What steps and preparation can emerging markets take to ensure that the LIBOR transition to alternative reference rates is a smooth one?
- Emerging markets must address unique challenges as they prepare to move from LIBOR to alternative reference rates.
- This transition will create disruption in emerging markets, which tend to have highly dollarised economies, high levels of floating rate or FX-denominated debt, and international reserves of cross-border outward investments.
- Banks in Latin America are working both individually and with local and international organisations to devise solutions to the problems posed by the LIBOR transition.
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For years, LIBOR (London Interbank Offer Rate) permeated financial systems around the world, defining how contracts are priced and how risk is managed. In 2017, the UK’s Financial Conduct Authority announced it may discontinue LIBOR after year-end 2021.
The world has had nearly four years to prepare for the end of LIBOR’s reign as the most important global benchmark for interest rates, yet hundreds of trillions of dollars of derivative and debt exposures are still priced using the LIBOR benchmark. While major markets have already identified alternative risk-free rates (RFR), most emerging markets are still woefully behind in their transitions.
Impact of the LIBOR transition
In a recent survey of market participants in Latin America, fewer than 25 percent of respondents in Mexico said that their institutions were ready to shift their debt obligations to alternative reference rates when many new tenors and currencies of the ubiquitous benchmark disappear at the end of this year. For the main USD LIBOR tenors, the end date is 30 June 2023.
LIBOR’s discontinuation will impact all aspects of the global financial services industry, including traditional and corporate financial systems. Emerging markets, which tend to have highly dollarised economies, high levels of floating rate or FX-denominated debt, and international reserves of cross-border outward investments, face disruption.
The emerging market conundrum
Public and private working groups have identified alternative RFRs across the LIBOR currencies such as the Secured Overnight Financing Rate (SOFR) for the U.S. dollar, Sterling Overnight Index Average (SONIA) for the British sterling, the Euro Short-Term Rate (€STR) for the euro, the Swiss Average Rate Overnight (SARON) for the Swiss franc, and the Tokyo Overnight Average rate (TONA) for the Japanese yen.
Instead of the forward-looking LIBOR term rates, these new RFRs are based on reported overnight money market transactions, providing a backward-looking benchmark. Markets for these RFRs are at different stages of development and adoption, and some are already seeing liquidity growth.
This fractured – and uneven – approach to replacing LIBOR presents unique challenges for emerging markets.
While central banks in Asia and the Middle East are helping their financial institutions manage the transition, emerging market banks face challenges in shifting from a forward-looking benchmark like LIBOR, in which the interest payment amount is known well in advance, to a backward-looking benchmark, especially for borrowers that depend on international banks for credit.
This uncertainty about the amount of future interest payments and the inability to calculate funds due until the interest payment due date is problematic. Since these borrowers need to make payments using revenue generated in their local currency, they must contend with fluctuating foreign-exchange and interest rates.
While a longer look-back or shift in interest determination could solve the challenge of interest rate uncertainty, the risk of a mismatch between the actual interest period and the period used for determining the interest rate makes it difficult for banks to manage their exposure and could misalign banks’ cost of funds with the amount of interest received. In emerging markets, banks may be unable or less willing to provide new loans to borrowers.
Lastly, switching to backward-looking RFRs could conflict with trade and banking laws, and regulations in some emerging markets.
Latin American banks respond to LIBOR transition
Latin American banks are working both individually and as a union in conjunction with local authorities and international organisations, notes Salvador Covarrubias Chavez, Managing Director and Head of FX and STM, Santander Mexico.
“Our first goal in adopting the new RFRs is to adjust our systems, risk methodologies, and accounting. We are focusing on legal issues and adherence to the ‘fallback’ protocols,” he explains. “Our second focus is to develop local markets in relation to the new Interbank Equilibrium Interest Rate (TIIE).”
Banks must coordinate the migration to new reference rates for both local and foreign clients. “We have invested in training teams responsible for implementing these changes,” notes Covarrubias Chavez. “Each institution differs in its type of exposure and is subject to different international regulations in addition to Mexican regulations.”
He believes that derivatives listed in both local and international Stock Exchanges and Chambers, combined with government incentives such as debt issues related to the new rates, should allow the Latin American market to develop at a reasonable pace.
“It’s critical that clients’ operations migrate to the new rates even when they are covered by bilateral contracts,” explains Covarrubias Chavez. “Coverage liquidity is found in counterparties that settle by chambers and that will be valued with the new reference rates.”
Covarrubias Chavez recommends that banks remain focused on deadlines–even if they keep changing–and prepare their systems, define valuation methodologies, participate in derivatives, and stay in constant communication with local authorities.
6 steps for participants in emerging markets
- Perform due diligence ASAP: determine if any existing transactions that reference LIBOR will continue beyond 2021 and whether there are fallback provisions in both loan agreements and hedge documents if LIBOR is no longer published. If provisions don’t exist, determine which consents you need to amend to reference an RFR versus LIBOR.
- Have a contingency plan: identify what you will do if forward-looking RFRs are available in relevant currencies – and what you will do if they are not. For example, will you use a fixed rate, or a floating rate based on the Bank of England’s Base Rate? Will you use this rate temporarily until an appropriate forward-looking term RFR is available or will you make the change permanent?
- Communicate your transition plan for financing in progress: if you are entering into any financing agreements and haven’t yet determined the LIBOR alternative rate, make sure the counterparties agree on the process for replacing the rate midway through the transition.
- Identify an implementation strategy: whether you choose amendment, replacement, redemption, or no action, engage any third parties to implement your strategy.
- Commit resources: you’ll need both time and money to complete the transition. Create a dedicated LIBOR transition team and be ready to pull in relationship managers, lawyers, originators, transaction managers, and agency and operations teams as needed.
- Stay up to date: follow market developments from reliable sources. Consider the following:
- Loan Market Association (LMA)
- Loan Syndications and Trading Association (LSTA)
- Association of Corporate Treasurers (ACT)
- K. Finance
- Working Group on Sterling Risk-Free Reference Rates (RFRWG)
- Alternative Reference Rates Committee (ARRC)
- Working group on euro risk-free rates
- Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
Adapted from LIBOR Transition – A Compounding Problem for Emerging Markets by Mayer Brown.
USD cash fallbacks: facilitating a smooth transition
While an estimated 67 percent of current USD LIBOR exposures will mature before June 2023, an estimated $5tn reference cash products will remain outstanding, posing a significant risk to global markets.
The ARRC and policy makers are working to provide a suitable legal framework to address fallback issues, and has named Refinitiv as publisher of its spread adjustment rates for cash products.
In publishing the ARRC’s fallback rates, Refinitiv will leverage its experience as a benchmark administrator of rates such as WMR, CDOR and Term SONIA.