In 2017, the UK’s Financial Conduct Authority announced that as of 2021 it will no longer look to banks to supply Interbank borrowing rates which contribute to the calculation and publishing of LIBOR. This does not necessarily mean LIBOR will stop being published, however it does give a strong indication it is nearing its end of life, and that end of life poses a number of questions for treasurers. What is the expected path forward if LIBOR stops being published? How will older contracts which reference LIBOR continue? What are the ramifications to business while these changes are being made?
How does the market move forward?
There are two general paths for moving forward. In the first, LIBOR continues to be supported and published. Given the scale of the market and the slow pace of the changes so far this may be the most likely option, at least in the short term. The second path is a complete replacement of each currency LIBOR currently published. Where a replacement is used, a renegotiation of every contract would be required. What many expect to see is an increased usage of alternatives, with adjustments applied to mimic LIBOR and accommodate differences in risk profiles of each reference rate.
There are already a number of replacements being proposed for all currencies which have continued to publish LIBOR rates. In many cases these rates are an attempt at a risk-free rate and most are current overnight terms only. The risk-free replacements are typically based on market trading data, usually related to interbank repo trades. For example, the Alternate Rate Reference Committee has come up with the Secured Overnight Financing Rate (SOFR) as the USD alternative to LIBOR. This rate which is based on interbank repo trades is overnight terms only. This gap in risk profile and terms presents significant issues in replacing LIBOR.
What are the Ramifications for Corporates?
For any buy side corporates with deals referencing LIBOR, the change may have a significant impact. Corporates should expect deals may need renegotiation. Pricing and risk also need to be re-evaluated. Accommodating a simple renegotiation requires an understanding of how LIBOR compares to any new index, what risk differences arise, and how that may impact any new deal.
A summary of how a LIBOR change will impact corporates is summarized below:
- Renegotiation of instruments referencing LIBOR, and update of supporting agreements.
- Reassessment of risks associated with respective portfolio of derivatives. Business unit and counterparty risk assessments may need to be redone.
- Possible changes to agreements such as supporting CSA agreements. Older contracts which could be uncollateralized may need new CSA agreements.
- Reassessment of impact on liquidity to meet new or changed CSA requirement.
- Changes to the risk profile of the portfolio.
- Changes to ALM and Capitalization requirements could be impacted
Impacts on Pricing
- New reference rates used in the market.
- New CSA requirements will impact on pricing of a contract. Buy side participants should see a reduction in risk based margins.
- Relatively new market “risk-free” prices have an impact on pricing.
- The price of supplying collateral should be considered as well. In most cases, there is a net cost associated with supplying collateral, even when using cash.
- Increases in liquidity or basis risk since 2008 now has material impacts on pricing.
- Changes in counterparty risk. CDS pricing has impacted the cost of underlying swaps with a greater focus on counterparty risk.