Preparing for a post-LIBOR world

Challenges associated with the transition The transition from LIBOR presents a number of operational, legal, conduct and funding challenges to many institutions in Kenya and the wider East Africa Market. These include financial institutions such as banks, insurance and reinsurance firms, wealth and asset managers; energy companies such as Independent Power Producers (IPPs) whose revenues are tariff based (usually in USD); the National Treasury given significant government borrowing in hard currencies; and large corporates who trade or obtain funding in forex and use hedging instruments. There are three fundamental challenges affecting the shift:

Operational and legal challenges The transition away from LIBOR is not a simple matter of merely replacing the old rate with a new one. The new rates are structurally different from LIBOR. For example, SONIA is only an overnight rate whereas LIBOR rates are one, three, six- and twelve-months tenors. While SONIA can be compounded for a longer period, this would not capture the term structure and credit spread embedded in LIBOR.

Furthermore, LIBOR is a forward-looking term rate with a range of seven maturities up to a year and the alternatives are backward-looking overnight rates. While market participants would value a forward-looking term representation of SOFR, one doesn't exist yet. It should be noted that in September 2020, the Alternative Reference Rates Committee (ARRC) released a Request for Proposals (RFP) seeking firms to publish daily indicative spreads and, after a trigger event has occurred, static spreads and spread-adjusted fallback rates for cash products that transition away from USD LIBOR.

It is calculated that, on average, a compounded SONIA would have been 30 basis points lower than three-month pound-LIBOR over the last 10 years and nearly 400 basis points lower during the financial crisis when bank credit spreads blew out. Simply substituting SONIA (or any other ARR) for LIBOR in products or contracts that reference it would radically alter expected cash flows and the way they behave as interest rates change, in a bid to protect themselves from adverse changes in asset pricing.

Many players within the financial sector will need to not only switch to the new rates across the full range of financial products but also coordinate changes to settlement, accounting, taxation, and other critical operations or be forced to face the adverse effects that come with basis risk. Basis risk refers to the potential mismatch between the floating rate paid by the borrower on the hedged loan and the floating rate received by the borrower on the related swap owing to the two financial instruments having failed to mitigate away from LIBOR on the same schedule. While the spread between the loan and swap may be small, those differences could potentially affect how a borrower accounts for the hedge for accounting and tax purposes.

From a legal perspective, one of the harder issues to deal with is that of legacy contracts and how to address the proposed reference rate transition in the said contracts. Legal contracts, in this case, refers to active contracts that are due to mature past 2021 and that require unanimous holder consent to amend provisions deemed essential to the contract.

‘Fallback’ provisions in each of these contracts will then determine what happens but these provisions were designed to cover a temporary unavailability of LIBOR rather than its permanent elimination, and they often change the economics of the product – for example, effectively converting floating-rate products into fixed-rate products. One of the counterparties to a LIBOR contract may suffer material losses while the other receives windfall gains. Government agencies in the United States, United Kingdom and Europe have initiated legislative solutions that would, in specific situations, result in the mandatory transitions for these contracts.

Accounting and tax implications In anticipation of the unique challenges and implications that will come with the reform, standard setting and regulatory bodies within the tax and accounting industries are reviewing their regulations and standards to provide guidance on how to account for issues such as debt modification, transfer pricing, credit spreads and hedges. While financial services firms continuously monitor regulatory developments throughout the transition process, they should proactively take these steps:

• Determine the impact of new hedge accounting standards to facilitate targeted change, and existing strategies requiring modification;
• Understand the criterion that would trigger evaluation of prospective hedges;
• Evaluate operational approaches to contract modification and the tax impact triggered by modifications; and
• Analyze and update internal processes and procedures such as transfer pricing and intercompany funding as needed so that appropriate rates and spreads are applied across the company.

Ambiguity East African markets seem to be lagging behind in terms of preparedness for the impending LIBOR transition. To our knowledge, regulators and central banks have not provided any guidance to financial institutions in the region regarding the impending LIBOR transition. As a result, financial firms must create their own roadmaps while facing strict timelines before LIBOR ceases to exist.

The Official Sector and Trade Associations have played an important role in the development of the alternative rates within different jurisdictions globally and should therefore lead the way in forming a Working Group (WG) to guide local transition away from LIBOR. Some of the proposed objectives of the WG would be:

• Identifying likely risks from LIBOR transition and potential mitigation measures,
• Creating awareness and training affected stakeholders,
• Creating awareness of proposed alternative rates for the various stakeholders,
• Coordinating with similar WGs globally on the transition and learning from their experiences,
• Proposing a transition roadmap in consultation with the relevant stakeholders and
• Responding to emerging issues from stakeholders when carrying out the transition.

Impact analysis and roadmap development Financial institutions will need to not only consider fallback provisions and debt modification approaches for external debt, but also transfer pricing or tax issues that could arise if intercompany funding or other agreements are not properly identified and modified. The sooner banks begin to prepare for the changes, the less disruption and risk they will face.

In this regard, financial institutions should consider taking the following steps now:

• Conduct an initial impact assessment with an aim of developing an understanding of how contracts are impacted as well as understanding the fallback language that had been adopted in these contracts and quantifying the exposure (direct and indirect) in the relevant reference rates;
• Prepare an inventory of contracts impacted across the organization quantifying the impact (direct and indirect) of the transition across each of these contracts;
• Once quantified, the entity can move on to assess the risks associated with the transition to new reference rates;
• Plan transition activities based on the above findings, including how to group, organize, and sequence the work;
• Educate and facilitate communication with executives and key impacted businesses about the transition, tailoring discrete messages for institutional and retail customers and
• Reduce issuance of new LIBOR-linked products while including in any new LIBOR contracts provisions for amendments after regulators and the industry have clarified fallback terms.

The development of an initial draft of the roadmap for the transition period as well as the definition, communication and continuous monitoring of firm-wide scenarios will go a long way towards an effective and efficient transition to the new rates.