LIBOR end may disrupt emerging market lending
The anticipated cessation of LIBOR at the end of 2021 presents an ominous predicament for foreign lending into emerging market economies.
Borrowers in these markets must often account for revenues earned in local currencies and deal with central bank requirements regarding foreign exchange and currency transfers and other regulatory controls.
In many cases, such processes have hardened around the predictability afforded by forward-looking term LIBOR based rates. LIBOR’s replacement, at least for some period of time, by a non-forward looking benchmark may make it far more challenging for borrowers to comply with their loan payment obligations and could increase payment default risk.
LIBOR’s end is also likely to disrupt new foreign loans into emerging markets until new measures and practices are adopted by the relevant market participants.
Replacement of LIBOR
For several decades, LIBOR has been the most widely used benchmark interest rate in the global financial markets.
It is intended to reflect the cost of lending across a wide range of financial products, including mortgages, corporate debt, floating rate notes and interest rate swaps.
LIBOR is determined by averaging the rates that are submitted by a panel of banks to the Intercontinental Exchange Benchmark Administration. More than $200 trillion worth of financial contracts use US dollar LIBOR as their benchmark rate.
However, the pool of transactions that drive the methodology for LIBOR has been steadily shrinking since the 2008 financial crisis, causing regulators to lose confidence that LIBOR continues to be an accurate reflection of funding cost. The Financial Stability Board, an international body established by the G20, has been working with central banks, regulatory authorities and other market participants since 2014 to find new alternative reference rates to implement an orderly transition away from LIBOR.
After 2021, panel banks will no longer be compelled by the Bank of England and the UK Financial Conduct Authority to submit the rate information that is used to calculate LIBOR. The panel banks consist of between 11 to 16 banks for each of the underlying currencies (dollars, sterling, euros, Swiss francs and yen), and each bank submits data on every available LIBOR tenor for the applicable currency.
LIBOR may end before year end 2021 if the Bank of England determines that LIBOR does not reflect the true cost of funds.
All contracts using LIBOR will need to be amended before the deadline or risk having an interest rate that can no longer be determined.
Financial institutions are already undertaking the transition to replacement benchmarks such as risk-free rates. However, such efforts have not seriously commenced in most emerging market countries, where few central banking authorities have focused on the transition away from LIBOR to a new benchmark rate.
Rising Consensus Around SOFR
In the United States, the transition from LIBOR has been overseen by the Alternative Reference Rates Committee of the Federal Reserve Board.
The “secured overnight financing rate” — called “SOFR” — has been selected as the preferred fallback rate for dollar-denominated instruments by the Federal Reserve Board because it meets international standards for benchmark quality in light of the depth and liquidity of the markets in which it is produced and administered.
SOFR is an overnight, secured, nearly risk-free rate that is calculated historically and published daily.
SOFR reflects the cost of borrowing cash overnight, which is collateralized by US Treasuries. The Federal Reserve Bank of New York collects transaction data composed of repurchase agreements. A repurchase agreement is a type of short-term secured loan where securities are sold to a buyer and the seller agrees to repurchase those securities at a later date for a higher price. The difference in the original sale price and the repurchase price reflects interest paid on the loan and is called the repo rate. There are three types of repo rates cleared though the Fixed Income Clearing Corporation that are used to determine SOFR. SOFR is then published by the Federal Reserve Bank of New York each day and reflects the prior day’s data.
In contrast, LIBOR is an unsecured forward-looking rate published at various maturities that can range from overnight to one week, one month, two months, three months, six months or one year.
There are currently nearly $800 billion worth of transactions on a daily basis underlying the determination of SOFR, far greater than the value of the transactions used to determine LIBOR. The median daily volume of three-month LIBOR transactions (the most commonly used tenor for LIBOR) is less than $1 billion, and it can sometimes drop below $500 million.
As SOFR is an overnight rate based on US Treasuries, unlike term LIBOR, it does not seek to align to a lender’s cost of funds over the relevant interest rate period. Furthermore, neither SOFR nor LIBOR accounts for economic, country and counterparty risk typically addressed through the addition of a margin to the relevant benchmark rate.
Thus, the switch to SOFR will require the addition of two separate margin components, one to account for lenders’ costs of funds over each interest period to which it is being applied and the second to address the traditional credit risks lenders or markets perceive relating to a borrower or its operating environment.
Ultimately, the determination and agreement upon the interest rate to be applied to transactions is likely to become more complicated with new components to be considered by lenders and borrowers.
Several variations of SOFR have been considered as possible benchmark replacement options.
Concept credit agreements have been published by the Loan Syndications and Trading Association in the United States to demonstrate the use of SOFR-based rates in practice.
“Daily simple SOFR” is determined by multiplying the daily published rate to the outstanding principal of the loan to reflect the amount of interest accrued on each day of the interest period. Such interest amounts are aggregated over the interest period with the amount of interest payable in arrears at the end being equal to the sum of such amounts.
By contrast, “daily compounded SOFR” is calculated by compounding interest daily during the interest period by adding each day’s interest to the principal balance of the calculation for the following day. The accumulated additional principal and interest is payable in arrears at the end of the interest period.
Daily compounded SOFR “in advance”, or “term SOFR,” is predicted to be a forward-looking rate for SOFR. It would be known at the beginning of each interest period and would more closely mirror market conventions for LIBOR.
The implementation of term SOFR will require a volume of trading and liquidity in SOFR-based term-loan products that will permit market participants to advise on rates based on market transactions. There are many competing views about when and how this may be accomplished. Furthermore, the predictive qualities of any forward-looking term rate may face the same challenges that have caused LIBOR’s impending demise. However, much of the hesitancy surrounding the adoption of daily SOFR as LIBOR’s replacement may be attributed to continued desire in the marketplace for forward-looking interest-rate measures.
Several other global financial centers have introduced their own alternative reference rates, such as the “sterling overnight index average” in the UK administered by the Bank of England, the “euro short-term rate” administered by the European Central Bank and the “Singapore overnight rate average” administered by the Monetary Authority of Singapore.
While SOFR is expected to be the primary replacement for US dollar LIBOR as the global benchmark, the end of LIBOR is likely to lead to adoption of a broader range of international rates focused on other major currencies and regional banking practices.
For borrowers in emerging markets, this may provide additional options, but also may vastly complicate the process of selecting the most beneficial financing structure.
Implications of SOFR Adoption
With a forward-looking interest rate such as LIBOR, both the bank and the borrower have certainty with respect to the amount and timing of future interest payments because the interest rate is determined and fixed at the beginning of each interest period.
Borrowers know the exact amount of interest they will need to pay on the next interest payment date and may plan accordingly. In addition, borrowers may enter into long-term interest rate swaps to manage exposure to interest-rate fluctuations over the entire term of the loan. Most lenders will similarly enter into hedging transactions to manage and match any interest rate fluctuation risk in respect of their own liabilities over the interest period. In this regard, with LIBOR, both borrowers and lenders have been able to manage credit risk associated with interest rates.
A switch to a backward-looking rate like SOFR will no longer permit borrowers to know the amount of interest they will owe at the start of an interest period.
If financial markets reach an environment where SOFR sees a fair amount of fluctuation, borrowers may have to create reserves to ensure that they will have the necessary funds on hand to make interest payments. (See “SOFR too volatile?” in the August 2020 NewsWire.)
The backward-looking nature of SOFR also creates a possible administrative challenge. With LIBOR, lenders are able to invoice borrowers for their upcoming interest payments at any time during the interest period. With SOFR, such advance invoicing or notice will not be possible, as the final rate will not be determined until the interest payment date.
The US commercial bank market seems to be coalescing around a short look-back period to calculate daily simple SOFR or daily compounded SOFR. In such a look-back period, the interest rate applied to a particular payment period may be shifted a few days earlier so that the final interest amount will be determinable a few days before payment is due.
Impact on Emerging Markets
In emerging market economies, the loss of certainty about the interest-payment amount due at the end of each interest period may create significant issues for borrowers.
First, since the revenues of many such borrowers are earned in local currency, borrowers often need to account for foreign-exchange as well as interest-rate fluctuations when considering their hard currency needs at the end of each the interest period.
Second, to the extent that central banks or other relevant monetary authorities require advance notice or proof of a borrower’s foreign-currency needs, the inability to produce an invoice or even a firm calculation until the interest payment date when such funds are due is obviously a problem.
By way of example, in Senegal, foreign currency loans must be authorized by the Ministry of Economy and Finance. Even once authorized, to obtain the foreign currency to make payments on such loans, permission must still be sought from the regional central bank for West Africa. Such permission is typically sought days if not weeks in advance of when the currency is required.
With forward-looking term LIBOR, where the interest payment amount is known far in advance, borrowers and their local banks have generally been able to handle this hurdle without difficulty.
If the international US dollar lending market shifts to SOFR or other backward looking interest rates, borrowers will not know their currency needs until the payment date (or if a short five-day look-back is expected, then a few days in advance). For a country like Senegal, the volume of euro-based foreign lending and the continued viability of EURIBOR, at least in the short term, may lessen the impact. However, if sufficient planning and transition procedures are not implemented by all parties before LIBOR disappears, then serious disruption in both payments and new loan activity for US dollar transactions is likely to occur in countries with foreign-exchange controls.
One possible solution to the loss of interest-rate certainty and the additional time parties in emerging markets require to make foreign currency payments would be to permit a longer look-back or shift in interest determination. However, a greater mismatch between the actual interest period and the period used for determining the interest rate will make it more difficult for banks to manage their own exposure. It will further misalign the bank’s own cost of funds with the amount of interest it will receive.
A longer look-back or shift in the observational period of the interest rate will also create a significant divergence in practice between lending practices in developed markets and those in emerging markets.
If the practice in certain emerging markets requires more significant interest rate shifts, then it may stifle banks’ ability and willingness to provide new loans to borrowers in such jurisdictions.
A switch from LIBOR to SOFR might also run afoul of certain laws and regulations in emerging market countries.
For example, the market shift from what has been a stable and long-standing practice of forward-looking LIBOR to SOFR might inadvertently cause foreign lenders to contravene Kenya’s consumer protections laws. Michael Kontos, the managing partner of Walker Kontos, a Kenyan law firm, has noted that the switch to an interest rate that is not prospective in nature, and therefore transparent to a borrower, might create technical grounds for a borrower to bring a challenge under Kenyan law.
The transition also may create additional regulatory compliance issues. For example, all foreign loans to Brazilian entities must be registered as foreign capital under the financial operation registration (ROF) module of the Central Bank of Brazil, presumably to aid the country in managing its foreign currency needs and exposures. Jose Cobena, counsel in the Norton Rose Fulbright São Paolo office, notes that amendments to switch existing term loans from LIBOR to SOFR will require a new or updated ROF and may also face revised tax treatment.
The fracturing of LIBOR as the global benchmark into new reference rates across varying jurisdictions may present challenges for banks in multiple regions to co-finance projects in emerging markets.
It may splinter or complicate the agency roles for banks that seek a centralized actor to manage the flow of information and payments between borrowers and lenders. With the source of LIBOR and market conventions for interest-rate determination being well established, it is often possible for a single agent bank to handle this responsibility for a group of lenders. The switch to SOFR, or perhaps multiple benchmark rates within a syndicate of loans, as well as additional uncertainties surrounding adjustments to be made to new short-term benchmarks to better reflect longer interest periods, may make agency roles far more challenging, at least until such time as standard procedures and methodologies are widely adopted.
Impact on Local Lenders
The end of LIBOR will also have a significant impact on banks in emerging markets, many of whom have long-term credit arrangements with international banks based on US dollar loans.
Such banks will need to re-evaluate their interest-rate exposures to foreign lenders, including considering whether their own loan portfolios and hedging transactions should be altered to better control their exposure to the impending switch to SOFR.
Undoubtedly, some countries and banks will be better prepared than others. Those that choose to delay measures for too long may face increased financial risk and interruptions to their borrowing and lending operations as counterparties seek assurances that the transformed interest-rate risk has been mitigated.
There is significant variation in practices for interest-rate setting by banks in emerging markets.
While some markets and banks are relatively transparent and rely on LIBOR or other widely accepted benchmark rates, others use less straightforward rates typically presented as designed to reflect their cost of lending. In either case, banks in emerging markets will probably need to implement new rate structures as both the benchmark rates and their costs of funds are likely to change.
The lack of market transactions and transparency that precipitated the end of LIBOR might also trickle down to banks in emerging markets, leading to more transparent local benchmarks. As an example, in September 2019, the Reserve Bank of India required the country’s banks to transition to an external benchmark for interest rates.
Local banks will also be beholden to the speed at which central banks and other monetary authorities adjust to the end of LIBOR.
In El Salvador, banks and financial institutions are required to report their liquidity status, which includes information on the entity’s ability to honor its debts as they fall due, to the Superintendency of the Financial System each month. The central bank of El Salvador has not yet adopted any rules or announced a transition plan away from LIBOR. Zygmunt Brett, partner at the law firm BLP Abogados, notes that the private sector has undertaken initiatives to assess LIBOR exposures, but without a coordinated transition plan from the central bank, the end of LIBOR may present liquidity, operational and regulatory risks for both banks and borrowers.
Into the Void
While the end of LIBOR has been foretold for many years, the lack of an accepted forward-looking alternative together with the lingering hope that one might arise, has caused many banks and other financial institutions to delay their plans for necessary transitions.
Both lenders and borrowers may have to accept backwards looking interest rates for perhaps months or years, as there may be no forward-looking rate with the type of widespread acceptance as LIBOR for some time.
As year end 2021 approaches, borrowers and banks that fail to undertake an assessment of their exposures to LIBOR and transition to new practices and procedures are risking defaults with existing loans and interruptions in new loan activity.