LIBOR Replacement and the way forward
The impacts of LIBOR replacement and a step-by-step guide for smooth transmission to Alternative Reference Rates (ARRs).
Allegations of LIBOR manipulation started back in the 1990s or probably even earlier, which resulted in the imposition of fines on participating banks and a subsequent lack of confidence in the accuracy of LIBOR. However, on the back of the 2011 ‘LIBOR scandal’, the Financial Stability Board (FSB) recommended in 2014 to replace various IBORs with Alternative Reference Rates (ARRs) or as termed by some market participants ‘Risk Free Rates’ (RFRs). Subsequently, worldwide financial regulators actively started to introduce ARRs and provided guidelines for a smooth transition.
For instance the Financial Conduct Authority (FCA), the UK regulator, formally announced in 2021 (after its initial announcement in 2017) that all LIBOR settings for EUR, CHF, GBP, and JPY as well as the 1-week and 2-month LIBOR settings for USD will cease or no longer be representative after 31 December 2021. The remaining USD LIBOR reference rates will cease to exist after 30 June 2023. Based on recommendations in 2018 by the working group for the Euro Overnight Index Average (EONIA) and the Euro Interbank Offered Rate (EURIBOR), the European Central Bank (ECB) published the first Euro short-term rate (€STR) as an ARR for EONIA and EURIBOR on 2 October 2019. The ECB has already announced to discontinue EONIA on 3 January 2022. However, the EURIBOR will continue along with €STR after 3 January 2022.
The ECB recommends to use €STR as the primary rate but has not announced yet when EURIBOR will cease to exist.
Why do Treasures care?
IBORs are the standard reference benchmarks for millions of contracts worldwide. According to an estimate by Bloomberg, the estimated market value of the underlying contracts is over USD 370 trillion. Discontinuation of IBORs will impact almost every Treasury transaction of your organization regardless whether it is lending (deposits), borrowing (loans), investing (bonds) or a hedging (derivatives) transaction.
Implementation of ARRs will have an impact on the valuation of your existing transactions and pricing of new transactions. Changes in benchmarks will further change interest calculations, resulting cash flows and settlement dates. Changes in interest calculation methods might have impacts on your taxation as there could be changes to your debt instrument value. Resulting changes in accounting methods used for ARRs pose another challenge. In addition to financial impacts, your system infrastructure will be affected due to the required implementation of ARRs.
What should Treasurers do?
Familiarize yourself with ARRs and related events especially fallback provisions of existing contracts
The ECB defines ‘fallback provision’ as clauses in a contract that determine what rate parties should use in the event that the agreed upon benchmark rate like IBORs are not available.
Here is the list of major ARRs replacing current benchmarks along with their cessation deadlines:
Plan and prepare for transition to ARRs
Plan early in order to be prepared when IBORs ceased to exist. Also note: Newly issued instrument contracts are already quoted using ARRs.
Identify your IBOR based exposure and relevant transactions
Identify the number of transactions, total value of transactions, currencies of transactions nature of transactions, counterparties involved and affected fallback provisions.
Engage with your financial business partners and if possible negotiate existing contracts
Once the exposure is identified, engage with the relevant financial business partners, including banks and/or counterparties to coordinate their post-IBOR plans and timelines with yours.
Update your systems and infrastructure
Update your treasury management system (TMS) to accommodate ARRs. Consult with your TMS as well as market data providers to understand what needs to be done to implement required changes, expected timelines and costs of implementation. Please note some regulating bodies demand full operational readiness of organizations by 31 December 2021. The Swiss Financial Market Supervisory Authority (FINMA) demanded in their December 2020 notification ‘Full operational readiness: All relevant systems and processes should already be able to function without reliance on LIBOR’.
Current Benchmarks vs Alternative Reference Rates (ARRs)
|Currency||Current Benchmark||ARR||ARR Publisher||Cessation Deadline|
|EUR||EONIA||€STR||European Central Bank||3. January 2022|
|EUR||EURIBOR||€STR||European Central Bank||Not announced yet|
|EUR||EUR LIBOR||€STR||European Central Bank||31. December 2021|
|CHF||CHF LIBOR||SARON||SIX Swiss Exchange AG||31. December 2021|
|GBP||GBP LIBOR||SONIA||Bank of England||31. December 2021|
|USD||USD LIBOR||SOFR||US Federal Reserve Bank||31. December 2021*|
|JPY||JPY LIBOR||TONAR||Bank of Japan||31. December 2021|
* Only for 1-week and 2-month, remaining USD LIBOR settings will be changing after 30.06.2023.
SAP system adaptation
There is already a large number of SAP updates available for the new interest calculation methods for money market transactions and bonds. Even the new feature to include/exclude the spread into the compounding has been added to the solution. Updates for ABS/MBS and Sinking Bonds are not yet available and are expected around Q3 2021.
While the number of impacted instruments may not be large for some companies in 2021, ARRs are the new future convention and USD-LIBORs will follow in 2023. The above five steps should help your organization to understand and manage a smooth transition to ARRs.
We have already accompanied and consulted various clients regarding their IBORs replacement journey and are happy to help your organization.
Feel free to contact.