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14 November 2019 5 min read

(L)IBOR Transition… it’s happening to Treasuries as well

Gabriella Symeonidou

Gabriella Symeonidou
Manager | Finance Risk and Compliance | London

As everyone should very well know by now, the most famous rate to date used for interbank lending, the interbank offered rate (IBOR) is being discontinued and being replaced by alternate reference rates (ARRs).

Surprisingly, in a webinar hosted by the Association of Corporate Treasurers last week, more than 50% of the participants admitted that their institutions have not started work on IBOR Transition and more than 60% have not contacted any external stakeholders to discuss impact and expected changes. The FCA in particular, announced that LIBOR will be discontinued by 2021; this gives 2 years to banks and corporates to start thinking the potential impacts on their businesses.

For those who have not yet started to think about the impacts on Treasuries and why Treasurers should have this on the top of their list, below are some of the many changes one should expect.

  1. A Treasury’s hedging strategy will require adjustment; derivatives especially will need repricing based on the new rates and this will result in potentially having to re-adjust your hedging to maintain your institution’s risk appetite and hedge effectiveness ratio.
  2. Treasuries will face challenges in refinancing given that currently available ARRs are in overnight rates and are not yet sufficiently liquid. This means that Treasurers will need to design alternative funding strategies to reduce costs of funding using overnight rates. Adding to the complexity, there are different transition timelines across both jurisdictions and product types. The derivatives market for example is much more advanced in looking at ways to transition to ARRs, unlike the bond market, Similarly, UK and US, are more advanced looking at SONIA and SOFR respectively, unlike other jurisdictions that are still in the process of finalising what their respective ARR will be.  This has a direct impact on fair value calculations, hedge accounting and management of basis risk as the ARR chosen for derivatives might be different to the one on their underlying obligations.
  3. ARRs are expected to be lower than their IBOR equivalents; why is this? IBORs include the cost of bank credit risk and term liquidity risk as they are based on the submission of panel banks indicating where they can borrow unsecured funds in the relevant interbank market, whereas ARRs are based on overnight transactions, hence do not include this credit premium. This therefore means that in most cases ARRs are expected to be lower than their LIBOR equivalents and that adjustments will be required when pricing transactions in order to minimise the economic impact of the transition, most likely by the inclusion of a “risk premium”.
  4. New fund transfer pricing methodologies or adjustments to existing ones will most likely be introduced as a result of this and Treasury will have a key role in communicating this to the business and supporting them in understanding the impact of this on their businesses

What does this mean for Treasurers? Act fast!

  1. Perform an impact assessment to analyse specific impacts based on your business model and jurisdictional setup. The impact assessment should take a product angle to understand which of your institutions products are impacted, whether their maturity extends beyond 2021 and any interdependencies with other products for which transition might not be as advanced as others. Exposures should also be made available by counterparty as a whole.
  2. Identify new and existing documentation that reference LIBOR to determine what fall-backs apply if a benchmark rate ceases to be available and then initiate discussion with external counterparties to understand what changes they are making
  3. Prepare a phased plan for your transition, starting from the high impacted areas and products and ensure you have a firm-wide governance structure to help you implement your transition plan. A key success factor for this is to nominate an individual responsible for IBOR transition across your organisation.
  4. Engage with other market players and participate in industry-wide IBOR working groups to gain knowledge on best practices

Begin to mitigate legal and conduct risk by ensuring that any new IBOR issuances have an improved fall-back language in the contracts, and understand approach being taken to legacy contracts maturing after 2021