The London Interbank Offered Rate (LIBOR)—the deep-rooted benchmark interest rate first established in the 1980s—is being phased out. Amid this change, BNY Mellon’s Joon Kim, Global Head of Trade Finance Product and Portfolio Management, Treasury Services, discusses the extensive impact this will have on trade finance and the importance of banks being fully prepared. Read his opinion piece below:
Over the past decade, the integrity of LIBOR—a benchmark interest rate used for all manner of financial contracts, from home mortgages and student loans to derivative pricing and receivables finance—has been increasingly called into question.
The death knell of LIBOR began to sound in 2012 when it was discovered that various banks had manipulated the rate in their favour—leading to hundreds of thousands of contracts being mispriced. In the wake of this, regulators stepped in to make sweeping changes. Not long after, however, diminishing volumes of interbank unsecured term borrowing—the basis for the reference rate—led regulators to set in motion the phase-out of LIBOR once and for all. In its place, regulators began to develop “risk-free rates” (RFRs), which use historical transaction data to derive a new benchmark.
With LIBOR used for millions of financial contracts worldwide worth more than USD$240 trillion[1], the decision sent shockwaves across the financial industry—not least within trade finance, where a huge number of contracts are either directly or indirectly linked to LIBOR. Given that the majority of these transactions are denominated in USD, the replacement of the USD element of LIBOR with an RFR—known as the Secured Overnight Financing Rate (SOFR)—will have by far the biggest impact. So amid these sweeping changes, some of which will be fully implemented at the end of 2021, what does this mean for banks and how should they prepare?
Understanding the change
Though SOFR will effectively serve as the replacement for USD LIBOR, there are some crucial differences between the two rates. For example, SOFR is a single daily, secured overnight rate, while LIBOR is split across seven different maturities. As a result, SOFR will require a daily compound to be calculated on an overnight basis—adding additional complexity to interest rate calculations for longer-term loans, such as those predominant in trade finance. This means that for a 360-day trade finance loan, the daily compound interest will need to be calculated 360 times—rather than once using a USD LIBOR with a 12-month maturity.
This adapted structure will also mean that SOFR rates cannot be calculated in advance—as the rate is backward-looking, compared to the forward-looking nature of LIBOR. This creates issues with respect to establishing discount rates and calculating risk premiums—a critical consideration in trade finance. As SOFR is likely to be lower than LIBOR, this spread will also have to be accounted for.
Key considerations
These significant differences mean that USD LIBOR cannot be simply swapped out with SOFR in existing contracts. As a result, preparation will be key—and banks will need to factor in a wide array of factors, including technology upgrades, model recalibration, contract renegotiations and fallback language.
For contracts being written today, banks need to make sure they take into account the end of LIBOR, with regulators recommending banks should stop issuing new LIBOR contracts as soon as possible. For existing LIBOR contracts that extend beyond the deadline, exposure needs to be identified and dealt with. Many contracts will include provisions—known as “fallback language”—that stipulate what should be used as a replacement rate in the event that LIBOR is not published. Such language, however, is often inconsistent across products and institutions, as well as intended for the temporary, rather than permanent, unavailability of LIBOR. This should, therefore, not be depended on—and lengthy renegotiations and repapering of many outstanding contracts will likely still be needed.
Fortunately, in response to growing concerns that many banks would be unable to implement the necessary volume of changes and renegotiate certain legacy contracts ahead of the 2021 deadline, the Financial Conduct Authority (FCA) recently announced an extension for the most widely-used USD LIBOR tenors—i.e. overnight, one-, three-, six- and 12-months— until June 2023. As a result, there will be far more contracts that will naturally mature before SOFR comes into effect, resulting in a decreased workload for banks.
But of course, the original deadline still applies for one-week and two-month settings of USD LIBOR—as well as other LIBOR currencies. What’s more, in spite of the deadline extension, regulators are advising banks that no new USD LIBOR contracts should be issued after 2021. Banks should therefore still be alert to the requirements of the upcoming December deadline.
Now is the time to prepare
Indeed, while the industry may find some respite in the deadline extension, there is still a lot to get done. From ensuring operational and technology systems are ready to use the new RFRs, to identifying and amending existing financial instruments and contracts that may be affected, there are myriad considerations at play—ones that banks need to be aware of and get right. As we continue to move forward on this journey, banks should look to establish dedicated teams that are committed to facilitating a seamless and successful transition away from LIBOR. Amid an already challenging environment, having such a comprehensive strategy in place will prove critical in the coming months and beyond.
The views expressed herein are those of the author only and may not reflect the views of BNY Mellon. This does not constitute Treasury Services advice, or any other business or legal advice, and it should not be relied upon as such.
[1] https://www.bloomberg.com/opinion/articles/2019-12-06/wave-goodbye-to-libor-welcome-its-successor-sofr
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