Trade Finance and IBOR Transition

Backward-looking risk free rates (RFRs) using compounded daily rates will replace IBORs in most financial products, but trade finance looks as if it will be an exception.  In this article, we examine why trade finance is a special case and why any delay in the development of forward-looking term RFRs would be particularly problematic for the trade finance market. The term "trade finance" covers both trade payables and trade receivables financing in its various forms (for example, factoring, invoice discounting, supply chain finance, trade receivables securitisation and bills of exchange facilities) and also loan based products (such as export credit agency backed financing, pre-export financing and commodity loans).

Most trade payables and trade receivables finance transactions calculate a discount to face value by using a forward-looking interest rate (whether it is explicitly referred to in legal documentation or not).  Of course, it is possible for the parties simply to agree the discount rate on a case by case basis, but using a forward-looking interest rate allows the parties to compare the cost of finance against alternative products and against their own cost of funds.  It also provides a transparent way of calculating the discount based on publically available information.

For loan-based trade finance products, the need for forward-looking rates might be less obvious.  However, there are a number of reasons why forward-looking rates are appropriate for trade finance loans, which do not necessarily apply to the general corporate syndicated loan market.  Payments under trade finance loans are often funded by, or otherwise linked to, other types of transaction, for example, sales and purchases of commodities, hedging transactions or the issue of letters of credit.  This means that there is an advantage in using a forward-looking rate which is readily available and which does not fluctuate over a 24 hour period; it makes it easier for parties to ensure that payments will match and to plan cash flows.  It is also preferable for many trade finance borrowers who do not have access to pricing information from the derivatives market and are therefore unable to calculate or anticipate swaps-based forward-looking rates.

The desirability of using forward-looking RFRs for trade finance transactions has been recognised by industry bodies and currency working groups.
 

• In relation to US$ (for which the RFR is expected to be SOFR), the ARRC FAQs of 15 October 2020 explicitly acknowledge that a forward-looking term structure for SOFR may be necessary; it states that with the availability of SOFR term rates and liquid derivative markets, it is expected it will be possible to use SOFR for cash products before the end of 2021.  ARRC has formed a term rate working group and (in September 2020) issued a RfP for an administrator for a forward-looking term rate. 
• The Working Group on Sterling Risk-Free Rates task force[1] estimated that it would be operationally achievable for 90 per cent of the loan market (by value) to adopt SONIA compounded in arrear in place of sterling LIBOR, but recommended the use of a term or other alternative rate for trade finance products such as export finance, discounting and supply chain finance. It emphasised the need in trade finance products for transparent rates that are observable to all parties and the operational requirement for some trade finance borrowers to have longer timescales to arrange interest payments than SONIA compounded in arrear would allow.  The Sterling Working Group has been working with four administrators (FTSE Russell, ICE, Refinitiv and IHS Markit) on the potential methodologies for term reference rates.  On 11 January, ICE and Refinitiv announced that they have finalised their methodologies which are now available for use in new contracts.  Both are offering SONIA term rates in 1, 3, 6 and 12 month tenors.  Each uses SONIA overnight index swap quotes to calculate their rates with back-up from negotiable dealer-to-client data from Tradweb and, for ICE, reference to SONIA futures listed at ICE Futures Europe.
• In November the BAFT IBOR Transition Working Group released a white paper - sofr-trade-finance-priorities.pdf (baft.org) – which argues that forward-looking rates are required for discounted trade finance products and that forward-looking RFRs should also be available for trade finance loans alongside backward-looking rates. 

 
If everyone accepts that the trade finance market needs forward-looking RFRs, what is the issue?  

Quite simply we risk running out of time to put forward-looking RFRs in place before the publication of LIBOR ceases.  The development of forward-looking RFRs is lagging behind the backward-looking rates.  

For example, the LMA has released an updated exposure draft of its multicurrency term and revolving facilities agreement incorporating a rate switch mechanism which references backward-looking RFRs, but no equivalent drafting has been developed for forward-looking RFRs[2].  The SOFR linked derivatives market also needs to develop sufficient liquidity to underpin a robust forward-looking term rate for US$ trade finance products.  It is understandable that backward-looking RFRs should be the priority, given that they are the solution which will be adopted by the bulk of the corporate loan market, the bond market and the derivatives market, but nevertheless it is concerning for the trade finance market and other potential users of forward-looking RFRs that their development is lagging behind.

It is also not entirely clear how long market participants will have to prepare.  The Financial Stability Board's guidance published in October calls upon firms to be ready for LIBOR to cease by the end of 2021. More recent coordinated statements from ICE Benchmark Administration Limited (IBA), the FCA, and US banking regulators in November suggest that there may be a little longer in relation to US$ LIBOR. IBA is consulting (as of early December) on its intention to cease publishing 1-week and 2-month US$ LIBOR settings immediately after its publication on 31 December 2021, but to cease publishing the remaining settings from 30 June 2023.  The FCA responded to that to say that it supported the consultation and was in discussions with US$ LIBOR panel banks for them to continue submissions through to the end of June 2023. US regulators issued a statement noting that extending the publication of certain USD LIBOR tenors until 30 June 30 2023 would allow most legacy US$ LIBOR contracts to mature before LIBOR experiences disruptions.  While this appears to be a welcome development, all other LIBOR currencies remain on the original 2021 trajectory.

In any event, a number of factors point to a relatively long lead time between agreement in principle on a methodology for forward-looking term RFRs and operational implementation:
 

• Different approaches for different currencies: experience in developing backward-looking RFRs suggests that that the precise way in which forward-looking rates are calculated is likely to differ between currencies.  In fact, some jurisdictions such as Switzerland, have indicated that they do not intend to progress forward-looking RFRs at all citing the unsuitability of the underlying securities markets from which that rate would be derived.  Trade finance facilities often feature multiple currencies which adds to the complication here.
• Published Rates: one of the attractions of forward-looking RFRs is the potential for rates to be published and readily accessible for multiple parties.  While ICE and Refinitiv have published their methodologies for forwarding-looking SONIA rates, the development of forward-looking interest rate methodologies for other currencies is less developed. Inevitably, there will also be some delay while the trade finance market works out which methodologies to adopt and for administrators to commence publication of rates. 
• Credit Adjustment etc: at first sight, the transition from IBORs to RFRs appears to be a technical issue, however, experience with backward-looking RFRs has shown that there are a number of commercial issues to be hammered out, either at an industry level or between transaction parties.  The most obvious example, is the basis on which a credit adjustment (effectively an additional margin) should be made when switching from an IBOR to an RFR to reflect the fact that there is an element of credit risk inherent in an IBOR rate (which by definition is absent from an RFR). Other commercial issues include:
  • whether floors that prohibit negative interest rates should apply solely to the RFR itself, or to the RFR plus the margin including any spread adjustment;
  • the circumstances in which an RFR should itself be replaced by cost of funds or another alternative rate such as a prime or central bank rate;
  • whether break costs and market disruption provisions are appropriate in the absence of matched-funding; and
  • the operation of trigger events which would bring about the switch to the term RFR ahead of the relevant IBOR's demise.
• Variations in Documentation: trade finance documentation does not have the same degree of standardisation as the syndicated corporate loan market.  While many loan-based trade finance facilities are documented using LMA precedents, equally many are not, whereas receivables sale documentation tends to be bespoke or specific to a particular funder.  The precedent drafting being developed by the LMA will not necessarily fit into all trade finance products.  This will add to the challenges involved in re-papering exercises.  Similarly, trade finance facilities that are not based on LMA documentation will have different provisions in relation to changes in the calculation of interest, meaning more room for dispute if re-papering exercises are not successful before IBORs cease to be published.

Working through these issues will take time.  For trade finance participants the best practical advice therefore is not to wait for a fully developed solution to IBOR transition or to assume a form of LIBOR will endure or that there will be a legislative solution, but to prepare for IBOR transition by:
 

• identifying facilities and products that will need forward-looking RFRs and those which can be made to work with backward-looking rates;
• identifying all relevant currencies for which a forward-looking RFR solution will be required; and
• assessing how existing documentation will hold up if a LIBOR rate ceases without a corresponding forward-looking RFR replacement.