LIBOR Transition for UK corporates

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?

Switching to preferred alternative rates

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.

Implications for UK corporates

Identifying LIBOR references in contracts

The issue

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

  • Contracts outside of treasury such as procurement, supply chain and revenue contacts referencing LIBOR will need to be identified and assessed for impact to determine actions needed prior to the LIBOR transition.
  • The change from LIBOR may necessitate renegotiation of existing contracts that lack fallback language with customers and updated fallback language in contracts for new customers.
  • Corporations that do not proactively manage their transition from LIBOR may find it increasingly difficult to mitigate potential adverse effects on their cashflows, systems and operations.
  • Customers/clients may be less educated about the change in reference rates and may need to be educated as part of the renegotiation/amendment process.
  • Some types of executory contracts (e.g. leases) are longer-term in nature and any new contracts entered into will extend beyond 2021 (or have the option to extend past 2021). The LIBOR transition should be considered when entering into these types of contracts so as to avoid additional costs that will be required to renegotiate contracts at a later date.
  • Significant resources may be required to review the number of contracts outstanding as part of a review of LIBOR exposure.

Operations may need to change

The issue

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

  • Valuation models, accounting and tax configuration, and data sourcing may need to be changed so that valuations, transfer pricing and accounting and tax records are accurate going forward.
  • Internal processes such as transfer pricing and intercompany funding may require that new analyses and updated procedures are in place so that appropriate rates and spreads are applied across the company.

Interest rate management

The issue

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

  • Differences in transition or fallback provisions between debt, cash products and derivatives can create basis risk.
  • Challenges may arise with existing cross-currency basis risk management instruments that reference two floating rates.
  • Institutions need to understand to-be curve construction and behavior to appropriately develop risk management strategies and transition plans.
  • Companies should evaluate the economic impact of International Swaps and Derivatives Associations (ISDA’s) proposed changes relative to hedged exposure along with the economic impact of the fallback language for cash products.
  • Analyses of LIBOR exposure will allow corporates to develop appropriate transition and hedging strategies.

Liquidity management

The issue

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

  • LIBOR-based financial instruments may be more difficult to liquidate because market demand may decline as the end of 2021 approaches.
  • Volatility in SONIA (especially at period end) and uncertainties around the availability of forward-looking tenor rates may increase settlement risk.

 

Accounting and tax

The Issue

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

  • A change from LIBOR to SONIA could critically affect accounting conclusions. While the IASB is looking to provide relief in some areas, corporations will need to stay abreast of IASB decisions and consider the timing of their LIBOR transition efforts with the effective date of relief provisions provided by the IASB.
  • Limited historical replacement rate market data (e.g. volatility) could present challenges when valuing instruments such as options, caps and floors.

Debt management

The issue

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

  • A more than minor modification to a contract may be deemed an extinguishment of a debt instrument, resulting in the recognition of gains or losses.
  • Transfer pricing or tax issues could arise if intercompany funding or other agreements are not appropriately modified to include fallback language.
  • Given the differences in conventions, potential timing differences of when certain fallback provisions are triggered and the possible downstream effects on corporate cash flows, operations or even hedge accounting, corporates that wait to plan their transition might find it increasingly difficult to mitigate the associated risks.

Investment management

The issue

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

  • Changing investment strategies and/or exiting existing positions in an orderly manner to reduce LIBOR exposure can require an extensive amount of time. Analyzing and addressing LIBOR exposure now can reduce the likelihood of unfavorable impacts.
  • Valuation models for investments may need to be modified to incorporate SONIA or other alternative rates.

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How we can help

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.

Contact us

Yann Umbricht

Yann Umbricht

Partner, Head of Treasury, PwC United Kingdom

Tel: +44 (0)7801 179669

Christopher Raftopoulos

Christopher Raftopoulos

Director, Treasury Advisory and Assurance, PwC United Kingdom

Tel: +44 (0)7753 928134

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