Outlook for Corporates

On 16 January 2020, UK regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) issued a letter to major banks and insurers currently supervised in the UK [1]. This letter reiterated the consistent message that, “the intention is that Sterling LIBOR will cease to exist after the end of 2021” and also, importantly, that, “no firm should plan otherwise.” The Financial Policy Committee previously echoed this sentiment in October 2019 noting further that, “there is no justification for firms continuing to increase their exposures to LIBOR” [2]  

This recent letter sets out the Regulator’s expectations for transition progress during 2020, including the following series of targets:

  • Switch the convention of Sterling interest rate swaps (swaps) from Sterling LIBOR to SONIA in derivative markets from 2 March 2020; 
  • Cease issuance of cash products linked to Sterling LIBOR by end-Q3 2020; and
  • Significantly reduce the stock of Sterling LIBOR referencing contracts by Q1 2021.

A number of areas which are considered key to delivery, and should feature in sell-side firms’ planning from Q1 2020, were also set out in the letter, including product development and client communications and awareness.

But what does this mean for Corporates?

These latest developments send a clear message about Sterling LIBOR transition to the financial sector, encouraging an increase in pace of their transition activities or risk supervisory measures. However, this recent letter also sends a broader message to the non-financial sector in terms of ensuring such firms are ready and are actively engaging with the transition. In the first direct communication from the UK regulators with firms in the non-financial sector, the Bank of England and FCA issued a joint letter on 9 March 2020 to trade associations setting out the impact transition will have on their members and stakeholders [3]. This communication highlights how serious they are about meeting transition target dates. We examine the key implications of the recent target dates for Corporates below.

Shifting the swap market convention 

UK regulators state that SONIA should be prioritised over Sterling LIBOR for new Sterling swaps and that Sterling LIBOR exposures should be kept to a minimum after 2 March 2020. This deadline is almost upon us and we anticipate increasing volumes of new, SONIA-referenced products being offered by banks. Not everyone wants to be a first-mover but the deadline means that transition is inevitable. Corporates should consider:  

  • Revisiting risk management strategies to assess whether they remain effective following the transition, especially where the underlying exposure remains linked to Sterling LIBOR.
  • Switching from Sterling LIBOR to SONIA will impact the price of a swap. It is important that corporates understand the new pricing convention so that they can assess the cost of the swap.
  • The execution of any new product types will require an assessment of structure and pay off profiles and updates to risk management policies.

Cease issuance of cash products 

UK regulators expectation is that the issuance of Sterling LIBOR based cash products with maturities beyond 2021 should end by Q3 2020. The biggest challenge facing UK regulators in achieving this target relates to the development of a term structure. Many of our corporate clients are reluctant to execute SONIA referenced cash products until there is greater clarity on the pricing convention. The current view of the Working Group on Sterling Risk-Free Reference Rates is that SONIA, compounded in arrears, will and should become the norm. This is consistent with the regulators’ preference and expectation that term rates not be used except where absolutely necessary. Therefore, whilst they might be available, the expectation is that they will not be widely used and that the market should not wait for a term rate to be developed. The regulatory cost of using such products is likely to outweigh the benefits for lenders. Corporates should consider:  

  • At present, the term structure of Sterling LIBOR provides Corporates with certainty of cash flows, helping in the management of their forecasting and liquidity and, in turn, developing funding and hedging strategies. Corporates will need to adopt forecasting processes, investment and funding strategies to reflect the new pricing convention.
  • Corporates will need to bear in mind the operational requirements for accommodating the new pricing convention and will need to ensure that systems can be configured.
  • Switching from Sterling LIBOR to SONIA will impact the price of a cash product. It is important that corporates understand the new pricing convention so that they can assess the cost. Additionally, it will be important to understand the difference in the pricing convention of a cash product vs hedging product in order to assess whether the risk management strategy remains effective.
  • The execution of any new product types will require an assessment of structure and pay off profiles and updates to risk management policies.  

To help meet this Q3 target, a Loan Enablers Task Force has been established to work through the perceived barriers to transition in the sterling lending market. The Task Force has set out a roadmap that is intended to guide market participants in achieving this target [4].

Reduction in stock of LIBOR referenced contracts

To achieve the target of Q1 2021, UK regulators expect a reduction in the execution of products linked to LIBOR as well as the transition of legacy Sterling LIBOR products to SONIA. 

  • Banks may be reluctant to offer Sterling LIBOR products beyond Q1 2020 in an effort to meet the regulatory target. Corporates need to be prepared to execute SONIA products this year. Product development is not straightforward given the complexities of market convention for loans, and differences in pricing conventions across geographies.
  • Corporates can expect engagement from their counterparties to transition any legacy Sterling LIBOR products to SONIA. However Corporates should not wait for the bank to engage and should instead initiate conversations to understand the bank’s transition process and build this into their own transition plan.
  • As liquidity in Sterling LIBOR reduces, a potential risk to Corporates who continue to maintain a LIBOR portfolio may present itself in the form of increased costs of funding and hedging [5]. 

The above is complicated by progress on SOFR (the risk free rate (RFR) for USD products and other RFRs, which is slower then Sterling LIBOR. A lack of alignment in timelines creates complexity for transition projects, and there is a risk that firms focus on Sterling to the exclusion of other currencies, or that firms with non-Sterling LIBOR exposures will not progress in the absence of concrete target dates. The pricing convention for a USD loan linked to SOFR maybe different to that for a GBP loan linked to SONIA. This can have implications for funding costs, hedging strategies and transfer pricing for intercompany loans. 

This letter is the culmination of a series of clear signals from Regulators that the transition is happening and Sterling LIBOR will “cease to exist after the end of 2021”. Some sections of the market do not appear to be fully convinced, but what the PRA and FCA have called LIBOR’s “expected demise” makes 2020 the make-or-break year for the transition. Whether or not Sterling LIBOR does in fact cease to be by the end of next year, the regulators continue to push home the message that firms must proceed on that basis. The issues raised within the letter only serve to highlight the complexity and uncertainty involved in the transition. Whilst it might be hard to plan the transition in detail with certain areas such as term structure not yet agreed, there are a series of steps Corporates can take now to ensure that they are prepared and are actively engaged with the transition:

  • Ensure there is a comprehensive overview of the direct and indirect exposure to LIBOR. This not only includes debt, cash and derivative portfolio but can extend to intercompany loans, leases, trade receivables, internal models etc.
  • Seek to understand the proposed pricing conventions for the different products and different jurisdictions.
  • Using available market information, model and monitor the change in exposure for cash and derivative portfolios from switching from Sterling LIBOR to SONIA. Be prepared to deal with the use of new overnight rates by building impact and scenario analyses into cash flow and liquidity management plans. It will also be important to identify system configurations required. 
  • Firms should adopt the mindset and practice of what we would characterise as “SONIA first, before LIBOR, where possible”.  Don’t wait for engagement from the banks, take control of your transition by initiating conversations now.
  • Assess the impact on existing and future risk management strategies. This includes considering whether the use of products referencing alternative rates (an overnight bank rate for example) would be preferable from a risk management and forecasting perspective. 
  • Understand any accounting and tax implications.
  • Identify the required changes to models, processes, controls and systems. Engage with treasury management system and/or external service providers now.  

To date, our corporate clients have told us that they have received limited engagement from their banking counterparties on IBOR reform and that they have many questions about the transition. However this will change rapidly in the coming months. The rhetoric around the end-2021 target date has been fairly uncompromising thus far, and this latest set of communications is consistent with, or perhaps even an elevation of, that tone. On that basis, firms should consider the transition to be very real and the communicated dates to be more than just “targets”.   

A lot remains to be done, and not a huge amount of time relative to the scale and complexity of the task. Rather than waiting for the banks to engage, Corporates need to take control of the transition by initiating conversations with the banks to understand the transition process for legacy products, the new RFR products available and to support the development of new market conventions. This will allow Corporates to develop detailed transition plans to support them as the pace of transition increases. 

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[1]https://www.fca.org.uk/publication/correspondence/dear-smf-letter-next-steps-libor-transition.pdf

[2] https://www.bankofengland.co.uk/-/media/boe/files/financial-policy-summary-and-record/2019/october-2019.pdf?la=en&hash=5AC2F4CC658151FCFA3B4BA438CDAA37D5996310

[3] https://www.bankofengland.co.uk/-/media/boe/files/letter/2020/how-the-discontinuation-of-libor-may-affect-your-members-and-stakeholders.pdf?la=en&hash=D9A81997BE52277310381903350FF1754495657E

[4] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/path-for-discontinuation-of-new-sterling-libor-linked-lending-end-q3-2020.pdf?la=en&hash=E5B0DFBF3D410DF4FE9771F8B00141462104F16E

[5] https://www.fca.org.uk/news/speeches/next-steps-transition-libor