The fate of Libor, the rate that underpins $350 trillionworth of financial contracts, has been hanging in the wind foryears. Now its future is clear: The U.K.'s Financial ConductAuthority (FCA) says Liborwill cease to exist by the end of 2021. And that means a lot ofwork for corporate treasurers, who are responsible for all thoseloan agreements, derivatives contracts, and other documents thatrefer to Libor.

|

The reputation of Libor, the rate at which major banks lend toone another, was tarnished by a 2012 scandal that revealed banks had manipulated the rate. But regulators' move to pullthe plug has more to do with the fact that in the wake of thefinancial crisis, interbank lending tailed off, making the bankquotes on which Libor is based largely hypothetical. In fact, inhisspeech announcing that Libor would cease, FCA chief executiveAndrew Bailey said that for one of Libor's 35 currency and maturityiterations, the dozen banks that submit quotes had, in all of 2016,done just 15 transactions big enough to be relevant.

|

The FCA sounded Libor's death knell as regulators were stillscrambling to settle on replacement rates. In June, the AlternativeReference Rate Committee (ARRC), a group convened by the FederalReserve, recommended that the U.S. shift to using the Treasury reporate—what people pay to borrow money overnight using U.S.Treasuries as collateral. The Fed has put out a request for comments on the recommendation and says it willbegin publishing the new rate sometime next year.

|

The U.K. has said it will replace Libor with Sonia, the SterlingOver Night Index Average, the rate at which U.K. banks borrow fromeach other overnight.

|

With regulators proposing new rates and Libor still around foranother four-plus years, the process of changing over seems to begetting off to a good start. But that doesn't take into account themany, many contracts out there that use Libor and extend beyond2021.

|

Richard Jones, chair of the finance and real estate practicegroup at the law firm Dechert, said most sophisticated contractsthat use Libor as a benchmark provide an alternative rate to beused if Libor is unavailable, though he notes that the authors ofthe clauses generally assumed the alternative would be used for aday or two when Libor wasn't published, not as a remedy for therate's permanent discontinuation.

|

“No one has read these clauses with any level of materialattention since they were first drafted,” Jones said. “They varywidely.”

|

He cited the “practical complexity” of forcing marketparticipants to deal with a number of different alternative rateson outstanding contracts. “Right now we're in a situation where alot of documents have a fairly wide variation in what the alternateto Libor is, most of which present different mechanical problems tothe bank that's supposed to provide a rate and probably representsome disruption,” Jones said.

|

The International Swaps and Derivatives Association (ISDA) hassaid it is working on a protocol that would amend derivatives contractsthat cite Libor to reflect a new rate, similar to a protocol itprovided after the euro was introduced.

|

But it's not possible to unilaterally rewrite a financialcontract. Even if ISDA comes out with a protocol for derivativescontracts or banks agree on new loan language, financialinstitutions will have to get the corporate customers with whichthey executed the contracts to agree to the change.

|

And it's not as simple as just substituting one rate foranother. As a measure of what banks charged each other to borrow,Libor took into account the credit risk of the banks. The Treasuryrepo rate measures the cost of short-term loans backed by U.S.Treasury securities, and is therefore a risk-free rate. Updates toexisting contracts would have to include a calculation to amend thespread to reflect the risks of the parties to the transaction.

|

Jones said it's likely that financial institutions and theircustomers will reach agreements to amend outstanding contracts.

|

“Most people, most deals, the bank calls the borrower up andsays, 'We've got this new rate and we'd like to modify theagreement to adjust the rate and spread so you, the user, will getsort of what your expectations were,'” he said. “People will say,'Absolutely, send it over.' I think that's going to happen alot.”

|

But the banks still need to get in touch with all theircustomers and get them to agree, and some customers might balk inhopes of getting a better deal. “It won't be seamless; it won't besmooth,” Jones said.

|

He also noted the possibility that Libor could go away soonerthan expected, perhaps because too many banks balk at providingquotes. “It strikes me there's still some risk there could be acrisis out there,” Jones said.

Lots of Paperwork

Tom Deas, who is former chairman of both the NationalAssociation of Corporate Treasurers and the International Group ofTreasury Associations, said that even if banks and end users gettogether and agree to amend outstanding contracts to reflectLibor's replacement, corporate treasurers will still have to dealwith many more arcane agreements that their companies haveoutstanding.

|

Treasurers “have got more bases to touch,” Deas said. “It's amore labor-intensive exercise to affect what could be thousands ofagreements and get them modified. It's not a difficult task, butit's just burdensome by the volume of agreements that need to bemanaged.”

|

“Take a retiree who was going to be paid an amount afterretirement on a deferred basis and it would accrue interest atLibor,” he said. “In common-law countries like the U.S. and U.K.,you've got to get agreement with that retiree to the change. Andyou know, I can't believe that most people—when they understandit—would object to [the change], but it just becomes a bigadministrative drill that people have to go through in order to dothat.”

|

Deas noted that changes to escrow agreements would have to beapproved by three parties, rather than just two: the party that putup the amount in escrow, the party that is to receive that money,and the bank that is holding it. And corporations with intracompanyloans are supposed to have agreements setting forth the terms ofthe loans; changes to those agreements may have to pass muster withtax authorities and other regulators in the countries where thesubsidiaries are located, he said.

|

Deas also noted the possibility that changing the rate on whicha loan agreement is based could trigger tax consequences. “UnderU.S. tax law, if a loan agreement is changed by more than a deminimis amount, it's considered a redemption of the oldagreement, which gives rise to tax consequences, a gain or loss,and the issuance of a new agreement,” he said.

|

Summing up the process of preparing for the end of Libor, Deasconcluded: “It's not that the hurdle is very high, it's just thatthere are a lot of these little hurdles that you have to jumpover.

|

“It becomes a paperwork-intensive thing that treasurers have tomanage,” he said. “They're going to have to look at all manner ofagreements out there and help guide the efforts to get appropriateamendments, whatever's required.”

Keeping Track

Tom Hunt, director of treasury services at the Association forFinancial Professionals, said the level of concern about Libor'sreplacement seems to be related to a company's industry.

|

At a couple of recent roundtables for finance and treasuryprofessionals, Hunt said, he saw more concern about the change fromthose whose companies are in the financial sector—insurancecompanies, banks, and other financial services companies.

|

Manufacturing companies might go to market only every few years,he said, and responding to the change in the base rate might justmean amending their credit agreement, while those at financialfirms might use the rate for many transactions.

|

Kevin Ruiz, a principal at Chicago-based consultancy TreasuryStrategies, said that while some companies are doing a good job oftracking which contracts rely on Libor, others may not even beaware of which rate a contract uses.

|

“I'm not saying everybody should be freaking out,” Ruiz said.“I'm saying most treasurers should have a strong view of their riskexposures, including the rates on which these contracts are based.”Companies should also be aware of whether any of their contractsthat use Libor also cite a fallback rate to use if Libor isn'tavailable, he said.

|

But Ruiz has an upbeat view of the efforts treasuries are likelyto have to expend to prepare for Libor's replacement.

|

“These kinds of changes, the genesis of them is not necessarilya good thing, but the outcome is usually great,” he said. “Itforces you to make changes in the ways you've always done things,it forces you to look at your contracts, and it forces to you toask 'Why are we doing what we are doing?'”

|

Complete your profile to continue reading and get FREE access to Treasury & Risk, part of your ALM digital membership.

  • Critical Treasury & Risk information including in-depth analysis of treasury and finance best practices, case studies with corporate innovators, informative newsletters, educational webcasts and videos, and resources from industry leaders.
  • Exclusive discounts on ALM and Treasury & Risk events.
  • Access to other award-winning ALM websites including PropertyCasualty360.com and Law.com.
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.

Susan Kelly

Susan Kelly is a business journalist who has written for Treasury & Risk, FierceCFO, Global Finance, Financial Week, Bridge News and The Bond Buyer.