Transition from LIBOR: Practical considerations for corporate treasurers
March 08, 2018
As has been widely reported in the Treasury Press the UK Financial Conduct Authority has decided to no longer compel panel banks to participate in the LIBOR submission process beyond the end of 2021. This is part of a drive in various jurisdictions to retire existing LIBOR benchmarks and begin the process of developing replacements.
The replacement process varies across jurisdictions. In the UK, the Risk Free Rate Working Group recommended SONIA (Sterling Overnight Index Average) as the alternative risk-free rate and the BoE plans to issue a consultation paper on the subject in the first half of 2018. In the US, details on the Alternative Reference Rate Committee recommendation of SOFR (Secured Overnight Funding Rate) are due for publication in Q2 2018. Similar activities are also underway in the Eurozone, Switzerland and Japan.
Given that the pricing of many financial instruments is tied to LIBOR including OTC and exchange traded derivatives as well as credit instruments such as commercial and retail loans, mortgages, structured products and bonds, such changes will have significant implications for the Treasurer.
Key challenges for the treasurer
Whilst there is much uncertainty in the detail there are a number of key issues for the Treasurer to navigate. Please note the following is not an exhaustive list more a starting point for consideration:
- Firstly, there will need to be changes to fallback provisions in key documentation.
- Derivatives - changes to ISDA masters and CSAs may be required. If amendments to derivatives result in recognition of a new contract, additional collateral may be required;
- Lending - interest rate determination provisions may need amending. Parties will need to consider whether any revised terms result in extinguishment or modification with consequent accounting implications; and
- Debt - a replacement rate could affect noteholder interests and issuers should consider disclosures regarding uncertainty relating to future levels of benchmark rates, the possibility of rate discontinuance and/or replacement, and the potential impact on payments.
- Secondly, the transition to new reference rates may require costly changes to internal and third party treasury-related systems;
- Thirdly, in relation to hedging and hedge accounting, there is the potential for basis risk between bilaterally-agreed loans and related derivatives. Additionally, the introduction of new benchmarks could critically affect existing hedge accounting treatments; and
- Fourthly, parties should consider possible tax consequences. In particular whether a change in interest calculations for debt instruments would constitute a change in terms of the debt, resulting in tax consequences for the issuer and holder of the debt and possible re-characterisation of the debt for tax purposes.
In addition to the above, work still needs to be undertaken to understand the practical mechanics of other transitionary issues such as how basis markets will be developed between new and legacy products, adjusting for basis inconsistency between global markets (e.g. for cross currency swaps) and how banks credit spread premia will be captured in the context of new risk-free benchmark rates.
What should treasurers be doing now?
Immediate priorities for the next three to six months centre on program mobilisation and impact assessments including identifying what type of instruments may be impacted, reviewing fallback provisions in documentation, updating hedging documents and looking to future-proof new contracts or hedging arrangements by considering the wording of any new loans/derivatives entered into. Four years may seem a long time, but given the volume of potential changes required to contracts, systems and processes, treasurers should start assessing the impact now.