In July 2017, Financial Conduct Authority’s (FCA) chief executive Andrew Bailey announced that the FCA would no longer compel banks to submit data to the London Interbank Offered Rate (LIBOR) after 2021, there is now a clear global direction of travel towards alternative risk-free rate benchmarks (RFRs) based on transactional data. This transition will be one of the most significant transformations of interest rate benchmarks in the last 25 years. The erstwhile interbank offered rates (IBORs), which have been the backbone of $350 trillion worth of financial contracts since their inception in the 1970s, will be replaced by new risk-free rates (RFRs).
IBORs currently underpin a huge range of financial products and valuations, from loans and mortgages through securitisations and to derivatives across multiple jurisdictions. They are used in determining all sorts of tax, pension, insurance and leasing agreements and are embedded in a wide range of finance processes such as remuneration plans and budgeting tools. The impact will, therefore, be felt far and wide and therefore as a result some countries are already publishing and using these new rates to write new contracts. Across major geographies such as the US, the UK, Europe, Switzerland and Japan, the transition to rates such as SOFR (Secured Overnight Financing Rate), SONIA (Sterling Overnight Index Average), SARON (Swiss Average Rate Overnight), ESTER (Euro Short-Term Rate) and TONAR (Tokyo Overnight Average Rate) has already begun.
India is not insulated from the change, any financial contracts with international counterparties, be it external commercial borrowings (ECB) or trade credit, that reference IBORs come under the purview of this transition. In addition, instruments linked to the Mumbai Interbank Forward Offer Rate (MIFOR), which is derived from USD LIBOR, will also be affected. RBI marks India’s total external debt at $554.7 billion as of June 2019. External commercial borrowings, which amount to $214.1 billion, make up the largest portion of this debt at 38.4%. Trade credit stands at 18.7% of the total. These non-trivial billions are going to be affected by the largest reform in financial benchmarks in the last 25 years.
In India, the corporations that raise funds using ECBs, hedge the ensuing risks using OTC instruments, finance imports using trade credit or invest in MIFOR linked instruments will be impacted by the transition. MIFOR is calculated from USD LIBOR and will be affected by the discontinuation of the rate. It remains to be seen how the RBI will address the change along with benchmark administrators. In the meantime, corporations can get ahead of the transition with respect to commercial borrowings and hedging. This mammoth transition requires collective effort from various arms as the risks are manifold.
Legal: Legally, legacy contracts affected by the change will need to be identified and counterparties must reach a consensus if changes are made . Fallback provisions that are present in legacy contracts may act as a short-term band-aid rather than long-term corrective surgery. Significant costs will be incurred for changing contractual terms.
Accounting and tax: Any change in contracts leads to a whole host of risks that must be addressed. Uncertainty will be faced by treasury and finance functions as these contracts are valued based on new rates. A change in contractual terms will lead to a change in the fair-value calculation of a contract according to IFRS 13. Tax recognition may occur earlier than expected as the fair-value of contracts changes.
Risk management: Risk functions will have to calculate new pricing curves linked to RFRs. Owning to the fact that the market for products that reference the new rates will take time to develop liquidity, the calculation of these curves is not as straightforward or even the same as curves for IBORs.
Hedging: Once the contracts change, their corresponding hedges may not be effective or even qualify for hedge accounting treatment due to added basis risk. Additionally, instruments used in hedging such as interest rate swaps, forward rate agreements and full currency swaps will also be affected by the changing benchmark.
Valuation and curve construction: There will be impacts on pricing and valuation of financial instruments, including derivatives and non-derivatives contracts. The adjustment would be needed for existing curve framework and there will be challenges in curve construction led by insufficient liquidity of RFRs.
Operations and IT: IT and systems infrastructure related to calculation of pricing curves, hedge accounting and data repositories will have to be upgraded to incorporate new methods. Different publication times and pricing across all RFRs needed to be incorporated in processes and systems.
Liquidity: As rates for all tenors (especially long term) may not be immediately available, RFRs would pose refinancing challenges due to lack of liquidity.
Corporates must strategise how to adapt to the changing benchmarks. They will have to rethink how funds are raised in foreign currencies and consequently distributed across various assets. Different arms of companies must come together to collectively address change management and plan the way forward. It is time to be proactive, rather than reactive to assess the impact of the change on their balance sheets.
- Author along with Preeti Sharan, Associate Director, KPMG in India
(A version of this article appeared in The Economic Times on Nov 28, 2019)