End of Libor could trigger supply chain shock

Over 80% of global trade and supply chain finance prices use London’s interbank dollar offer benchmarks. Supervisors have ordered Libor funding for new transactions to cease after December 31, 2021, when most Libor rate releases will cease.

While the Intercontinental Exchange, the Libor rate-fixing body, will continue to publish one- and three-month Libor until June 30, 2023 for legacy transactions, regulated institutions have been warned that any new instrument referencing Libor instead of the secure overnight finance rate would not be welcome. and subjected to scrutiny.

The end of Libor risks significantly disrupting trade and supply chain finance at a time when central bankers in the US, UK and EU say chain-induced inflation supply is transient and will normalize by mid-2022. If the post-Libor transition to SOFR stifles global trade finance from January, they may have made a serious miscalculation.

Trade finance has always been a complicated and expensive banking industry. Trade crosses borders, involves complex multi-party and multi-jurisdictional documentation, requires licensing and compliance with complex national export and import regulations, and borrows in foreign currencies from both domestic banks and exporting companies .

Knowing your client, the fight against money laundering and terrorist financing, the fight against tax evasion and the fight against corruption are particularly difficult for a diverse clientele in several jurisdictions. Few banks have prioritized modernizing their trade finance operations over more profitable and less demanding market and credit activities as they digitize in 2020 during the pandemic. The Global the trade finance gap widened to $ 1.7 billion in 2020, a trade finance gap that is 15% higher than in 2019.

Too few banks are ready for the end of Libor, and even fewer exporting companies have trade finance documents for alternative references. Banks making the transition are targeting larger customers with trade deals over $ 50 million each, ignoring most customers.

Supervisors are part of the problem. They did not recognize early enough the need for SOFR forward rates for trade finance. They feared that trading in SOFR futures would affect SOFR’s overnight liquidity and reintroduce the risk of rate manipulation that hampered Libor. Supervisors have suggested that banks could calculate term rates for loans by looking back, dialing daily SOFR rates over the term to determine interest due at term.

It was unreasonable. No bank has ever lent money on retrospective compound rates, and neither bank nor corporate treasury systems support retrospective loan pricing or credit modeling. Business borrowers want the certainty of a fixed rate term to maturity, not a retrospective rate that is unknowable and non-priced when a loan is extended.

The regulator-backed alternative benchmark committee made matters worse when it announced in March 2021 that it would postpone its planned June 2021 approval of a SOFR benchmark, the latest element of its transition plan from Libor to SOFR.

CME group started posting one, three, six and 12 months SOFR forward reference rate from April 2021, based on implicit market expectations from derivatives. Some have questioned the robustness of the CME methodology and whether the use of the term SOFR can be limited by supervisors to specific use cases. The institutional use of these exclusive reference rates is also subject to user license CME, although no fees are charged until 2026. ARRC approval of the CME forward SOFR benchmark rates in July 2021 came too late to change Libor lending systems and documentation globally by the end of the year.

Even now, the path to the transition is not clear. Since SOFR is a risk-free rate, a “credit spread adjustment” is required for a benchmark similar to Libor, with an additional traded margin reflecting the risk specific to the borrower. The alternative is a margin traded on SOFR that is larger than what borrowers are used to seeing with Libor. Investors in lending instruments have pushed for credit spread adjustments that increase with duration, adding to the complexity.

Competition to provide a credit-sensitive post-Libor benchmark has led to further fragmentation: Ameribor from the American Financial Exchange, BSBY from Bloomberg and Bank Yield Index from ICE. All of these benchmark offerings have displeased supervisors and are too new to see which, if any, will gain critical mass as rivals to the term SOFR. Bank of England Governor Andrew Bailey warned an ARRC symposium in May that a growing mix of references was not viable.

The first SOFR trade deal was announced by JP Morgan on August 5, 2021. While JP Morgan intends to complete its own SOFR migration by the end of 2021, few other banks or clients using Libor will be successful. this feat.

Thousands of banks around the world that use Libor are doing nothing in the face of increasing complexity rather than building expensive systems and changing customer documentation to the “wrong” reference. Hundreds of thousands of exporting companies will do nothing to change Libor systems and documentation until they are guided by their banks.

Failure to continue financing trade at normal levels in 2022 could exacerbate the supply chain crisis and further disrupt the global economy. This risks higher and more persistent global inflation, weaker economic growth, and a weaker and more volatile post-pandemic recovery. As with any financial shock, weaker emerging markets, developing economies and small businesses will be marginalized and suffer the worst effects.

It would be ironic for supervisors responsible for financial stability to force banks and exporters to stop using Libor and thereby trigger the next wave of chaos in global trade and the supply chain. If trade and supply chain finance were to freeze in the post-Libor world of January 2022, central banks might have doomed ourselves and the rest of us to an economic, financial and economic outlook. inflationists much more complicated and uncertain.

Kathleen Tyson is Executive Director of Pacemaker.Global, a financial technology company that provides central banks with financial stability analysis and solutions.

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