Hedge Trackers’ Perspective on Replacing the Most Important Number in the World

Bloomberg Opinion – “How Do You Replace the Most Important Number in the World?”

Satyajit Das, writing for Bloomberg

“A further issue relates to hedging interest rate risk. The nascent derivative markets in new benchmarks don’t currently approach the quality, depth and liquidity of established Libor-based instruments. The new benchmarks, especially where the reference rate used in a loan or investment differs from that underlying the derivative, create mismatches that will be exacerbated in volatile conditions. This may create hedge accounting difficulties, forcing mark-to-market gains to be recognized as current-year gains or losses, creating earnings unpredictability that may discourage risk management.

Finally, with Libor being phased out by 2021, the transition from existing to new rate structures presents logistical challenges. It requires identification of affected transactions, selection between migration to the new rates or using fallback arrangements and then documentation of the changes. Procedural and authority issues, as well as legal and tax implications — for example, from the termination of certain hedging arrangements — complicate the transition. Asymmetric effects on parties, creating winners and losers from rate changes, increase the risk of litigation. Bank of England Governor Mark Carney has warned of the complexity of transition.”

Hedge Trackers Senior Director of Client Services, Ruth Hardie,

Understanding the issues relating to interest rate risk and the complexity of the transition from LIBOR, this is how I’d recommend Treasury respond:

1. Read through all of your documents containing LIBOR. Don’t limit yourself to the obvious – think leases, accounts receivable, transfer pricing, etc.
2. Know your fallback positions.
3. Start renegotiating troublesome fallbacks now.
4. Begin talking to your bank about innovative options.
5. Educate the rest of your organization on the transitions so that new contracts that use an interest rate can begin migrating away from LIBOR.