The planned discontinuance of LIBOR and replacement by alternative rates, creates both challenges and opportunities for corporates in the MENA region. Delaying preparation for this transition, could lead to significant economic and operational impacts. The London Interbank Offer Rate (LIBOR) is one of the most common series of benchmark interest rates, referenced by contracts measured in the trillions of dollars across global currencies.
Regulators and industry bodies have proposed and agreed on the new interest rate benchmarks that would replace LIBOR rates, and LIBOR rates are anticipated to be no longer published or supported after the end of 2021. These new alternative rates are likely to impact corporates significantly, as the users of LIBOR linked products, as replacing LIBOR will affect a significant number of financial agreements (within treasury, finance and across the organisation).
It is imperative that corporates mobilise to ensure that they are able to reliably communicate with key stakeholders the nature of their LIBOR exposures, and the impact of LIBOR reforms on their organisations. Are you ready for the TRANSITION?
Cash and cash equivalents: Sweep accounts and transfer pricing.
Accounts receivable: Payment penalties, factoring arrangements.
Fixed income investments: Liquidity and impact on pricing.
Customer arrangements: LIBOR payment terms, contract modification.
Operating leases, sales-type/direct financing leases
Derivatives: ISDA protocol and economics. Impact on hedging relationships.
Other assets: Consider LIBOR usage in contract terms, and impairment models.
Term data/credit facility (fixed): Attractiveness to investors. Hedging. Pricing.
Term debt/credit facility (floating): Fallback. Sensitivity to funding risks. Hedging. Operational risks with coupon payments.
Commercial paper: Pricing and liquidity.
Intercompany loans: Repricing, profitability shifts between entities.
Other liabilities: Liquidity on long dated contacts.
Equity (preferred stock with a floating rate component): Valuation shift.
Pension assets (defined benefit): Basis risk between pension assets and liabilities? Value transfer during transition?
The time to act is now. The deadline for the phase out of LIBOR from your business processes will be the end of 2021, maybe sooner.
Even now, there are significant events driving the market to adopt the new transition rates. Companies may experience difficulty in offloading LIBOR-based assets as 2022 approaches.
The LIBOR transition is not only a financial industry problem. LIBOR exposure is lurking in more than derivatives and investments.
The Risk of Value Transfer is real and companies must actively manage basis risk between LIBOR and alternative reference rates. Fallback language helps establish how financial instruments settle cash but will not fully mitigate basis risk.
Various jurisdictions are eliminating IBOR rates and will adopt replacement rates as follows:
Although Panel Banks will continue to participate in the LIBOR submission process until the end of 2021, market participants are actively preparing for the transition by identifying exposures, understanding the impact of those exposures, and taking action to modify both direct LIBOR references and contractual fallback provisions, that would be triggered if LIBOR ceases to exist.
Some corporations provide funding to their customers or clients as part of sale transactions or enter into other contracts such as procurement contracts that could contain references to LIBOR. These types of contracts and arrangements are frequently dispersed throughout the company making it difficult to readily identify a company’s exposure.
The transition away from LIBOR will require additional considerations for current systems and processes. Specifically, current systems may not have been designed to source replacement rates, or may be unable to perform the calculations required to value financial instruments and accrue interest based on new reference rates. In addition, the impact that the LIBOR transition would have on processes such as transfer pricing and intercompany funding will need to be assessed.
Companies will need to evaluate their methods and approach to interest rate management and monitoring, in order to accommodate the transition from LIBOR to alternative reference rates. As LIBOR is phased out, interest rate management programs should expect to encounter challenges from potentially reduced liquidity for LIBOR-based products, basis risk between products and currencies, and general uncertainty around transition. Furthermore, lines of credit and borrowing facilities are often tied to LIBOR or another benchmark interest rate. These agreements would need to be renegotiated or amended, to appropriately reflect the new benchmark interest rate and any subsequent credit spread adjustments required.
Differences in transition or fallback provisions between debt, cash products and derivatives can create basis risk.
Challenges may arise with existing cross-currency basis risk management instruments that reference two floating rates.
Institutions need to understand the to-be curve construction and behavior, to appropriately develop risk management strategies and transition plans.
Companies should evaluate the economic impact of International Swaps and Derivatives Associations (ISDA’s) proposed changes relative to hedged exposure, along with the economic impact of the fallback language for cash products.
Analyses of LIBOR exposure will allow corporates to develop appropriate transition and hedging strategies.
As we move closer to the end of 2021, it is likely that LIBOR-based financial instruments will likely experience a decrease in liquidity. The trading volume challenges of LIBOR-linked products, could lead to changes in pricing, and companies would need to decide when to make the switch from LIBOR to SOFR or other risk-free rate (RRF) products.
LIBOR-based financial instruments would be more difficult to liquidate as we get closer towards the end of 2021, as market demand for such instrumentscould decline.
Volatility in SOFR and other alternate reference rates (especially at period end) and uncertainties around the availability of forward-looking tenor rates may increase settlement risk.
As a result of the transition away from LIBOR, standard setting and regulatory bodies have reviewed their regulations and standards in contemplation of other reference rates, and the practical implications of LIBOR reform. In particular, changes to the accounting guidance, including hedge accounting and debt modification/extinguishment, would likely impact companies.
Similarly, tax authorities are contemplating how the transition away from LIBOR would impact issues related to deemed taxable exchanges based on modifications, credit spread adjustments and transfer pricing. These discussions are expected to continue as standard setters and regulators continue to respond to market developments. As a result, corporates should continuously monitor regulatory developments throughout the transition process.
A change from LIBOR to SOFR could critically affect accounting conclusions. While the IASB is looking to provide relief in some areas, corporations will need to stay abreast of IASB decisions, and consider the timing of their LIBOR transition efforts with the effective date of relief provisions provided by the IASB.
Limited historical replacement rate market data (e.g. volatility) could present challenges when valuing instruments such as options, caps and floors.
Existing financial products with scheduled maturities beyond 2021 that provide for LIBOR-based interest payments, would need to be modified to reference SOFR or another alternative rate.
Additionally, new financial instrument contracts that reference LIBOR and extend beyond 2021, will need to contain fallback provisions that specify an alternative rate other than LIBOR, that would be used if and when certain trigger events occur. Financial instrument contracts that do not contain relevant fallback provisions could result in a negative economic impact, or an invalid reference rate. Even cash products that contain fallback language that references the end of LIBOR, are still highly susceptible to value transfer, as no perfect mechanism exists to adjust for the spread between LIBOR and SOFR or other alternative reference rates.
A more than minor modification to a contract may be deemed an extinguishment of a debt instrument, resulting in the recognition of gains or losses.
Transfer pricing or tax issues could arise if intercompany funding or other agreements are not appropriately modified to include fallback language.
Given the differences in conventions, potential timing differences of when certain fallback provisions are triggered, and the possible downstream effects on corporate cash flows, operations or even hedge accounting, corporates that wait to plan their transition could find it increasingly difficult to mitigate the associated risks.
As new alternative reference rate products become available, investment committees will need to prepare for future issuances, by understanding the liquidity and pricing in the market for LIBOR products compared to products with alternative rates. This understanding will permit investment committees to determine how the alternative rates complement or require adjustments to existing strategies. We expect first mover advantages for those institutions, who can strategically transition their portfolios from LIBOR to SOFR and other risk-free rate-linked products in a timely manner. Proactive institutions are actively monitoring their investment strategy to minimize the acquisition of LIBOR-based products with maturity dates extending beyond 2021. Any strategy for minimizing LIBOR exposure should consider direct exposure (holdings of LIBOR-linked products with maturity dates extending beyond 2021) and indirect exposure (products, valuation techniques, systems, etc. that may have an underlying/input that is impacted by changes in LIBOR).
Similar to the changes for investment portfolios, corporates that manage long-dated pension assets will need to monitor those investments, and determine if the terms of the investments, which may have been determined far before LIBOR reform was contemplated, require adjustment.
Changing investment strategies and/or exiting existing positions, in an orderly manner to reduce LIBOR exposure, could require an extensive amount of time. Analyzing and addressing LIBOR exposures now would reduce the likelihood of unfavorable impacts.
Valuation models for investments may need to be modified to incorporate SOFR or other alternative rates.
Corporates need to have plans that set out how their organisations will move towards these alternative rates, and then refine them as the industry and regulators clarify the biggest unknowns.
We can help ensure that the potential risk consequences associated with LIBOR’s replacement are anticipated and appropriate plans and resources are allocated to identify and mitigate their effect.
Along with our team of dedicated LIBOR professionals, technology and sector expertise, we can help you find ways to progress and succeed - even in periods of uncertainty. To deliver meaningful change, we would work with you to implement the key components of a comprehensive LIBOR transition plan.
Partner - FS Finance Function Leader, PwC Middle East
Tel: +971 4304 3100
Director, Treasury Advisory, PwC Middle East
Manish Agrawal, CFA
Senior Manager, Treasury Advisory, PwC Middle East