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The discontinuance of LIBOR and replacement by alternative rates creates both challenges and opportunities for UK corporates. Delaying preparation could lead to significant economic and operational impacts.
The London Interbank Offer Rate (LIBOR) is one of the most common series of benchmark interest rates referenced by contracts measured in the trillions of dollars across global currencies.
Regulators and industry bodies have proposed and agreed on the new interest rate benchmarks to replace LIBOR rates that are anticipated to no longer be published or supported past the end of 2021. These new alternative rates are likely to significantly impact corporates as users of LIBOR linked products, and replacing LIBOR will affect a significant number of financial agreements (within treasury, finance and across the organisation).
It it is imperative that corporates mobilise further to ensure that they are able to reliably communicate to key stakeholders the nature or their LIBOR exposures and the impact of LIBOR reform on their organisations. Are you ready?
The Bank of England formed the Risk Free Rate Working Group, which recommended a reformed Sterling Overnight Index Average (SONIA) as the alternative unsecured risk-free rate for the Pound Sterling (GBP) LIBOR market. Other jurisdictions are also eliminating IBOR rates and will adopt replacement rates as follows:
The Secured Overnight Financing Rate (SOFR) is expected to be the preferred alternative reference rate for US dollar financial products after 2021.
The European Central Bank (ECB) formed the Working Group on Euro Risk-free Rates, which recommended the Euro Short-Term Rate (€STR) unsecured rate to replace EONIA
The Swiss National Bank selected the Swiss Average Rate Overnight (SARON), a secured reference rate based on data from the Swiss Franc repo market, as an alternative to CHF LIBOR.
The Bank of Japan formed a working group that ultimately recommended the Tokyo Overnight Average Rate (TONAR) as an unsecured overnight rate replacement.
Although Panel Banks will continue to participate in the LIBOR submission process until the end of 2021, market participants are actively preparing for the transition by identifying exposures, understanding the impact of those exposures, and taking action to modify both direct LIBOR references and contractual fallback provisions that will be triggered if LIBOR ceases to exist.
Some corporations provide funding to their customers or clients as part of sale transactions or enter into other contracts such as leases and procurement contracts that contain references to LIBOR. These types of contracts and arrangements are frequently dispersed throughout the company making it difficult to readily identify a company’s exposure.
Why it matters
The transition away from LIBOR will require additional considerations for current systems and processes. Specifically, current systems may not have been designed to source replacement rates or may be unable to perform the calculations required to value financial instruments and accrue interest based on new reference rates. In addition, the impact that the LIBOR transition will have on processes such as transfer pricing and intercompany funding will need to be assessed.
Why it matters
Companies will need to evaluate their methods and approach to interest rate management and monitoring in order to accommodate the transition from LIBOR to alternative reference rates. As LIBOR is phased out, interest rate management programs should expect to encounter challenges from potential reduced liquidity for LIBOR-based products, basis risk between products and currencies, and general uncertainty around transition. Furthermore, lines of credit and borrowing facilities are often tied to LIBOR or another benchmark interest rate. These agreements may need to be renegotiated or amended to appropriately reflect the new benchmark interest rate and any subsequent credit spread adjustments required.
Why it matters
As the end of 2021 nears, it is likely that LIBOR-based financial instruments will likely experience a decrease in liquidity. The trading volume changes of LIBOR-linked products could lead to changes in pricing, and companies will need to decide when to make the switch from LIBOR to SONIA or other risk-free rate (RRF) products.
Why it matters
As a result of the transition away from LIBOR, standard setting and regulatory bodies have reviewed their regulations and standards in contemplation of other reference rates and the practical implications of LIBOR reform. In particular, changes to accounting guidance, including hedge accounting and debt modification/extinguishment, will likely impact companies. Similarly, tax authorities are contemplating how the transition away from LIBOR will impact on issues such as deemed taxable exchanges based on modifications, credit spread adjustments and transfer pricing. These discussions are expected to continue as standard setters and regulators continue to respond to market developments. As a result, corporates should continuously monitor regulatory developments throughout the transition process.
Why it matters
Existing financial products with scheduled maturities beyond 2021 that provide for LIBOR-based interest payments will need to be modified to reference SONIA or another alternative rate. Additionally, new financial instrument contracts that reference LIBOR and extend beyond 2021 will need to contain fallback provisions that specify an alternative rate other than LIBOR that will be used if and when certain trigger events occur. Financial instrument contracts that do not contain relevant fallback provisions could result in a negative economic impact or an invalid reference rate. Even cash products that contain fallback language that references the end of LIBOR are still highly susceptible to value transfer, as no perfect mechanism exists to adjust for the spread between LIBOR and SONIA or other alternative reference rates.
Why it matters
As new alternative reference rate products become available, investment committees will need to prepare for future issuances by understanding the liquidity and pricing in the market for LIBOR products compared to products with alternative rates. This understanding will permit investment committees to determine how the alternative rates complement or require adjustments to existing strategies. We expect first mover advantages for those institutions who can strategically transition their portfolios from LIBOR to SONIA and other risk-free rate-linked products in a timely manner. Proactive institutions are actively monitoring their investment strategy to minimize the acquisition of LIBOR-based products with maturity dates extending beyond 2021. Any strategy for minimizing LIBOR exposure should consider direct exposure (holdings of LIBOR-linked products with maturity dates extending beyond 2021) and indirect exposure (products, valuation techniques, systems, etc. that may have an underlying/input that is impacted by changes in LIBOR).
Similar to the changes for investment portfolios, corporates that manage long-dated pension assets will need to monitor those investments and determine if the terms of the investments, which may have been determined far before LIBOR reform was contemplated, require adjustment.
Why it matters
Corporates need to have plans that set out how their organisations will move towards these alternative rates and then refine them as the industry and regulators clarify the biggest unknowns.
We can help ensure that the potential risk consequences associated with LIBOR’s replacement are anticipated and appropriate plans and resources allocated to identify and mitigate their effect.
Along with our team of dedicated LIBOR professionals, technology and sector expertise, we can help you find ways to progress and succeed - even in periods of uncertainty. To deliver meaningful change, we can work with you to implement the key components of a comprehensive LIBOR transition plan.
Director, Treasury Advisory and Assurance, PwC United Kingdom
Tel: +44 (0)7753 928134