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SL urged to brace for Libor transition

6 February 2020 09:16 am - 0     - {{hitsCtrl.values.hits}}

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  • Benchmark Libor to be phased out by end-2021 as world moves towards new short-term lending benchmark rates
  • Transition from Libor to Alternative Reference Rates complicated -ICRA Lanka
  • SL’s considerable amount of floating rate and FX debt could compound impact of Libor transition on economy
  • ICRA Lanka proposes CB to set up a working committee to co-ordinate transition process

 

 

The world is moving towards new short-term lending benchmark rates to replace the beleaguered London inter-bank offer rate (Libor), which helped governments, banks and companies to raise trillions of debt and the Sri Lankan corporates are risking a bumpy ride if they delay the transition process, cautions ICRA Lanka. 


In 2017, the Financial Conduct Authority in the United Kingdom announced the popular benchmark rate would be phased out by end-2021 and urged the central banks, banks and companies to find replacement and start transitioning from Libor to be fully ready for the new benchmark rate. 


While the banks and regulators settled for replacements created by the Federal Reserve, known as the Secured Overnight Financing Rate (SOFR) for pricing the dollar-denominated assets, Sterling Overnight Index Average (SONIA) has emerged for sterling-denominated assets.


Meanwhile, several other Alternative Reference Rates (ARRs) have also been proposed for other major currencies. 


But the question remains if the Sri Lankan issuers are ready for the transition, which is less than two years away, because there are significant differences between Libor and other reference rates, particularly in relation to the SOFR, as the Sri Lankan issues are dominated by dollar-denominated debt and have 
wider implications. 


“Transition from Libor to ARRs will be much more complicated than a straightforward administrative change in the benchmark rate. Therefore, the CBSL and Sri Lankan companies must start getting ready for it. 


This is because there are major differences between Libor and ARRs and in order to have a smooth transition, the impact of these intricacies must be understood deeply and reacted swiftly,” ICRA Lanka, which is part of Moody’s Investors Service, stated in a special report on the coming transition.


Libor is currently the most popular benchmark rate in the world with instruments linked to it grossing over US $ 400 trillion. But it fell out of favour by the regulators, investors and public in the aftermath of the 2008 global financial meltdown, due to its scandalous rigging. 


Sri Lanka has a considerable amount of floating rate (17 percent of the total debt in 2017) and foreign exchange-denominated debt (49 percent of the total debt in 2017). ICRA Lanka warned that this may compound the impact of Libor transition on the economy.

“The CBSL issues US dollar-denominated Sri Lanka Development Bonds (SLDBs) from time to time to raise funds. As of July 31, 2019, there are over US $ 1.3 billion worth Libor-linked floating rate SLDBs, maturing after 2021. 


The main implication for the SLDBs comes from the fall back language of the bond offer document. The fallback terms in the SLDBs are designed to handle cases where Libor is temporarily unavailable and are not geared to address the phase out of Libor in a sustainable manner.


In the current form, eventually, the floating rate will fall back to a fixed rate and this may not be commercially acceptable to the CBSL or investors. In addition, this may also initiate some litigation against the CBSL by bondholders,” ICRA Lanka added. 


The rating agency also forewarned that the foreign holding in the treasury bonds might be affected due to the Libor transition as bond holders swap their exposure back to rupees. 
“If there are no markets developed for the SOFR for hedging of the local currency, this may pose an impediment.” 


In addition to the Central Bank, the other issuers such as banks, state-owned enterprises and other companies could also be affected from the transition. The lack of advance visibility of the SOFR, compared to Libor, could have implications on repricing loan products and could also lead to basis risk, which arises from when they are swapped or hedged against the current or interest rate risks. 


The basis risk arises when the hedge becomes imperfect as various products could be at different stages in the transition process away from Libor. 


Meanwhile, the transition could entail wide scale implications on corporates, as the companies need to ensure that their reporting and trading softwares support the new reference rate. It will demand technology upgrades, staff training and could cause legal costs for amending or rewriting contracts.  


As a proactive measure, ICRA Lanka proposed to the Central Bank to set up a working committee consisting of stakeholders to co-ordinate the transition process. 


This will help all stakeholders to understand the potential impact and draw realistic time frames to complete the transition while ironing out the potential problems that may come their way.

 

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