LIBOR Phase Out: Considerations for Supply Chain Finance

future

LIBOR has been the default benchmark interest rate for supply chain finance since this technique was developed approximately 20 years ago. By year-end 2021, LIBOR will be phased out.

So how does this impact supply chain finance? For a market that is approaching $500 billion globally in size, it’s a significant challenge.

There are two areas to explore – 1) how the change will impact future pricing and 2) the operational workload to change current contracts. I would argue the second issue is far more important than the first.

When it comes to pricing, you can use a different base rate. The Fed convened the Alternative Reference Rates Committee (ARRC) in late 2014 to identify a set of alternative U.S. dollar reference interest rates and to determine an adoption plan for their use. In June 2017, ARRC recommend a broad Treasuries repo rate, now called the Secured Overnight Financing Rate (SOFR), which is the cost of overnight loans that use U.S. government securities as collateral.

SOFR may not be the most applicable rate for supply chain finance for at least two reasons:

  1. First, SOFR is essentially a risk-free rate, as it is based on transactions secured by U.S. government securities, whereas LIBOR is more closely aligned to a bank’s cost of funds.
  2. Second, SOFR is an overnight rate, while LIBOR is a forward-looking term rate (i.e., 1 month, 3 months, 6 months and 1 year).

In my opinion, these problems can be overcome. A good banker should be able to have the new benchmark and add what risk + capital premiums to come up with the price, although I would argue supply chain finance has been mispriced in the past. (See post Is Supply Chain Finance Pricing Mispriced?)

The bigger issue, in my opinion, is the operational work. Many banks that offer supply chain finance to large corporates use LIBOR as a base rate to calculate spread the banks charge. By changing the base rate, all contracts will be open for renegotiation. This will have huge implications that have yet to be thought through. Think about the operational processes involved. Today, if your supply chain finance agreement references LIBOR, you have to make companies physically resign documents.

The amount of time it takes to operationally implement changing all those contracts and the implications for negotiations are immense. Think about it, someone is looking to sell exposure, and you don’t have a contract in place, but they want you to sign it. Think of the leverage that company has.

I don’t hear many talking about the operational work involved. This is a huge operations process. 2021 is just around the corner.

David Gustin runs a research and advisory practice centered on helping financial institutions, vendors and corporations understand the intersection of trade credit, payments and the financial supply chain. This post was written while David worked on a special project with The Interface Financial Group.

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