LIBOR Phase-out, RFR Adoption: A Path Forward for Sri Lanka
By Lalinda Sugathadasa
The Central Bank of Sri Lanka (CBSL) should play a more active role in facilitating the transition in Sri Lanka.
There is indeed little doubt that Central Banks and major firms around the world have heaved a sigh of relief in light of the announcement from LIBOR’s administrator, ICE Benchmark Administration (IBA), that it would continue to publish overnight and one, three, six and 12 month USD LIBOR settings until 30 June 2023.
Sri Lanka, with a relatively high dollarised debt (USD 56 billion, or 67% of the GDP in 2019), is likely to have a substantial exposure to USD LIBOR and the current picture is expected to remain more or less the same for the next five years.
The Alternative Reference Rate Committee (ARRC), the body that is tasked with facilitating the USD LIBOR transition, has identified SOFR as the preferred replacement rate and is urging market participants to continue to push ahead with the transition.
It is true that the postponement has greatly eased Sri Lanka’s worries in this respect, but that should not be a reason for market participants to be complacent and treat it as a simple administrative change in the benchmark rates.
Orderly transition from LIBOR and the adoption of Alternative Reference Rates (ARRs) should continue to be encouraged to promote financial system stability. This requires the collective efforts of Sri Lanka’s regulator, the Central Bank of Sri Lanka (CBSL) and other domestic market participants.
The purpose of this article is to serve as a primer on the path forward for LIBOR phaseout and the adoption of a Risk-Free Rate (RFR) in Sri Lanka.
Developments in the region
The Covid-19 crisis may have hindered transition progress in the region. However, several milestones were still met last year. First and foremost, the conventions for a series of SOFR linked cross-currency basis swaps (CNY/USD, SGD/USD, MYR/USD) were finalised in Asia last year.
Meanwhile, billions of dollars worth of SOFR referenced debt instruments have already been issued in Asia. Moreover, major jurisdictions in the region have adopted their own overnight RFRs to replace existing interbank offer rates (IBORs) – including in Hong Kong (HONIA), Japan (TONIA), Australia (AONIA), Thailand (THOR), Indonesia (IndONIA), Malaysia (AOIR) and Singapore (SORA).
Unfortunately, the South Asian market is lagging behind its East Asian counterparts. The Reserve Bank of India (RBI), the regulator that the CBSL often turns to for inspiration, has taken some strides with respect to the LIBOR transition, putting plans in motion to replace India’s widely used MIFOR, which is linked to LIBOR. In addition, the Central Bank of the South Asia’s third largest economy, Bangladesh Bank, has released a policy document outlining a strategy to phase out LIBOR.
As of now, Sri Lanka does not have a synthetic LIBOR linked index such as SOR, MIFOR or THBFIX. The CBSL suspended compilation and publication of Sri Lanka Interbank Offered Rate (SLIBOR) last year and announced that an ARR is in the works for market participants to use in future.
Sri Lanka’s context
The magnitude of Sri Lanka’s exposure to LIBOR in the form of loans, bonds, derivatives, and deposits is hard to judge – let alone measure those that expire after the end of June 2023. Though comparatively a shallower market, it is worthwhile to investigate the nature of LIBOR-linked instruments in Sri Lanka.
The Government of Sri Lanka (GoSL) is the entity with the single most exposure to LIBOR in the country. The GoSL borrows long-term (over 10 years) from bilateral agencies or multilateral institutions to fund large-scale development projects. Typically, these are denominated in USD or EUR, hence the loans with variable interest rates are linked to USD LIBOR or EURIBOR, both of which are set to be phased out.
In addition, the GoSL raises medium-term syndicated credit lines (for instance the Foreign Currency Term Financing Facility recently set up by the GoSL) from international and domestic banks and investment houses from time to time which may have exposure to a base rate such as LIBOR. The GoSL also issues Sri Lanka Development Bonds (SLDBs), a series of Eurobonds, from time to time to raise foreign currency (FC) reserves, where the floating rate notes are linked to USD LIBOR.
By far, domestic banks are the most vibrant of all when it comes to exposure to LIBOR. Domestic banks have LIBOR exposure on both the asset and liability side of their balance sheets and have exposure through a myriad of modalities. The bulk of the exposure on the liability side, are through long-term subordinated loans from international banks and multilateral agencies. In addition, a limited number of banks offer variable interest rate eurocurrency deposits, which pays LIBOR plus a margin.
Exposures on the asset side are mainly from lending to large corporates, typically as bilateral loans with relatively softer securities, and sometimes as syndicated loans. State banks also have large FC exposures to Sri Lanka’s largest State-Owned Enterprises (SOEs) such as utilities and the national airline.
Domestic banks also have considerable amounts of floating rate SLDBs on their balance sheets. Banks hedge the interest rate risk arising from FC floating rate instruments through interest rate swaps (IRS) and offer OTC IRS as a part of their product offerings to clients. However, the market for FC IRS is comparatively small in Sri Lanka.
Some of the large non-bank SOEs have obtained short-term FC floating rate loans from international banks, typically against pledged securities. In certain instances, State banks have extended overdraft facilities linked to LIBOR to these SOEs. It is also quite possible for Sri Lanka’s State-owned petroleum company to have some LIBOR exposure via non-financial contracts.
In addition, large private firms occasionally fund their short to medium-term offshore operations through FC borrowings, often from non-state domestic banks as collateralised floating rate loans. There are few instances where large scale borrowings were obtained as syndicated loans. The use of derivatives among Sri Lankan corporates to hedge their interest rate risk is limited; even in these limited cases, they use plain vanilla swaps.
There seemed to be widespread incredulity about the repercussions of the LIBOR phase-out among both banks and corporates alike, which has led to complacency. The risks for firms range from operational risk to reputational risk, and the lack of market readiness could have a substantial impact on the profitability and access to Eurodollar markets.
Borrowers run the risk of facing a potential increase in interest expense if the existing credit agreement triggers an alternative rate once LIBOR ceases to exist, such as the prime rate, which has historically been higher than the LIBOR. To avoid this fate, borrowers must either seek an amendment or prepay the loan in advance.
The vast majority of derivative contracts in Sri Lanka are either standard 2006 ISDA master agreements or some version of them. The existing fallback provisions in these contracts are grossly inadequate to handle a permanent cessation of the reference rate and hence, the floating leg of such derivatives will be impaired rendering the instrument completely inoperable.
There seemed to be a divergence of fallback protocols (i.e., mode of the benchmark replacement, spread adjustments, trigger events) between derivates and cash products which results in some degree of basis risk for market participants.
Given the risks associated with LIBOR transition, it is absolutely necessary for the CBSL, banks, and firms to act with urgency to formulate exit strategies at the product, firm, and market levels.
At the product level, two main approaches have emerged to deal with the LIBOR phase out. Under the Amendment approach, the borrower, agent or originator chooses a replacement rate and spread adjustment and the lender or majority of the lenders have five days to object. An objection triggers the parties to adopt a prime-based rate in the absence of a mutually agreeable replacement rate.
The second approach, the Hardwired approach, considers a preset fallback to change the replacement rate to an ARR (SOFR in most cases in Sri Lanka) plus a modified spread prescribed or recommended by ARRC or ISDA.
The derivatives market is more likely to adopt the Hardwired approach where the RFR is compounded in arrears. For common legacy derivatives such as IRS, it is necessary for the parties to adhere to the ISDA fallbacks protocol while for new contracts they should apply the ISDA fallbacks supplement. In certain cases, the parties may decide that the unwinding of legacy derivative positions is more prudent than making contractual amendments.
For legacy cash products – including collateralised loans, credit lines, syndicated loans, and term loans – the ARRC has recommended to follow the Amendment approach, while newer issuances should incorporate the Hardwired fallback. For cash products, the ARR will be calculated in advance in the absence of forward-looking term rates.
Existing floating Eurocurrency deposits are less likely to be a problem for banks due to the limited number of such deposits. Banks can either allow the rate to fall back to a fixed rate or amend the rate after acquiring consent from the deposit holders. For new deposits, it is recommended to adopt the ARRC floating rate debt fallback to avoid any ambiguity arising from the permanent cessation of LIBOR.
The postponement of the LIBOR end date has helped to diminish the complications in SLDBs significantly. The bulk of the SLDBs that mature past June 2023 are fixed-term bonds, while only USD 6 million are floating rate notes at the time of writing.
Amending the fallback language requires unanimous consent from the instrument holders. Therefore, consent solicitation should be initiated in an appropriate time frame ahead of the envisaged end date for LIBOR. Optionally, the latest ARRC recommended fallback language can be incorporated into contracts and the consent threshold level can be lowered for new issuances.
Multilateral agencies and major international banks that are primarily on the sell-side have laid out plans to transition away from LIBOR. As such, solicitation of amendments to sovereign and non-sovereign loan agreements are underway to support the transition for borrowers. This reduces the risks for the GoSL and domestic banks that are on the buy-side of these instruments.
However, the amount of effort put in by domestic banks to transition the sell-side of their portfolios is inadequate. With Sri Lanka’s poor credit rating standing, it is less likely that banks’ FC exposures would grow apace for the next few years; they are exposing themselves to huge reputational risk if they decide to play a more reactive role.
Banks and companies need to do more to actively transition away from LIBOR. The first task for firms is to ascertain their LIBOR exposure levels in both financial and non-financial contracts. A cross-functional team can be formed to roll out firm-level transition plans, monitor market developments and determine the optimal timing for exit. Technological and operational readiness is of foremost importance in this regard.
Though there is no legal mandate for the CBSL to facilitate LIBOR transition, it is not realistic to expect the market to do this on its own. Therefore, as the regulator, the CBSL, should play a more active role in facilitating the transition in Sri Lanka. A good starting point is to establish a working group comprising key stakeholders to implement a comprehensive market-wide strategy.
In addition, the CBSL can seek firm-level plans from financial institutions to assess market readiness. There is also a severe knowledge gap among the market participants in Sri Lanka about the LIBOR transition. This must be addressed urgently to bridge the gap. It is also crucial for the CBSL to ensure the required infrastructure is in place for the transition.
Another issue that is not directly linked to LIBOR transition but potentially will serve to enhance the functioning of the domestic financial market and promote integration with the global market in future is the adoption of an RFR in Sri Lanka. Currently, loans and debt instruments such as commercial paper are priced using the Average Weighted Prime Lending Rate (AWPLR), a rate compiled by the CBSL based on short-term unsecured lending to prime customers by commercial banks.
While the domestic RFR which can replace AWPLR is currently under development, it is preferable that the rate is compliant with the International Organization of Securities Commissions (IOSCO) standards. Therefore, much work is still remaining to introduce and operationalise the upcoming ARR among the market participants.
Lalinda Sugathadasa is an economist and currently heading the research vertical at ICRA Lanka, a credit rating agency associated with Moody’s Investors Service