ICAEW’s Technical Manager, Financial Services Risk & Regulation John Mongelard says what Energy & Natural Resources firms need to do to avoid any surprises.
A victim of its own success the LIBOR (London InterBank Offer Rate) interest rate has crept into many loans and contracts. But from the end of 2021 it will be scrapped. It was based on a form of lending that banks no longer do anymore, so regulators have said it must end. But just saying it will end is not the end of the story. Among other things we may need to find a replacement rate (ideally another liquid rate, one that can be forward-looking) and we will have to navigate value transfer issues when contracts switch rates. But more importantly if you are running a business what exactly do you need to do?
- In Sterling (£/GBP) contracts and loans, many are switching from LIBOR to SONIA (Sterling Overnight Index Average). Firms therefore need to a) look at where they have exposures to Sterling LIBOR and then b) discuss with their bank or counterparty how to switch to a new rate.
- But what if you forget, or choose not to switch your LIBOR contracts and loans? Well, you will then have a contract that refers to a term that no longer has any meaning. Having a contract referring to ‘LIBOR’ in 2022 could put you in quite the legal quandary. To help, the UK government is bringing forward legislation to reduce the risk of contract uncertainty. Legislation could help if there are contract disputes outstanding on 1 January 2022 but, as always, ‘prevention’ is often better than ‘cure’. It therefore may be more prudent to take action where you can before 31 December 2021.
- A UK Finance poll showed businesses with less than 250 employees were most unlikely to be unaware of LIBOR being scrapped in the next 6 months. These firms should speak to an advisor and use the ICAEW resources freely available. ICAEW recently hosted speakers from the Bank of England and the Financial Conduct Authority, so you can hear it straight from the horse’s mouth about why you need to make changes soon.
- As above, many are switching from LIBOR to a SONIA rate. If that is not possible some are using the Bank of England base rate, the rate the UK central bank uses to control inflation and which many mortgages reference. However, just using base rate is not a ‘get out of jail free card’. If, for example, you have a LIBOR loan, you may hedge the risk that the interest rate rises with an interest rate swap or other financial derivative. Now you have to find a derivative that references Bank of England base rate (or whichever replacement floating rate you are using). Otherwise, a firm will be exposed to ‘basis risk’ where the floating rate on the loan is slightly different to the floating rate in the hedging derivative.
- Many questioned whether regulators were serious about LIBOR ending in December 2021 and whether the proverbial ‘can’ would be kicked down the road, not least because of the disruption of the pandemic in 2020. However, nearly all five currency LIBOR rates (Yen, Sterling, Euro, Swiss Franc and Dollar) will end this year. The exception is dollar LIBOR in some very liquid and short-term tenors. It will continue until end-June 2023 for legacy contracts. Where firms have exposures in USD LIBOR they should therefore be especially mindful. Liquidity in SOFR, the US replacement for LIBOR is likely to build now, following joint UK and US regulatory initiatives in July.
- Be wary of new rates trying to look like LIBOR. As an interbank rate, LIBOR carried a credit spread to reflect bank risk (banks are riskier than governments). Bloomberg offers a Short-Term Yield index (BSBY) but the worry is that it is based on transactions which may not perform well under stress. So, by all means use it, but you should understand the risks in so doing.
Read more about what you need to know about the LIBOR transition here.