More than 80% of trade and supply chain finance globally prices using the London interbank offer rate term benchmarks in dollars. Supervisors have ordered that Libor funding for new transactions cease after 31 December 2021 when most publication of Libor rates will stop.
While the Intercontinental Exchange, the rate setter for Libor, will continue to publish overnight 1-, 3-, 6- and 12-month Libor in dollars until 30 June 2023 for legacy transactions, regulated institutions have been warned any new instruments referencing Libor instead of the Secured Overnight Financing Rate will be unwelcome and subject to scrutiny.
The end of Libor risks widespread disruption to trade and supply chain finance at a time when central bankers in the US, UK and European Union are saying that supply chain-driven inflation is transitory and will normalise by mid-2022. If the post-Libor transition to SOFR chokes off global trade finance from January, they may have made a serious miscalculation.
Trade finance was always a complicated and expensive banking sector. Trade crosses borders, involves complex multi-party and multi-jurisdiction documentation, requires licences and compliance with complex domestic export and import regulations, and borrows in currencies foreign to both domestic banks and corporate exporters.
Know your customer, anti-money laundering and counter-terrorism financing, anti-tax avoidance and anti-bribery compliance requirements are particularly challenging for diverse clientele in multiple jurisdictions. Few banks prioritised modernising their trade finance operations over more profitable and less demanding market and credit activities as they digitised in 2020 during the pandemic. The global trade finance gap grew to $1.7tn in 2020, a shortfall in trade finance 15% bigger than 2019.
Too few banks are ready for the end of Libor, and even fewer exporting corporates have trade finance documentation for alternative benchmarks. Those banks making the transition are targeting larger clients with trade deals over $50m each, ignoring the bulk of clients.
Supervisors are part of the problem. They did not recognise the need for forward-term SOFR rates for trade finance early enough. They feared term SOFR derivatives trading would detract from the liquidity of overnight SOFR and reintroduce the risk of rate manipulation that flawed Libor. Supervisors suggested that banks could calculate term rates for lending by looking backwards, compounding daily SOFR rates during the term to determine interest due at term.
This was unreasonable. No bank has ever lent money on backwards-looking compounded rates and neither bank nor corporate treasury systems support backwards-looking loan pricing or credit modelling. Corporate borrowers want the certainty of a forward fixed rate to term, not a backwards-looking rate that is unknowable and unpriced when a loan is extended.
The regulator-backed Alternative Reference Rates Committee made matters worse when it announced in March 2021 that it would push back its planned June 2021 endorsement of a term SOFR benchmark, the last element of its Libor to SOFR transition plan.
The CME Group began publishing 1-, 3-, 6- and 12-month Term SOFR Reference Rates from April 2021, based on market expectations implied from derivatives. Some have questioned the robustness of the CME methodology and whether use of term SOFR can be limited by supervisors to specific use cases. Institutional use of these proprietary benchmark rates is also subject to user license from the CME, although no fees will be charged until 2026. The ARRC endorsement of CME Term SOFR Reference Rates in July 2021 came too late to change Libor lending systems and documentation globally by year-end.
Even now the transition path is unclear. SOFR being a risk-free rate means a ‘credit spread adjustment’ is needed for a Libor-like benchmark, with a negotiated margin on top reflecting borrower-specific risk. The alternative is a wider negotiated margin over SOFR than borrowers are used to seeing with Libor. Investors in lending instruments have pushed for credit spread adjustments that increase with tenor, adding to complexity.
Competition to provide a credit-sensitive, post-Libor benchmark has led to further fragmentation: the American Financial Exchange’s Ameribor, Bloomberg’s BSBY, and ICE’s Bank Yield Index. All these benchmark offerings have displeased supervisors and are too new to see which, if any, will gain critical mass as rivals to term SOFR. Bank of England Governor Andrew Bailey warned an ARRC symposium in May that a growing mix of benchmarks was not viable.
The first term SOFR trade deal was announced by JP Morgan on 5 August 2021. While JP Morgan intends to complete its own term SOFR migration by end-2021, few other banks or clients using Libor will manage that feat.
Thousands of banks globally that use Libor do nothing in the face of rising complexity rather than build costly systems and alter client documentation to the ‘wrong’ benchmark. Hundreds of thousands of corporate exporters will do nothing to amend Libor systems and documentation until guided by their banks.
Failure to continue to finance trade at normal levels in 2022 could worsen the supply chain crisis and further disrupt the global economy. That risks higher and more persistent global inflation, lower economic growth, and a weaker and more unstable post-pandemic recovery. As with every financial shock, weaker emerging markets, developing economies and smaller corporates will be marginalised and suffer the worst effects.
It would be ironic if the supervisors responsible for financial stability force banks and exporters to stop using Libor and thereby trigger the next round of global trade and supply chain chaos. Should trade and supply chain finance freeze in the post-Libor world of January 2022, central banks may have doomed themselves and the rest of us to a much more complicated and uncertain economic, financial stability and inflation outlook.
Kathleen Tyson is Chief Executive of Pacemaker.Global, a fintech company providing central banks with financial stability analysis and solutions.