By Casimir Leuridan & Melanie Beirens, Zanders, Belgium
The discontinuance of the Interbank Offered Rate (IBOR), scheduled for the end of 2021, will not only be a revolution for finance experts, it will also have significant implications for transfer pricing professionals.
The pricing of intercompany financial transactions, including cash pooling, financial guarantees, factoring, and hedging activities, will be affected by the planned rate switch. The greatest impact for MNEs is expected to center around intercompany loans.
From IBOR to ARR
The IBORs play a fundamental role for financial markets. In October 2019, more than USD 250 trillion in contracts were linked to IBORs, from plain-vanilla loans to complex derivatives.
Despite its popularity, the very nature of the IBOR has been questioned. The IBOR is defined as the interest rate at which banks included in the panel can borrow funds unsecured on the interbank market.
The IBOR is dependent on the panel banks and is thus quote-based. This has led to various scandals, e.g., Barclays was fined over USD 400 million in 2012 for manipulating the IBOR through its quotes, deteriorating the reputation of IBOR.
The discontinuance of IBOR is scheduled for the end of 2021, requiring new rates to take its place. The transition from quote-based IBORs to transaction-based alternative reference rates (ARRs) is being aided by local financial regulators, as each major currency will have a different ARR.
Although the ARRs are, in general, designed to be risk-free, this local approach will inevitably lead to differences. For instance, some ARRs are collateralized, e.g., Swiss average rate overnight (SARON) and the secured overnight financing rate (SOFR), which will contribute to a lower ARR compared to the corresponding IBOR.
Despite the above, most components of the methodologies will be applied consistently on the different ARRs. IBORs have a (small) credit risk component, namely the credit risk of the bank, which will no longer be the case for the risk-free ARRs.
Consequently, the ARRs are, in general, expected to be lower than the current IBORs. Further, the ARR will not only be based on the interbank market but will also involve payments made by banks to non-banks. This will increase the number of underlying transactions used to determine the interest rate.
Transfer pricing implications
The starting point for an analysis of the impact of the discontinuance IBOR on the pricing of intercompany financial instruments is the expected spread between the IBORs and the ARRs.
As explained above, this spread will not be consistent among different currencies and the impact of the new rates must, therefore, be assessed on a currency-by-currency basis. However, the spread will also depend on how markets react to these changes and on the stability of the ARRs.
When assessing the impact of the rate cessation on your intercompany loan portfolio it is important to first analyze which loans will be affected by the discontinuation of the IBOR and how they will be affected.
Only the floating rate loans maturing after the discontinuation will be impacted, while fixed-rate loans or loans maturing before the discontinuation will not.
The affected loans might require an adjustment to the credit spread at the time of the rate conversion to reflect the difference between the IBOR and the ARR.
Financial guarantees priced using the yield method will be affected in the same manner because this replicates the funding cost with or without the guarantee.
For cash pools, additional complexity is expected. The changes will be most striking for multi-currency cash pools due to the difference in characteristics between the ARRs. However, to understand the full impact of the IBOR reform for transfer pricing purposes, clarity is required on the term structure of the ARR.
With just two years to go, the greatest progress has been made on the creation of the alternative overnight rates, particularly on the alternative term rates expected in 2020.
For the pricing of future long-term (intercompany) loans, the term structure will be of crucial importance. Considering this challenging timeline, the transition to a fully transaction-based rate might not be feasible.
Hence, a hybrid approach may be necessary for the term structure. The first publication date is expected for SONIA term rates at the end of Q3 2020. The SOFR and Euro Short-Term Rate (€STER) term rates are expected by 2021.
Preparation for change
Preparation during 2020 will allow you to smoothen the IBOR transition. Assessing the impact for your MNE will be the first step, updating your pricing policy and documentation will be a crucial second step.
This should enable all newly initiated intercompany financial transactions with maturities extending over 2021 to be market conforming, i.e., prepared for the transition.
This can be done by structuring agreements with the new ARR already as the benchmark. Alternatively, fallback provisions can be put in place. These provisions should provide flexibility when the IBORs are discontinued and allow for the change in the reference rate. Ideally, these will also prevent the IBOR cessation to be considered a significant modification to the contract from a transfer pricing point of view and prevent the need to update the pricing.
In conclusion, transfer pricing professionals are encouraged to stay up-to-date with new developments regarding the IBOR reform as it can have a significant impact on the MNEs’ internal financing.
As market practice will change soon, these changes should also be reflected in the pricing of intercompany financial transactions. To smoothen this transition, transfer pricing professionals must stay ahead of the curve and assess the impact on their organization.
In addition, it is possible to already put mitigating measures in place such as amending the transfer pricing policy and including fall-back provisions in intercompany contracts.
— Melanie Beirens is a Senior Consultant at Zanders, Belgium.
— Casimir Leuridan is a Manager at Zanders, Belgium.
Thanks for the publication, very interesting. I had one small question that I Hope don’t sound silly. Is the ARR the same as the AAR as defined in the publication?