With LIBOR’s credibility undermined by the discovery of a rate-rigging scandal after the financial crisis, the industry is currently in the process of moving to a variety of different risk-free rates (RFRs) for the five currencies in which LIBOR is calculated: CHF, EUR, GBP, JPY and USD. Different rates are being adopted for each of the currencies, including the Sterling Overnight Index Average (SONIA) for GBP, the Secured Overnight Financing Rate (SOFR) for USD and the Tokyo Overnight Average Rate (TONAR) for JPY.
The COVID-19 pandemic has already brought some disruption to the planned timeline for transition, with UK regulators announcing in April that it would not be feasible to meet the planned deadline for new sterling LIBOR linked loans. However this has not affected the deadline for transitioning to LIBOR alternatives by the end of 2021. Indeed, Edwin Schooling Latter, Director Markets and Wholesale Policy at the FCA, warned in July 2020 that the coming four to six months would be the most critical period in the transition away from LIBOR, adding that “The time to act is now.”
Ready or not?
While the clock is still ticking, many treasurers are not yet ready for this major change. “Aside from the big names, a lot of corporates haven’t really thought about it, or are still working through it,” comments David Stebbings, Director, Head of Treasury Advisory at PwC, adding that this “isn’t only a treasury issue.”
Stebbings says that whilst it can be relatively straightforward to identify key issues relating to LIBOR where debt is concerned, finding all clauses in commercial contracts may present more difficulties – “for example, if you pay a bill late and you have to pay an interest penalty.” Hence, he believes that before starting a project it is absolutely key for corporates to go through some form of business-wide risk assessment to ensure all issues are identified and actions planned to address each of them.
Adam Bridgewater, Risk Product Manager at Kyriba, points out that the ISDA-Clarus RFR adoption indicator shows only 6.4% of new derivative trades in August 2020 being based on risk-free rates. “This suggests that many corporate treasurers, along with others in the market, are not yet in a position to adopt the new rates,” he says. “Corporate treasurers are also mostly unprepared to migrate existing trades and processes to the new rates as they are waiting for their banks to start offering lending as well as to facilitate the process of legally transferring existing trade contracts.”
In addition, Bridgewater points out that rate administrators are still releasing information on methodologies. “In the case of USD LIBOR, the market is still awaiting the Alternative Reference Rates Committee (AARC) to announce the methodology for calculating interest under the Secured Overnight Financing Rate (SOFR),” he adds.
Understanding the challenges
In transitioning away from LIBOR, Bridgewater notes that corporate treasurers face a number of significant challenges. For one thing, migration is set to be time-consuming for both banks and corporates, with lengthy delays to be expected. As such, beginning discussions early, and considering engaging advisors, “will result in better outcomes for corporate treasury portfolios and departments.”
Bridgewater adds that other challenges include the calculation complexity of the new risk-free rates, putting “a greater reliance on automation and so systems” and underlining the need for preparing and testing well in advance. In addition, he says that a period of maturing in the market is to be expected, with many market participants waiting on each other, and on the banks, to migrate to risk-free rates before they can update their own processes away from LIBOR. “This is unlikely to happen smoothly and so corporate treasures would be wise to begin early but build flexibility into their planning and processes so that blocking issues can be resolved as they inevitably arise,” he comments.
Further, with wide-ranging, complex and time-consuming changes planned in 2021, Bridgewater says the transition is an opportunity to revisit current system architectures and digital transformation plans ahead of the transition to improve systems at the start of the year, “while capacity is available and in advance of when the functionality will be required.”
In light of these challenges, corporate treasurers should be initiating discussions with their banks now to understand the timelines for banks to start offering lending on risk-free rates and migrating existing trades for each currency.
“Given that new issuance on risk-free rates has already started happening, migrating to risk-free rates should be built into their new financing and refinancing planning,” says Bridgewater. “In addition, corporate treasurers should already start planning the best strategy through which to migrate their existing floating rate borrowing and derivative hedging contracts to risk-free rates with their banks.”
Finally, Bridgewater points out that treasurers should also ensure that their treasury systems are ready for the transition from LIBOR and make sure their internal processes are ready for the change.