No more Libor: trade finance users unprepared for transition
There's just over three months to go until the first cessation of certain Libor rates. So why do corporate users of trade finance still have a long way to go in transitioning all of their Libor-linked instruments to a suitable alternative?
After years of preparation for its cessation there is now a clear timeframe for transition from Libor – the longstanding default benchmark rate for trade finance. After 31 December 2021, Libor rates for sterling, euro, swiss franc and yen, as well as one-week and two-month US dollar Libor, will no longer be published – with cessation of US dollar one-day, one-month, six-month and one-year rates to follow in 2023.
As a result, financial markets across the world have just three months to transition their Libor-linked exposures to a suitable alternative rate. However, a recent TXF report – ‘No more Libor: What next for trade finance?’ – undertaken in collaboration with Baker McKenzie and BAFT (Bankers Association for Finance and Trade), finds that many corporates within the trade finance sector are still underprepared for the 2021 transition, and more surprisingly, even the 2023 transition.
Libor is an average rate based on a small number of banks’ daily estimates of their cost to borrow unsecured funds from each other and has a critical role in global markets as the world's most widely used benchmark for short-term rates. At almost 40 years old, it is widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including adjustable-rate mortgages, credit cards, floating-rate bank loans and interest rate swaps.
It is estimated that across these markets Libor underpins approximately $300 trillion of financial contracts worldwide, according to the Bank of England Working Group. Consequently, the cessation of Libor is going to have huge ramifications for every Libor-linked exposure.
Why move away from Libor?
While global markets have grown in complexity and size, the methodology for calculating Libor rates has remained unchanged. The main argument for moving away from Libor – apart from the 2012 Libor rates manipulation scandal – is because it is no longer based on sufficient volume of actual transactions. Following the 2008 Global Financial Crisis, banks were unwilling to lend to each other, eliminating observable financial transactions and consequently, the ability for the Intercontinental Exchange (ICE), the exchange tasked with collecting and publishing the data, to generate an empirically robust Libor rate.
As real transactional data dried up that referenced Libor, it became increasingly reliant on ‘expert judgement’ from the 20 Libor panel banks, a position that was ultimately deemed untenable by many. Indeed, in 2012 many of these banks (Deutsche, Barclays, Citigroup, JP Morgan Chase, and Royal Bank of Scotland) were found to have abused their position by manipulating Libor rates.
As a result of the rate fixing scandal, and concerns over the volume of transactions, in 2017, the UK Financial Conduct Authority (FCA) announced it would not support the production of Libor after the end of 2021, paving the way for its discontinuation.
What will replace Libor?
Risk Free reference rates (RFRs) are the alternative rates which have been identified as the favoured Libor replacement. RFRs are deemed risk free, or as near as makes little difference, because they are based on real, short term (overnight) transactions, removing the risk associated with ‘expert judgements’, as well as credit and term risk.
The Bank of England, which convenes and hosts the UK industries Working Group on Sterling Risk Free Reference Rates (RFRWG), has marked RFR as the preferred alternative to Libor. This is a broad industry group and includes representation from corporates and relevant trade associations (such as the Association of Corporate Treasures).
One RFR is set to replace each Libor-quoted currency. SOFR for the US dollar, SONIA for sterling, ESTER for the euro, TONAR for the yen, and SARON for the swiss franc. Each of these RFRs will be based on live data from their corresponding underlying, and importantly, liquid market.
It is estimated by the Federal Reserve Bank of New York that the transaction volumes underlying SOFR are approximately $1 trillion in daily volumes. According to the Bank of England, in Q2 2202 Sonia was underpinned by £60 billion of daily transactions.
While US dollar Libor is the most widely used benchmark across the trade finance industry globally, the transition of sterling and other Libor currencies will have a marked impact on the trade finance sector.
“There are now deep and liquid markets across the SONIA product set,” says Alastair Hughes, head of division in the Bank of England’s Markets Directorate, and responsible for work on risk-free rate transition. “In lending we have seen a wide range of borrowers access SONIA facilities. We are not just talking about large multinationals like Shell here, but also businesses such as National Express and housing associations. We're seeing tens of billions worth of SONIA-linked sterling facilities being put in place and this number is growing all the time.”
Both RFRs and Libor reflect short-term borrowing costs, however Libor can’t simply be swapped out with an RFR in existing contracts that reference Libor – at least not without appropriate adjustments.
While Libor is a forward-looking rate, giving the cost of borrowing for the future period starting on the day it is published, an RFR is backward looking. This means that borrowers with debt linked to an RFR will not know the floating rate for each interest period until the end of the period.
Furthermore, as an RFR does not include a credit premium for the banking sector, it typically fixes lower than Libor. As a result, amending loan agreements for Libor transition to incorporate appropriate transition language will be key. As such, the main objective during transition will be to minimise the transfer of economic value between the parties as the transition is made to the relevant RFR plus a Credit Adjustment Spread.
Corporates need to catch up
Despite the progress by the Bank of England and FCA in establishing SONIA, it is apparent many corporates are dragging their feet on Libor transition. Survey results from TXF’s report indicate nearly 70% of corporates are not prepared to successfully transition from Libor by 31 December 2021, or even the 30 June 2023 deadlines.
“I don’t think understanding the new index is a problem for the financial community. I think the problem is leaving Libor,” says Justo García, at Homt Infrastructures, an engineering, procurement and construction contractor. “We're accustomed to Libor, it’s difficult to get rid of it.”
That perception of the market is evident in the data. Across all the corporates surveyed, just 13% of all their Libor-linked exposures have been successfully transitioned to an RFR. And if any of these Libor-linked exposures are backstop facilities that are yet to be drawn, it is likely that the percentage of exposures that have been successfully transitioned is lower than 13%.
A combined 88% of those surveyed stated that transitioning Libor-linked trade finance exposures to an alternative RFR was difficult. This was reported as a reason why ‘very little progress’ (1.6 out of five) has been made. “There's some quite complex economics around moving from one rate to the other,” says Hughes. “But I think the important thing here is that there is clear guidance to make sure financial providers know and understand they have programmes and governance in place to monitor and help people move across.
“We're very aware corporates sometimes feel there's a knowledge gap between them and the financial service provider. And obviously, historically there have been some unfortunate cases, which may mean, they're not as trusting of financial service providers as perhaps they once were.”
Digging into the data further, corporates offering derivatives, swaps, and futures have made the most progress in transitioning away from Libor – 36% of corporates reported that they had made a great deal of progress in this space. Less progress has been made with bank-to-bank loans (18%), traditional trade (11%), supply chain finance (8%), and structured trade/export finance (4%). Trade/export finance is by far the least prepared with 38% reporting none or minimal progress in transitioning.
Some of the slow progress is down to lack of prioritisation. Dealing with fallout from Covid-19 (48%) and Brexit (25%) were both cited by corporates as more important than transitioning all Libor-linked exposures to an alternative RFR (just 3% of corporates stated that Libor transition was their top priority). To compound matters, there was a reported lack of understanding of what Libor cessation means and how to go about successfully transitioning their Libor-linked exposures to a RFR.
Responses also highlighted a disparity between the perceived level of support corporates get from the banks and banks’ perception of their own support. This was made worse by a lack of clarity on which RFRs should be used, with delays in the development of a forward-looking RFR being one of the biggest hurdles.
This sentiment was echoed by García. “Right now, we are working on our project in the Maldives and are still using Libor as reference rate.
“We are not receiving enough information from the banks in order to know what is going to happen in the coming months. I think that they [the banks] are praying for an extension of Libor. My perception is that there is a kind of reluctance to proceed.”
A forward-looking rate for trade finance
The construct of RFRs might work for some in the export finance market – but not for all. Sovereigns, state-owned enterprises and borrowers in emerging markets in particular might struggle with the backward-looking nature of RFRs.
“To substitute Libor exactly would be to replicate its weaknesses '' says Hughes. “The underlying market that Libor seeks to measure – the market for unsecured wholesale term lending between banks – is no longer sufficiently active to support such a widely used reference rate. This has not changed in the last four years, and it makes Libor a less reliable and more volatile rate – not good characteristics for users of the rate, such as corporates.”
Compounded SONIA, to give it its full title, is the preferred replacement for sterling Libor recommended by the Working Group. And for the majority of products that currently use Libor, SONIA is the recommended alternative. However, the Working Group acknowledged in its use case paper that a limited proportion of the cash market would likely require alternative rates. Trade and working capital products such as supply chain finance and receivable facilities require a term rate or equivalent to calculate forward discounted cash flows to price the value of assets into the future.
The result has been the development of two forward looking Term SONIA reference rates (TSRR), produced by the ICE Benchmark Administration (IBA) and Refinitiv, both respected and regulated benchmark providers in the UK.
TSRR are forward-looking rates, similar to Libor, in that the rate is fixed at the outset of the given interest period. Term SONIA reflects the expected average Compounded SONIA rate over a given period, but unlike SONIA, it is not necessarily based on actual transactions.
Dealing with legacy
Standard and forward-looking SONIA rates will not ease everyone's concerns. There will be a significant pool of ‘tough legacy contracts’ referencing sterling Libor that will mature beyond the end of this year. Many of these contracts cannot be amended or don’t have robust contractual fallback language that will automatically transition those contracts to robust alternative rates.
As a result, the Bank of England, in collaboration with FCA, has created a ‘safety net’ for corporates that are unable to transfer to the SONIA rates with the creation of a synthetic Libor rate. The FCA was given those powers by the UK government through legislation which was passed earlier this year (Financial Services Act 2021).
Hughes stresses that it should be seen as a ‘bridge’ that is there to aid a smooth transition, and not a permanent solution. “The FCAs new powers will help ensure there is safety net in place, but this does not remove the need for borrowers to act and we continue to encourage market participants to amend their contracts where they can,” said Hughes. “Any safety net the FCA provides in the form of a synthetic Libor rate would be for a time limited period. The FCA have proposed these synthetic rates would be based on forward-looking risk-free rates, so SONIA for sterling, plus the relevant credit adjustment spread.”
The FCA still needs to confirm which legacy contracts will be permitted to use synthetic Libor and that decision will not be confirmed until the end of this year. TXF understands that It is expected to run for a maximum of 10 years.
The TXF perspective
It has long been understood that there are more hurdles to Libor transition in trade finance than in other sectors. With greater clarification on forward looking SONIA rates and incoming legislation on synthetic Libor, it’s important that corporates and banks engage with each other to come to mutually acceptable solutions.
The example of two forward looking rates in the UK has shown that it is possible to develop usable forward-looking term risk-free rates. All the pieces are now in place for a Term SOFR (US dollars) to be developed. For export finance and project finance, this is particularly significant as 88% of deals across 2020 were financed in US dollars. However, for this to take place the underlying SOFR derivatives markets, which underpins the creation of a robust Term SOFR, must increase in volume and liquidity. With new use of US dollar Libor discouraged after the end of 2021, this liquidity needs to develop quickly.