The regulatory recap
A long road to interest rate reform
In June 2013, the Financial Stability Board, which coordinates financial regulation for the G20 economies, began to reform global interest rate benchmarks. As a result of this the London Interbank Offered Rate (LIBOR), arguably the most important Interbank Offered Rate (IBOR) used in global financial markets, is set to be discontinued from 31 December 2021.1
The decision by the UK Financial Conduct Authority to no longer compel banks to contribute to LIBOR post 2021 was prompted by the rate’s lack of liquidity following the 2008 financial crisis, which in turn led to attempted market manipulation and false reporting.
In response, Replacement Risk-Free Rates (RFRs), considered to be more robust and reliable as they are overnight interest rates based on actual transactions, have been identified for each of the five main LIBOR currencies:
- USD – Secured Overnight Financing Rate (SOFR)
- GBP – Sterling Overnight Index Average (SONIA)
- CHF – Swiss Average Rate Overnight (SARON)
- Euro – Euro Short-Term Rate (€STR)
- JPY – Tokyo Overnight Average Rate (TONA)
This transition is significant – to date, LIBOR is still a key interest rate benchmark across a number of financial products including derivatives, securities, loans and mortgages, and is widely used among corporations ranging from the smallest to the largest multinationals.
Time is running out for corporates to phase out LIBOR and be business-ready for RFR transactions, especially with upcoming key interim milestones such as the cessation of new long-dated USD LIBOR floating rate notes and GBP LIBOR cash issuances in Q4 2020 and Q1 2021, respectively.
Scope, scale, and structure
An issue for corporates
The transition to RFRs is agnostic of line of business or balance sheet size for a given corporate. Longer-dated exposures, especially positions that currently exceed 2021, are of particular interest for banks and regulators alike as they will need to be re-priced ahead of maturities using the alternative RFRs pricing methods.
Products such as mortgages, business loans, bonds and derivatives may use LIBOR in some form, for example, as a reference rate, a fallback or in a late payment clause.
All of the RFRs developed for the five LIBOR currencies have robust and credible overnight reference rates, with the US’s SOFR and the Swiss SARON secured and determined by underlying repo transactions2. The remaining three – the UK’s SONIA, Japan’s TONA, and the Euro’s €STR are unsecured and determined by interbank money market transactions.
Building the blueprint for your business
Time to take stock
Corporates should start to reduce their reliance on LIBOR and transition to new RFRs sooner rather than later. References to LIBOR have been in existence for a long period and it is a good time for corporate leadership to take stock and review policies and pricing and intercompany lending contracts. Rates for the alternative benchmarks have been published for some time therefore treasuries have no reason to delay.
Corporates are advised to have an active transition plan and transition team in place to tackle the change head-on. This includes assessing the risks of the transition and developing risk mitigation plans and contingency arrangements, such as documentation, contract language, systems readiness for new benchmark rates and any tax and accounting implications associated with change to debt terms.
There are some key differences between IBORs and RFRs that corporates should consider;
|Established term structure with sufficient liquidity across tenors||Overnight rates using repo or money market transactions executed the previous day|
|Sufficient market depth of available instruments that allows for smoother forward rate estimation||Overnight rates can be relatively volatile as they are determined by actual market transactions|
|Forward looking – interest flows occurring at a future date are known upfront||Backward looking – interest flows are determined at the end of the period and not known upfront|
|Established market conventions and valuation models||Relatively new and lacking in market conventions and valuation models|
There are six main areas corporates should assess in ensuring they can successfully transition to RFRs:
- Legal – including identifying affected contracts and documents that reference LIBOR.
- Interest rate curve creation – IBORs are forward-looking pricing mechanisms, whereas RFRs are backward-looking.
- IT – the transition could impact internal and external systems, which may need to be updated to handle new benchmark rates.
- Risk – pricing gaps and volatility may arise from the change in reference rates and new hedging/insurance mechanisms may be required.
- Tax – changes in certain jurisdictions may require new contracts for tax purposes.
- Accounting – there could be impacts on discounted cash flow valuations (from property, leasing, pensions etc) and on hedge accounting for fair valuation of securities.
Building the blueprint for the industry
Being prepared is paramount
Treasury teams in particular will face many challenges in the transition to RFRs; a key advantage will be preparation. But they do not have to face this alone: financial institutions, industry associations, accounting firms and regulators are working to ensure the transition to RFRs is as smooth as possible.
Leaving action too late will put pressure on these organisations – if a corporate has to make changes to its treasury management system or enterprise resource planning system at the last minute, it may be competing for resources with many other corporates in the same predicament.
Championing change with Standard Chartered
Transitioning with a trusted partner
Standard Chartered has established a central IBOR Transition Programme to prepare for the discontinuation of LIBOR and other IBORs globally, to assist our clients through the transition. You can find in-depth details on the program here.
The Bank is also involved in discussions and transition efforts with global regulators, industry bodies, trade associations and individual market participants, while continuing to stay close to the developments across our geographic footprint. We have also introduced a suite of RFR-referenced products and encourage our clients to consider these, in view of the potential risks associated with LIBOR transition.
Now is the time to make the change to RFR and to take advantage of the experience and knowledge of banking partners. By doing so, corporate treasuries will benefit from a smooth transition.
2A repo is a form of collateralised short-term loan, in which the cash borrower pledges a security as collateral while agreeing to repurchase it at a (typically) higher price at a future date. Historically, Treasury repos have served as an important source of funding for dealers in government securities, allowing them to raise cash in exchange for Treasuries pledged as collateral.