The world’s most important number is changing, and traders need to be aware of its implications.
For businesses both large and small, changes to the London Inter-Bank Offered Rate (LIBOR) could have far-reaching consequences, and one industry expert, Paul Coles, is keeping a close eye on the transition.
Chair of the International Trade and Forfaiting Association (ITFA) Market Practice Committee, Coles has almost 25 years’ experience in trade finance at names such as the London Forfaiting Company, ABN AMRO, Royal Bank of Scotland, Bank of America, and currently HSBC, where he is the distribution lead within the bank’s trade transformation programme.
As chair of the market practice committee, Coles focuses on understanding issues that could impact trade finance, and communicating these in real-time to ITFA’s members.
“Some of that can be just understanding what’s happening in the industry, what’s happening from a regulatory perspective, trying to decipher some of these impacts, and looking at providing guidance to our members,” said Coles.
“And another aspect is trying to create some consistency and standardisation in how to do trade finance, particularly for smaller institutions that might not be aware of what’s coming their way, and how to implement changes.”
The world’s most important number – LIBOR
At present, the biggest issue on Coles’ agenda at the committee is that of LIBOR transition.
The committee is has been working with the Bankers Association for Finance and Trade (BAFT) on the updated Master Participation Agreement (MPA).
Additionally, in June this year, Coles helped launch the ITFA-TFG Libor for Trade Finance Hub – a guide to assist members and traders through the transition.
“That’s been a really useful initiative for everyone, because it means there’s a central location that people can go to and find out more about the latest changes,” said Coles.
“LIBOR is obviously far-reaching in terms of the impact on the industry, but it’s not always obvious to know where things are up to – and things change from week to week, so it’s really difficult to pin down what’s happened recently if you’re not looking for it.”
As the UK Financial Conduct Authority (FCA) confirmed at the end of last month, LIBOR will be phased out at the end of 2021, and will be replaced with ‘risk-free’ or ‘synthetic’ rates, as reported by TFG.
“Thankfully, a lot of clarity has come about in the last few months,” said Coles.
“But I think early on, the pain points for the industry were not understanding how it would apply to products such as discounting, which happens frequently in trade finance – for example, in the open account space and supply chain, but also where you have bill discounting under a letter of credit.
“So any discounted product would need a term rate, and this is where there was a lot of confusion as to whether the transition away from LIBOR would give us term rates for these new risk-free rates that were going to be published.”
As Coles noted, the real question then becomes: what does trade finance do if there’s no term rate?
Pressure has been applied around this issue, however, and the FCA has since offered more guidance on term rates for currencies such as the US dollar, sterling, and Japanese yen during a post-2021 transition period.
“It’s a good step forward, and we can look at how to integrate that, but the other challenge is that you potentially have multiple publishers for these new rates, so you have to choose which one to use,” said Coles.
“Different banks and different parties to trade finance may choose different rates, so there’s quite a lot still to unravel.
“And of course, from a systems perspective, you then have to figure out, okay, where’s my new feed coming from? And what does it look like? Does it match like-for-like with what was published as LIBOR before?
“Those are the issues that have really impacted trade finance so far.”
Asked whether he thinks banks are prepared for the transition to risk-free rates, Coles said the situation is changing day by day.
“It depends how much of it can be done manually, and how much is systems-driven, but also the migration of client documentation and operational processes,” he said.
“If you think of the secondary market, it’s different from the origination aspects of trade finance.
“So, for example, if you are originating a trade finance transaction, typically the bank will state what rates will apply.
“When it’s between two financial institutions, they look at a mutual third-party rate. So you already have this little difference in how it operates, and you have to reflect that in the documentation.”
Updating all the relevant documentation is therefore a key part of the LIBOR transition journey, and making sure that all parties understand what rate they are moving to – and when – will be key.
Structured letters of credit
Another topic that ITFA’s market practice committee has been following closely – based on popular demand from members – is that of structured letters of credit (SLOCs).
As a “sub-product” of letters of credit, Coles said that SLOCs are widely misunderstood in trade finance, so one of the committee’s main aims is to raise awareness of what SLOCs can and can’t do.
“We’re not really trying to assess their worth in absolute terms, but we want to highlight the differences between a structured letter of credit and a typical, traditional letter of credit, and allow people to understand where the differences are with regard to risk profiles, but also the similarities.
“We want to remove the grey areas as much as possible, and allow people to make their own informed decision.”
Among the most common misconceptions that ITFA attempts to dispel in its guidance on SLOCs is how the instrument relates to fraud and default, and what SLOCs can offer in the event of each.
“That’s where our guide really tries to go into detail around the relative risks and operational aspects that people need to look into, and then make their own informed decisions and their own risk assessments,” said Coles.
“But broadly speaking, they have a reference point and know which are the flags and indicators that they need to focus on.”
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