Last week, the International Swaps and Derivatives Association (ISDA) launched the ISDA 2020 interbank offering rates (IBORs) protocol (the protocol), which is designed to assist derivative market participants with their IBOR plans.
For purposes of context, IBORS are reference rates/benchmarks used in financial transactions to determine amounts payable by the parties to those financial transactions, including in loan markets, derivatives, bonds and structured financial products. In the Ugandan context, such rates are key determinants of pricing for money, especially foreign direct investments, interbank loans, and foreign backed loan syndications.
The main IBORS include the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR), and the Tokyo Interbank Offered Rate (TIBOR). In South Africa, the Johannesburg Interbank Average Rate (JIBAR) is also a famous benchmark rate at which banks buy and sell money. These rates are usually fixed daily (overnight) as effective interest rate (yield) and then converted into discounted rates, which can be spread across in one-month, three-month, six-month and twelve-month discount terms.
As a result of several scandals involving IBOR fixing/manipulation, international jurisdictions such as the UK, US and South Africa have decided to adopt new alternate reference rates (ARRs) or risk-free rates, which are more market based, robust and less susceptible to potential manipulation/fraud.
This move will impact several Ugandan firms’ asset and liabilities structures, risk profiles, existing and future agreements since Uganda is a net importer of capital for purposes of investment, large project finance, and financial institutions’ on-lending purposes. For instance, in 2016, it was reported that Stanbic Bank Uganda, the largest bank by assets in Uganda borrowed USD 55 million from a club of syndicated lenders arranged in Dubai at an interest rate of LIBOR plus 2.75% margin on the loan.
According to IFC, LIBOR is the most widely used interest rate benchmark to price/value a wide range of financial products, including corporate and personal loans, mortgages, bonds, securitizations and derivatives, underlying over $370 trillion of transactions globally.
Entities most likely to be impacted include Investment banks, Commercial banks, Retail banks, Asset managers, financial markets infrastructure/system providers, Pension funds, Insurance / reinsurance companies, Non-bank lenders such as venture capital and private equity funds, and Corporates. This impact is likely to arise from the fact that Uganda’s financial system is getting increasingly globalized and interlinked into the international financial system.
Furthermore, IBORs are also deeply embedded in our financial system due to several other applications such as regulatory cost of capital calculations by Bank of Uganda/BoU (the Ugandan Central Bank), performance benchmarks for asset/investment managers, accounting for provisions and impairment on assets, valuation, and late payment calculations such as penal interest in commercial contracts.
The UK Financial Conduct Authority (FCA) has set 31st December, 2021 as the date to end the use of LIBOR completely. However, to help achieve this, banks were advised to stop pricing new loans against the LIBOR by 30th September, 2020. Reuters has described this transition as “one of the biggest tasks faced by markets in decades” as contracts must be switched to alternatives compiled by Central Banks in Britain, the United States and the euro zone.
The Sterling Overnight Indexed Average (SONIA) is being proposed as the replacement rate by the Bank of England/BoE (the English Central Bank). SONIA measures the rate paid by banks on overnight funds. It is calculated as a trimmed/discounted rate paid on overnight unsecured wholesale funds. According to the BoE, the SONIA is the most ideal alternative rate because it is anchored in active, liquid underlying markets. However, this process is still in its infancy stages as no detailed guidance for key products such as bond, loan and derivative markets is yet to be concretized.
In a bid to prepare the Ugandan financial services sector for the transition, the following interventions may be undertaken by the affected entities as they prepare for the LIBOR sunset;
- Contract reviews and due diligence on the affected transactions with a view of formulating risk assessment and mitigation plans.
- Early customer outreach and engagement sessions with a view of jointly developing new models and mechanisms to address the likely implications of the transition on specific clients and building the requisite customer relationship management tools to address client concerns.
- There will most likely be need for document re-drafting, re-negotiations and amendments to existing and future finance documents. Financial Institutions are advised to empower their legal teams together with external Counsel to form working groups that will oversee this transition process. For contracts subject to foreign law, implications will have to be further assessed at group level in collaboration with international/group counsel.
- There is also need for comprehensive product and underlying infrastructure reviews. The most impacted products will include debt securities such as corporate and sovereign bonds; securitized products such as mortgage-backed securities, asset-backed securities, commercial mortgage-backed securities and collateralized debt obligations (CDOs); Short-term instruments such as repos, reverse repos, time deposits and commercial paper; Over-the-counter derivatives (OTCs) such as interest rate swaps, cross-currency swaps, equity derivatives, commodity derivatives and inflation derivatives; and Exchange-traded derivatives such as interest rate options and futures.
- Tax reviews and assessments should be carried out to determine both compliance and likely implications since in most cases, IBORS are the rates used in transfer pricing documentation as benchmark for assessing the arm’s length nature of intercompany loans. Once IBORs are phased out, the transfer pricing documentation and intercompany financing agreements will need to be updated to include the agreed replacement rates.
In a nutshell, it is anticipated that BoU will give formal regulatory and supervisory guidance to Ugandan supervised financial institutions on how to handle the IBORS transition process and official alternative reference rates to consider. The respective industry associations are advised to seek formal regulatory guidance to enhance both domestic and cross-border compliance before implementing any new alternative reference rates.