The IBOR revolution or the best is the enemy of the good?

By end of 2021 the latest, the market will have faced the transition. What does the move to a new risk-free rate mean for corporate treasurers in practice? Besides what seems to be just a switch to another reference rate, there are some technical issues I personally cannot answer to. The main issue comes from the way the rates are fixed. LIBOR is currently published for each of the 5 LIBOR currencies for specified interest periods at the beginning of those periods (e.g. 1 week, 2 weeks, 1 month, 3 months, …). It is intended to measure the funding costs of banks and embeds both a term and a credit spread to compensate for the credit risk of lending to another bank on a term basis. By contrast, the new proposed rates are overnight rates (O/N) which will be determined based on historic data and include only a nominal element of credit spread. Therefore, in most cases, they are expected to be lower than their LIBOR equivalents. Good news for borrowers! The economic difference between LIBOR and RFR’s (i.e. the new rates) ultimately means that a transition will be much more complicated than a straightforward administrative change in the benchmark rates. The first impact is, in my opinion, the required adjustment needed to the pricing of transactions to minimize the economic impact of transition, most likely the inclusion of a “risk premium”. However, the major difference comes from the forward-looking term rate of LIBOR compared to the back-looking new rates. LIBOR rates are fixed and publicly available at the beginning of each interest period and is quoted for a range of different maturities. Therefore, treasurers can manage their cash-flow by providing them with advance visibility as to their financial costs.  Conversely, the new rates will be calculated daily based on the relevant overnight rate.

Therefore, the transition comes from rates fixed a priori for the different periods where new rate is an O/N rate, fixed on day + 1 at 09:00. In short, we won’t be able to calculate amount due in advance as of today and as always done. This lack of visibility will be problematic for certain cash products, like loans. The periods will even be fixed afterwards based on daily fixing compounded. A treasurer must hold additional cash to be able to pay interests when calculated afterwards, at the end of the period. The major difficulty in my view is the Treasury Management System (TMS) and other IT systems which are not prepared for such a radical change. More than a change, a true revolution. Think about cash-pooling, for example, for which a reference rate based on O/N (i.e. EONIA for EUR) plus or minus a spread is used. Tomorrow interest scales will be calculated afterwards. You will also book loans in your system without knowing the effective rate to be applied. How to proceed with such cases? It means that to avoid daily calculation we will have to provision and accrue interests based on a reference rates estimated and simulated to at the end adjust the provision before final fixing and payment of interest amount. In terms of IFRS, no one seems to have addressed this issue yet (at least as far as I know). Nevertheless, we can expect IASB, ISDA, Central Banks or other Supervisors to deliver guidance to define how to apply new rates and book lending operations.

You all understand that it is more complex than it looks initially. The bad behaviors of some banks and rate manipulations will drive to new rates but also to a completely new approach. That’s more impactful than the new rates themselves. Who has ever imagined such a double revolution, when years ago on the bench of the University, a professor explained that (1) time creates value with interest (we have now and for long I guess EUR or CHF negative interest rates, which destroy value over time) and that (2) rates need to be defined at inception (which will not be the case anymore). There are reasons get mad, isn’t it?

I guess that coming months will be crucial to launch discussions with IT vendors to discuss how to handle loans and all interest rate products in a year or so. I can only advice all our fellow treasurers from EACT (European Association of Corporate Treasurers) to engage such talks with their IT suppliers (the sooner the better). I guess, as for EMIR or IAS 39, they will be disappointed by the answers received (if any) and the absence of solutions at this stage. We cannot blame IT vendors who wait for more clarity on this topic. I promise it will be one of the most complicate issue to be addressed by our community in the coming months and I am surprised that no one even mention this issue. Therefore, as conclusion, beside the review of all loan documentations and contracts to track LIBOR references (to be changed), do not forget to contemplate IT systems to understand how lending and hedging activities will be treated. Like with every new regulation, we should be critical and ask whether in seeking something better in terms of benchmark rates, we are not undermining something good or at least not that bad. I don't have the answer.

Fran?ois Masquelier, Chairman of ATEL – Luxembourg 12/04/2019