The fate of Libor, the rate that underpins $350 trillion worth of financial contracts, has been hanging in the wind for years. Now its future is clear: The U.K.'s Financial Conduct Authority (FCA) says Libor will cease to exist by the end of 2021. And that means a lot of work for corporate treasurers, who are responsible for all those loan agreements, derivatives contracts, and other documents that refer to Libor.

The reputation of Libor, the rate at which major banks lend to one another, was tarnished by a 2012 scandal that revealed banks had manipulated the rate. But regulators' move to pull the plug has more to do with the fact that in the wake of the financial crisis, interbank lending tailed off, making the bank quotes on which Libor is based largely hypothetical. In fact, in his speech announcing that Libor would cease, FCA chief executive Andrew Bailey said that for one of Libor's 35 currency and maturity iterations, 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 still scrambling to settle on replacement rates. In June, the Alternative Reference Rate Committee (ARRC), a group convened by the Federal Reserve, recommended that the U.S. shift to using the Treasury repo rate—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 will begin publishing the new rate sometime next year.

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

With regulators proposing new rates and Libor still around for another four-plus years, the process of changing over seems to be getting off to a good start. But that doesn't take into account the many, many contracts out there that use Libor and extend beyond 2021.

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

“No one has read these clauses with any level of material attention since they were first drafted,” Jones said. “They vary widely.”

He cited the “practical complexity” of forcing market participants to deal with a number of different alternative rates on outstanding contracts. “Right now we're in a situation where a lot of documents have a fairly wide variation in what the alternate to Libor is, most of which present different mechanical problems to the bank that's supposed to provide a rate and probably represent some disruption,” Jones said.

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

But it's not possible to unilaterally rewrite a financial contract. Even if ISDA comes out with a protocol for derivatives contracts or banks agree on new loan language, financial institutions will have to get the corporate customers with which they executed the contracts to agree to the change.

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

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

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

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

He also noted the possibility that Libor could go away sooner than expected, perhaps because too many banks balk at providing quotes. “It strikes me there's still some risk there could be a crisis out there,” Jones said.

Lots of Paperwork

Tom Deas, who is former chairman of both the National Association of Corporate Treasurers and the International Group of Treasury Associations, said that even if banks and end users get together and agree to amend outstanding contracts to reflect Libor's replacement, corporate treasurers will still have to deal with many more arcane agreements that their companies have outstanding.

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

“Take a retiree who was going to be paid an amount after retirement on a deferred basis and it would accrue interest at Libor,” 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. And you know, I can't believe that most people—when they understand it—would object to [the change], but it just becomes a big administrative drill that people have to go through in order to do that.”

Deas noted that changes to escrow agreements would have to be approved by three parties, rather than just two: the party that put up the amount in escrow, the party that is to receive that money, and the bank that is holding it. And corporations with intracompany loans are supposed to have agreements setting forth the terms of the loans; changes to those agreements may have to pass muster with tax authorities and other regulators in the countries where the subsidiaries are located, he said.

Deas also noted the possibility that changing the rate on which a loan agreement is based could trigger tax consequences. “Under U.S. tax law, if a loan agreement is changed by more than a de minimis amount, it's considered a redemption of the old agreement, 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, Deas concluded: “It's not that the hurdle is very high, it's just that there are a lot of these little hurdles that you have to jump over.

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

Keeping Track

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

At a couple of recent roundtables for finance and treasury professionals, Hunt said, he saw more concern about the change from those whose companies are in the financial sector—insurance companies, 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 just mean amending their credit agreement, while those at financial firms might use the rate for many transactions.

Kevin Ruiz, a principal at Chicago-based consultancy Treasury Strategies, said that while some companies are doing a good job of tracking which contracts rely on Libor, others may not even be aware 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 risk exposures, including the rates on which these contracts are based.” Companies should also be aware of whether any of their contracts that use Libor also cite a fallback rate to use if Libor isn't available, he said.

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

“These kinds of changes, the genesis of them is not necessarily a good thing, but the outcome is usually great,” he said. “It forces 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 to ask 'Why are we doing what we are doing?'”

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Libor&rsquo;s 2021 Demise Means More Work for Treasury

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