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The end of Libor

The end of Libor

Quickly identifying the impact and responding appropriately

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Years of fraudulent actions and collusion by an assortment of banks have brought the Libor and Euribor reference rates into disrepute. In response, Britain's Financial Services Authority will no longer calculate interest rates by looking up interbank rates on a daily basis as of 2021. Instead, rates will be calculated on the basis of actual transactions executed by the central banks in the given currency areas. Pursuant to EU Regulation 2016/1011, the method used to calculate Euribor and Eonia is also to be overhauled by 2020. Both the financial and corporate communities would do well not to underestimate the consequences of this impending shift.

Thanks to the clear stance adopted by Britain's Financial Services Authority, the reform that has been in progress since 2014 will come to an end in 2021. The Libor and Euribor rates are to be substituted by alternative, risk-free interest rates whose implementation and underlying data resources are currently being addressed in currency-specific working groups (see Table 1). The effects of the coming changeover will influence corporate treasuries in advance, creating the need for action to be taken in good time.

Currency Risk-free interest rate Working Group Underlying data resources
Sterling (GBP) Sonia Bank of England Working Group Unsecured overnight rate used in bilateral trading
Euro (EUR) Ester Working Group on Euro Risk-Free Rates Individual traded banking transactions payable on demand
US dollar (USD) Sofr Alternative Reference Rates Committee Secured, transaction-based overnight rate
Swiss franc (CHF) Saron National Working Group on Swiss Franc Reference Rates Repo transactions in CHF on the interbank market
Japanese yen (JPY) Tonar Japan Study Group on Risk-Free Rates Unsecured, transation-based overnight rate

Table 1: Possible future reference rates (RFRs)

Three aspects constitute the main distinctions between current and future reference rates (RFRs): 

  1. Unlike with Libor, different data sources will be valid for individual, currency-specific interest rates in the future. Rates will thus be published at varying times (e.g. 9:00 AM GMT for Sonia and 8:30 AM MET for Saron).
  2. Operative factors mark another major difference in future reference rates. Whereas current interest rates are published for varying maturities, most of the new reference rates exist only as overnight rates at the present time. Other operative factors are under discussion in the various working groups.
  3. The new reference rates also vary in terms of the degree of securitization. Unlike Libor, it will therefore no longer be possible to handle all rates in the same way. Each currency-specific rate must therefore be analysed on its own merits. These changes will affect different areas of corporate activities.

How will the transition affect companies?

The Libor/Euribor rate is commonly used as a reference rate for floating rates for both primary and derivative contracts, many of which have maturities extending beyond the year 2021. For contracts concluded before 2021, it is highly likely that changing the reference rate will change the market value of the underlying financial instrument. In the case of standalone derivatives, for example, this will lead to the recognition of value adjustments in profit and loss. 

Derivatives can also be affected in the context of hedge accounting, as an impact on hedge relationships is to be expected pursuant to IFRS 9. This impact too could be reflected in profit and loss effects. It follows that changing the reference rate has both direct and indirect accounting effects – as well as a significant influence on the entire measurement landscape and the valuation curves that this landscape requires.

Depending on the operative factors that apply in the future, condition-specific yield curves in particular will have to be remodelled or thoroughly adjusted. Cross-currency basis swap (CCBS) prices too are based on Libor rates. Here again, calculating the currency basis-adjusted yield curves will be a challenging practice in the future.

The necessary transition could conceivably also lead to modifications in the case of primary financial instruments. Such modifications could take the form of changes in the planned cash flow structure, or possibly the premature realization of transaction costs. Altering the reference rates again requires adjustments to the underlying contracts, and that will incur both internal and external transaction costs.

Economically, the new reference rates will be equivalent neither to each other nor to Libor, due to the use of different data resources (see Table 1). Accordingly, risk management is another area where a fundamental influence will occur. Economic hedges must be called into question, and baseline risks can materialize. That will be the case, for instance, if a hedge and the underlying transaction are not (or cannot be) adjusted in line with the new reference rates at the same time. Beyond that, any new developments can also give rise to operating risks, with the result that treasury staff will need suitable training and IT systems must be adapted to the new environment.

What, then, should corporate treasury departments do? The fallout from these changes affects all companies, will be time-consuming and will tie up a lot of resources. Corporate clients should therefore take action in good time, starting with an analysis of the data fields affected. Concrete measures can then be identified for the relevant contracts, processes and systems – irrespective of the fact that the new rulings have not yet been finalized and may yet be subject to further amendments.

Source: KPMG Corporate Treasury News, Edition 83, August 2018
Author: Sebastian Gammisch, Manager, Finance Advisory, sgammisch@kpmg.com

 

 

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