The world is moving to new reference rates for pricing financial assets in 2022, and the shift will likely affect over 400 trillion US dollars (USD) worth of financial arrangements globally — from loans and derivatives (e.g. swaps) to insurance contracts, leases and mortgages. The change may also compel fundamental alterations to current business models and contracts. With the switch-over approaching fast, companies should start planning now to manage the transition, in line with guidance from financial and tax regulators.
What are governments doing?
Interbank Offered Rates (IBOR), including the London Interbank Offered Rate (LIBOR), will no longer be published after 2021. Financial regulators around the world have been getting ready by designating replacement reference rates and outlining procedures for adopting them.
In 2017, the US Federal Reserve’s Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the preferred replacement rate for USD-denominated LIBOR. SOFR is based on overnight transactions in the USD Treasury repo market.
In the UK, the Financial Conduct Authority (FCA) and the Bank of England worked in coordination to designate the Sterling Overnight Index Average (SONIA) — the overnight rate paid by banks that borrow from other financial institutions — as the replacement rate for contracts denominated in British pounds (GBP).
Other regulators have identified replacement rates for instruments denominated in euros, yen, Swiss francs, and other currencies.
How are companies responding?
Because IBORs are used so broadly, transitioning to new reference rates will be a fundamental and potentially complex change for many current business and financing arrangements.
Companies will need to alter all financial instruments, including loans, that refer to an IBOR by replacing it with the appropriate non-IBOR rate by the beginning of 2022. This applies to agreements with both related and unrelated parties.
Companies with high volumes of affected contracts have little time to make the needed changes. Further, as the end of 2021 approaches, the potential for a surge in volatility of IBORs means market participants may have even less time to put in place comprehensive, efficient processes to manage the transition. Indeed, the FCA and Bank of England are encouraging market participants to switch their effected derivative and cash products from LIBOR to SONIA in 2020.
The switch raises complicated process- and data-related issues that companies will need to address. For example, institutions holding or issuing IBOR-based contracts will need to:
- engage internal stakeholders (e.g. treasury, legal, tax, and information technology professionals)
- identify all affected financial agreements and set a remediation strategy
- assess potential exposures and determine strategies to mitigate risk
- set consistent approaches for all relevant contracts
- document procedures and results.
Some companies are already tackling the transition by starting to identify contracts, assess their risks and form operational and governance procedures for the transition. Among the tricky data issues that await them — the IBOR replacement rates generally lack term structures. While IBORs are quoted at various tenors — e.g. overnight, 3-month, and 6-month — SOFR and other replacement rates are currently available only for overnight financing. Without a comprehensive term structure, it will be difficult to price a loan with, say, a 3-month or 6-month interest reset cadence.
A growing market in derivative products, such as swaps and futures, is linked to SOFR, SONIA and other IBOR replacement rates, and it’s possible to derive implied forward rates from these products. Conversely, a term structure can be generated from historical overnight rates, compounded over the relevant period (e.g. 1, 3 or 12 months). Market standard term reference rates may eventually be available and published by the relevant regulatory authorities. Until then, uncertainty and inconsistent approaches will likely prevail.
Once the term structure issue is resolved, current and new financial contracts that refer to an IBOR will need to be amended. For loans, the focus will likely be on variable-rate notes maturing after 2021. In the US, the ARRC has indicated that these notes can be amended by adding "fallback language" to the agreements, generally in one of two ways:
- A "hardwired approach" that specifically designates the replacement benchmark to be applied upon the end of LIBOR, and procedures for effecting the change.
- An "amendment approach" that allows the parties to amend the loan and specify a new benchmark once LIBOR ends or at some other future date, and governs the relevant processes.
Institutions need to balance the advantages of immediate, hard-wired resolution against those of waiting for more reliable and complete market data.
The transition’s tax implications are also important, particularly for related-party agreements. Tax authorities generally require that changes to related-party financial instruments be made using the same methods and terms that unrelated parties would agree to, but regulators have published little specific guidance on how to meet this broad standard.
One exception is the US Internal Revenue Service (IRS), which has proposed regulations that set out key rules for switching from USD LIBOR to SOFR. These regulations state that the SOFR-based rate should be determined so that the fair market value of the instrument after the change, calculated by some reasonable method, is "substantially equivalent" to what it was before the change. Equivalence of fair market values is achieved by applying a "spread adjustment" when the change is made. US taxpayers can also avoid the fair market value test by applying a safe harbor that compares historical averages of the old and new rate. The safe harbor for loans with unrelated parties is satisfied where the new rate is determined through arm's length negotiations.
With no forward rates for SOFR, many financial instruments will likely face challenges when they calculate fair market values after the change, and also when applying the safe harbor option, given limited published history on SOFR (i.e. since April 2018). However, the IRS’s guidance is helpful, and it is hoped that they will address such data issues in their final guidance.
UK tax authorities have recently issued broadly similar draft guidance, though not as specific in detail as that of the IRS. Other tax jurisdictions may follow suit in the coming months.
Companies with significant IBOR-based assets or liabilities need to undertake a coordinated process to modify their financial instruments and related business models as needed. In view of the significant operational, financial, reputational and tax risks the switch creates, the time to act is now.
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