By John Hintze
S&P: Libor departure presents challenges for floating-rate debt markets; corporate debt, too.
The shift away from the London Interbank Offered Rate (Libor) is now firmly on the horizon, but is a fractured market with no consensus reference now in store? It could be, according to a recent report from Standard & Poor’s concerning issues the structured finance market will have to address. These challenges will also impact more straightforward corporate debt as well as swaps.
The UK Financial Conduct Authority (FCA) announced in July a proposal to phase out Libor in favor of alternative rate references by 2021, and later in September the European Central Bank (ECB) said it would create an overnight interest rate before 2020. In the US, the Commodity Futures Trading Commission and the Securities and Federal Reserve have each expressed support for the FCA’s proposal.
“But any transition will create a significant challenge, as the market’s exposure to floating base rates like Libor, Tibor, Hibor and Eurobor is significant,” noted S&P in a recently issued report titled, “With a Libor Phase-Out Likely After 2021, How Will Structured Finance Ratings Be Affected.
“The Treasury department’s industry-supported market practices group has identified more than $160 trillion of Libor-related financial products, suggesting any transition to a new reference rate would have to be carefully choreographed and pre-tested in order not to disturb financial markets,” the report says.
The report specifically addresses structured finance, but many of the issues it raises will also apply to corporate debt and the swaps companies often use to hedge their assets and liabilities, according to S&P’s Paul Watters, head of corporate research, European corporate ratings.
“The real challenge will be coming up with a market-driven consensus about what the replacement benchmark should be,” Mr. Watters said.
Much of corporate floating-rate debt comes from bank lenders. Mr. Watters said that the Loan Market Association (LMA) in Europe provides standard language about how to replace Libor with another benchmark, and to the extent there’s a disagreement between parties it permits using other benchmarks so long as there is agreement. In the absence of Libor there is already provision for each lender to give their own cost of funding to the agent bank, to calculate a weighted average cost of funding.
“This is quite convoluted and lacks transparency so probably would suffice only as a short-term solution,” Mr. Watters said. One (transitory) problem for corporates’ existing debt, whether structured or otherwise, he said, may occur if Libor becomes an obsolescent benchmark in the event that an alternative benchmark becomes established. In that case, existing contracts would need to be amended.
“More problematic would be a situation where Libor ceased to be quoted or was no longer perceived to be a robust benchmark for the interbank market or swap market to use, and no acceptable alternative was available,” Mr. Watters said.
In that case, he said, it is conceivable that regulators could require banks to continue supporting Libor until a viable alternative is identified. However, that assumes consensus can be reached on a what that alternative is.
“The real challenge will be coming up with a market-driven consensus about what the replacement benchmark should be.”
“So effectively there would need to be an alternative benchmark that is deemed to be credible and robust and agreed upon by the industry,” Mr. Watters said. “If not, then you can imagine regulators would have to extend the life of Libor and push benchmark data providers to continue providing their data.”
Corporates should review the language in agreements supporting their existing long-term debt to see if they contain language providing steps to take in the absence of Libor, and S&P notes in its report that some structured transactions it analyzed do not. And clearly making sure such language is provided in future debt agreements is prudent.
Mr. Watters added that corporates may also want to track what alternatives to Libor are proposed going ahead, most likely from regulators and trade groups, and the likelihood of consensus arising around one. Several competing benchmarks could emerge, but like different measures of inflation, that could result in market participants disagreeing on which is more appropriate or cost effective.
“That’s really going to be the challenge, because [a benchmark] is going to have to be created from scratch,” Mr. Watters said.