses likely aren’t making necessary arrangements as they don’t believe the transition will truly happen.
For treasurers that have been preparing, it’s likely that the focus has been kept on the numbers-side of things, but what about the systems and processes – or the legal documents? For Guy Usher, Partner and Co-Head of Financial Services at European law firm, Fieldfisher, the changes centre around the manner in which LIBOR is being used in any one currency. “They’re often using GBP or USD LIBOR as an internal cost-of-funds benchmark, even if it bears no relation to their actual borrowing costs” he explains. “Keeping in mind the exposures when they changeover, they’re going to end up doing so over a period but at some point they will reach a threshold where they also change their internal funding benchmark.” This isn’t a transition which can be done by simply flipping a proverbial switch.
Steve Burrows, a financial regulatory and derivatives lawyer at Fieldfisher, adds that from a systems perspective, there will also be impacts on various treasury systems, for example accounting and balance sheets, financial modelling, discounting of cash flows and projections of internal rates of return. All these internal systems are likely to be linked to LIBOR, and will therefore need transitioning as well. “So it’s not just a case of calculating aspects such as interest payments; there are much broader implications that treasurers have to get their heads around.”
Preparation is key
With the transition being announced several years ago, both Usher and Burrows are agreed that businesses should have begun preparations already. Usher notes that corporate treasurers aren’t subject to the same regulatory requirements as banks, brokers and asset managers – such as being required to effectively monitor and report exposures and demonstrate a control of this issue for the past two years. “They’re not necessarily expected to drive the process and the change, it’s assumed that the markets and the banks will be.”
Burrows agrees, and explains that the assumption of corporates has largely been that because this whole initiative is regulator-led, it’s a problem for the banks and market counterparties to solve alone. “[The banks will] be in the driving seat and tell the corporates what to do and how it’ll be fixed,” he says. However, recently it has seemed that the pressure is beginning to mount on corporates, and he theorises that it’s likely because there’s not been as much progress in transitioning away from LIBOR in the cash markets in particular.
Usher concurs, and says there has been a large increase in corporate treasurers who are “waking up” and planning what they need to do. Instead of using ISDA or similar fallbacks as anything other than a safety net, companies active on the issues will be trading out of the positions when it suits them, to match their debt. “I think larger corporates will be wanting to change LIBOR exposures to RFR [risk free rate] at their own pace and on their own terms.”
Catching up… if you can
Whilst both Usher and Burrows have seen many businesses looking to make the necessary adjustments, they observe some that are yet to do so. To those, both say the time to start ‘doing’ was yesterday. The sheer amount there is to achieve means that companies need time to adjust. In order to catch up, Usher recommends the first step is to actually learn what their exposures are. “It’s a big exercise in a big corporate group, asking everyone what their LIBOR exposures are, then getting the documents, collating them, just to see what they’ve currently got,” he says.
Fieldfisher has been assisting on some major re-papering exercises. “That’s the full range: ABS, floating rate notes, investment grade debt, project financing, bilateral loans, intra-group loans and also commercial agreements,” Usher says.
For the commercial agreements, he notes that the references to LIBOR can vary. “Many contracts will have some light reference to LIBOR somewhere in a default interest provision. It still needs to be fixed but it’s not significant as it is only ever a contingent if somebody defaults on making a payment. But some corporates will also have commercial agreements which use LIBOR in a “meaningful economic” way which will require bespoke changes."
He says that "these preparations are mostly seen in larger businesses; it’s likely that smaller businesses will still “wait and see” for the banks to approach them."
Jumping the hurdles
A key challenge here stems from the legal technicalities as businesses look to make the transition. “Whilst some corporate treasurers are wanting to drive the process, they often won’t have been the people drafting the documents,” explains Usher. Instead, the banks or other providers will have done so – although not necessarily for commercial agreements. This is leaving organisations dependent on how the banks and their lawyers come back to them, and they are having to absorb and assess different styles of drafting. “It’s going to be quite an exercise for them to coordinate, and hard to get a good level of uniformity across the book with multiple banks and different lawyers,” he says.
Secondly, the costs of these adjustments can be quite significant. “There are actual costs of amending documents,” says Usher. The corporates will also have their own costs as well – for example, internal resource or outsourcing to a law firm. Typically, banks try to push the costs of amendments to documents onto the borrower, but he notes that in this situation, businesses are going to be reluctant to pick up that bill as usual. “This amendment is different in nature because it’s a ‘no-fault’. It needs fixing for both parties’ good,” he says.
These discussions need to be had early on in the transition, and treasurers need to establish their own preferences and gain clarity on how it will be done. “The whole process is ripe for disputes,” says Burrows, "but it’s likely to be more over the conduct of the transition and how it’s been managed as a whole, rather than the costs."
Getting up to speed
For Burrows, a key challenge now comes from the education around the LIBOR transition. This needs to be around getting used to the paradigm shift that’s going to have to come from moving things like term rates to compounded rates, and how that’s going to impact the finance of the group as a whole, he explains.
“We get the question a lot ‘what is everyone else doing?’, simply because the corporate treasurers are trying to establish for themselves what they should be doing to keep in line with their peers,” says Burrows. For banks, this is all second nature, but it’s unlikely that corporate treasurers have devoted a lot of time to this, and therefore won’t be up to speed with how the various products and market conventions work, as well as what the pros and cons of them are.
It seems clear that corporates, big and small, should be paying attention to the transition, and be actively working to adjust their businesses to ensure a smooth process when the time comes. As Burrows concludes: “You don’t want to be fighting for bandwidth against the banks when time starts running out. You don’t want to be left at the back of the queue because banks have bigger problems to deal with.”