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Are these the last days of ? Corporate Treasury Insights

February 2018 Global states of play

Introduction Whilst transaction data on the swap and futures markets referencing LIBOR rates are still significant, data on the inter-bank lending based on LIBOR has decreased. Consequently, contributions are increasingly based on inherently less reliable discretion Benchmark interest rates are a core and expert judgment. UK and US central banks have already identified alternative RFRs component of global financial markets, denominated in GBP and USD based exclusively on transaction data. Other global influencing borrowing and lending for central banks and industry bodies are developing replacements for similar benchmarks. all types of market participants across a myriad of financial instruments. Retail Jurisdiction Reference Proposed Borrowing and commercial loans, corporate debt, benchmark replacement rate type securitised products, and the derivatives markets all rely on these UK (£) GBP LIBOR SONIA Unsecured benchmark reference rates for the (April 2017) pricing and hedging of interest rates and US ($) USD LIBOR SOFR Secured other risks. (June 2017) The London Interbank Offer Rate, or Euro (€) TBD Unsecured LIBOR, is one of the most common (see Europe below) series of benchmark rates referenced by contracts measured in the trillions of Switzerland (Fr) CHF LIBOR SARON Secured dollars across global currencies. (Leading candidate) Following the financial crisis, calls grew to reform the process used to price Japan (¥) JPY LIBOR TONAR Unsecured LIBOR due to the way the rate was (June 2016) developed based on professional Proposed tenor: Overnight judgment by contributing banks, the Target implementation date: January 2022 lack of transactional data from which to derive such rates, and the potential for the rate-setting process to be In the UK, the Risk Free Rate Working benchmark rate. While the sterling risk manipulated as seen by regulatory Group recommended a reformed Sterling free rate, SONIA, is based on an existing enforcement actions and litigation in Overnight Index Average (SONIA) as the benchmark with a modified methodology, recent years. alternative risk-free rate for the GBP SOFR is a new benchmark, whose market. The alignment of the discount publication is slated for Q2 2018. The new As a result, regulatory and advisory curve and swap by using rate will be published by the FRBNY and bodies, working with market participants GBP SONIA could help encourage faster would have as much as $800 billion in in various jurisdictions around the world, adoption of a new rate in the UK as SONIA transactions supporting its publication. have begun releasing plans to retire is already the established reference rate In Europe, as efforts to rebase EURIBOR existing benchmarks and begin the for GBP OIS, in turn providing the on transactions have been unsuccessful, process of developing replacements. This standard GBP risk-free discount curve. the European Central Bank announced culminated in the UK Financial Conduct The working group, previously limited to that it may look to alternative reference Authority’s decision to no longer compel banks and broker-dealers, is now open to rates as well. The European Money Market panel banks to participate in the LIBOR investment managers, non-financial Institute continues to explore options for submission process after the end of 2021. corporates, financial market the risk-free rate including a hybrid infrastructures and trade associations. In this publication, we highlight methodology for EURIBOR based on a Some market participants remain some of the numerous challenges waterfall of input data including reluctant to switch to overnight rates as an that will need to be addressed as the transactions, calculations, and data from alternative for LIBOR term rates. The future of LIBOR remains uncertain and the unsecured euro money market. as the journey toward alternative expanded working group will be tasked benchmarks progresses. with developing term SONIA rates. The In Switzerland, the Swiss National Bank BoE plans to issue a consultation paper in followed the UK FCA announcement with a the first half of 2018. statement confirming its intent to select an alternative to CHF LIBOR in due course. In the US, the Alternative Reference Rate The current unsecured overnight index Committee, comprised of major OTC swap (TOIS) is being replaced at year end derivatives market participants, clearing by the Swiss Average Rate Overnight houses, and derivative administrators, (SARON), a reference rate based on data recommended the Secured Overnight from the Swiss franc repo market. SARON Funding Rate (SOFR) as the new could prove to be a replacement for the Swiss franc LIBOR as well.

In Japan, a study group on risk-free I cannot entirely discount the risk of earlier panel reference rates has been working on a

degradation, or having to fall back to use of our powers to Japanese yen nearly risk-free benchmark “ compel, with all the costs and risks of a messier“ and more rate since April 2015. It identified the uncollateralised overnight call rate costly transition that this might crystallise. Market TONAR, the Tokyo Overnight Average participants should continue to have those risks in mind Rate published by the Bank of Japan, as as the work on transition gets started. the best choice of a JPY risk-free rate. TONAR already has considerable transaction volume and a diversity of Andrew Bailey trading participants. Chief Executive, Financial Conduct Authority 10 key challenges in the quest to replace LIBOR

1 6 Benchmark rate term structures Fall back provisions – Derivatives As proposed benchmark replacements have all targeted short How does uncertainty in LIBOR’s future impact current swaps tenor overnight rates, how will new and legacy longer dated and agreements? exposures be treated? How suitable will the new rates be? Amendments, including changes to ISDA masters and CSAs may The proposed overnight rates are backward looking compared to need updating to reflect the permanent discontinuance of a existing forward looking IBOR rates. This has the potential to create benchmark. Fallback provisions may exist that allow the use of cash flow uncertainty e.g. with loans interest costs would be alternative rates, however the continued publication of LIBOR in confirmed at the end of the interest period instead of the beginning. spite of reduced liquidity may render a fallback rate as contractually The Sterling Working Group are exploring possible approaches to prohibited. If amendments to derivatives result in recognition of a create forward looking term reference rates. For longer dated new contract, additional collateral may be required. exposures (e.g. 10yr) implementation will likely be dependent upon sufficient trading to create liquidity in futures and swap contracts that provide price transparency across the term structure. 2 7 Global consistency Fall back provisions – Corporate lending As reform efforts have proposed varying replacement benchmarks How does uncertainty in LIBOR’s future affect corporate across the five LIBOR currencies, with an emphasis of reforming lending and borrowing and hedging arrangements? derivative products initially, how will market participants reconcile Parties to agreements may need to consider building in changes in benchmark rates across products and jurisdictions? flexibility to amend interest rate determination provisions The potential currency-specific products and rates means that may result from the discontinuation of LIBOR. They will transactions such as cross-currency hedging will need to adjust need to consider whether any revised terms result in for the different basis in each currency. Businesses must extinguishment (a new contract) or modification with determine how to best minimise basis risk within any given consequent accounting implications. currency and develop approaches for managing cross currency basis risk for varying rates. 3 8 Liquidity of new and legacy products Fall back provisions – Debt and floating rate How do the markets sustain sufficient liquidity in both existing securities LIBOR indexed products and new reference rate products during How does uncertainty in LIBOR’s future impact debt securities? transition periods? Issuers/trustees should consider how a replacement rate could affect To enable the markets to operate effectively and efficiently, the noteholder interests. Disclosures regarding uncertainty relating creation of a basis market would aid in the closing of legacy contracts to future levels of benchmark rates, the possibility of rate during the transition process. Healthy basis markets would also discontinuance and/or replacement, and the potential impact on ensure liquidity in legacy contracts as newer contracts are priced. payments arising from discontinuance or replacement. 4 9 Credit spread differential Benchmark rate for hedging/hedge accounting LIBOR inherently includes inter-bank credit on unsecured How will derivative hedging be impacted by new reference rates? borrowings. Some of the proposed benchmark rates are secured and exclude credit components. How does a shift to secured It is unclear whether a mechanism to hedge existing LIBOR-linked wholesale funding impact markets? loans and debt will exist after the transition period and there is the potential for basis risk between bilaterally-agreed loans and related Where risk free rates are used as replacements to IBORs, there derivatives. The introduction of new benchmarks could critically affect could be impacts on values if fall backs are triggered. This bank existing hedge accounting treatments. It is unclear whether the IASB credit risk element needs to be reflected, in pricing new deals, will provide additional guidance to assist transition and allow for credit spread premia may be considered between new and legacy continuation of existing hedge relationships that do not envisage transactions. replacement benchmarks. In the meantime, businesses should include reference to the potential replacement rate in their hedge documentation to avoid discontinuation of longer term hedges. 5 10 System infrastructure Tax consequences How will new benchmark rates impact an institution’s What tax implications may arise from the creation of new operational constructs? reference rate benchmarks? The transition to a new rate could mean a number of strategic, business and technological changes to a number of stakeholders, including Parties should consider whether a change in interest calculations administrators, financial institutions and end-users. Alternative for debt instruments would constitute a change in terms of the reference rates could require costly changes in internal and third-party debt, resulting in tax consequences for the issuer and holder of the pricing, accounting, and risk management models and systems. debt and possible recharacterisation of the debt for tax purposes. Next steps What should treasury departments be doing now?

As expected, the transition to any new reference rate will likely What reference rates will derivatives, loans, mortgages and entail costs, but continued reliance on LIBOR could entail much corporate debt use after 2021? How do firms remediate their higher costs if no viable alternative rates have been adequately legacy contracts which reference LIBOR? How will pricing and developed. Replacing a benchmark used in $350 trillion financial risk exposures be affected without LIBOR submissions? How are instruments will require considerable effort over an extended current business processes affected? What systems changes may period. LIBOR replacement will affect corporations, investment be required? To answer these and many other questions, banks, broker-dealers, retail banks and mortgage firms, asset Treasurers should be working now on developing their change managers, pension funds, hedge funds and insurers. Financial programmes over the short, medium and long term. Immediate instruments tied to LIBOR include OTC and exchange traded priorities for the next three to six months centre on program derivatives as well as credit instruments such as commercial and mobilisation and impact assessments including identifying what retail loans, mortgages, structured products and bonds. The same type of instruments may be impacted, reviewing fallback benchmark will not be a suitable replacement for LIBOR in every provisions in documentation, updating hedging documents and circumstance. Consequently, the cessation of LIBOR will clearly looking to future-proof new contracts or hedging arrangements have a significant impact on firms in many ways. by considering wording of any new loans/derivatives entered into. Thereafter, firms should transition to program roll-out. Four years may seem a long time, but given the volume of potential changes required to contracts, systems and processes, firms should start assessing the impact now.

Who can continue the dialogue with you?

Yann Umbricht Christopher Raftopoulos David Stebbings Head of Treasury and Commodity Group Treasury Treasury T: +44 (0)20 7804 2476 T: +44 (0)20 7212 2709 T: +44 (0)20 7804 2323 E: [email protected] E: [email protected] E: [email protected]

Yvonne Welsh George Theophylactou Graham Robinson Treasury Valuations Treasury Tax T: +44 (0)20 7213 4099 T: +44 (0)7841 110915 T: +44 (0)20 7804 3266 E: [email protected] E: [email protected] E: [email protected]

Annalie Croney Robert Waddington Sanjay Bibekar Legal Treasury Treasury Technology T: +44 (0)20 7212 2553 T: +44 (0)121 265 5235 T: +44 (0)20 7804 9582 E: [email protected] E: [email protected] E: [email protected]

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