TECHNICAL PAPER - MARKET COMMENT ON THE REPERCUSSIONS OF NEGATIVE REFERENCE RATES (FOR EXAMPLE LIBOR)

Following the recent decisions by several central banks to set negative benchmark interest rates – in addition to Japan, most notably the European Central Bank (ECB) and subsequently Switzerland, Denmark and Sweden – there are some repercussions that need to be considered by Trade Financiers.

There are several basic aims in moving benchmark interest rates into negative territory, predominantly linked to either:

• weakening a currency, thereby making its exports more attractive, and increasing the cost of imports in order to stave off deflation; or
• boosting spending by discouraging savings and promoting borrowing.

The latter is essentially aimed at banks: by making central bank deposits costly, the theory is that they will need to deploy their deposits elsewhere, hopefully in the form of loans which can stimulate an economy.  In turn, the interbank reference rates (such as LIBOR and EURIBOR) reflect the impact of the central bank rates and have consequently also gone negative in a number of cases.

This causes some issues for lines of business that use interest rate benchmarks as a mutually agreeable proxy for the cost of funds for a given period in a specified currency.

Trade Finance is one such line of business, especially since the financing is predominantly risk-based and pricing is typically quoted on a “reference rate plus risk margin” basis, even though the underlying transactions are not deposits.

What are we currently seeing in the market?

Our understanding is that it is becoming commonplace for institutions to set a floor of “zero” for the reference rate in master or transactional agreements, by using wording such as: ''If LIBOR is less than zero at any time of determination, then LIBOR shall be deemed to be zero''.

Why is this a growing trend?

Banks must assess and mitigate risk, in this case interest rate risk.

So what is the issue with setting a zero floor?

Clients may question why the perceived benefit of a negative (i.e. cheaper) rate is not being passed on to them. In reality though, it is not “free money” being provided by the central banks which is then not being passed on to customers; it is a disincentive to holding excess liquidity.

Consider the following related scenarios

LIABILITIES: Clients place funds on deposit with a bank. If the banks receive more deposits than they can redeploy profitably elsewhere (or have to retain some of these funds for regulatory reasons), they typically need to place the excess with a relevant central bank at the prevailing rate. If this rate is negative, the bank is effectively incurring a cost when placing these funds. In turn, these costs are sometimes then reflected in the negative deposit rates charged to clients (although it may not be always the case).

ASSETS: Conversely, if a bank is creating an asset by lending money to a client, it will need to use funds it has obtained from the liabilities side of its balance sheet. As explained above, the cost of obtaining these funds may be impacted by the negative benchmark rates.

What should you do?

In this context, each institution needs to assess how and where it obtains its funding in order to finance assets, and what an appropriate rate may be.

One way of addressing the issue is by using a “cost of funds” rate rather than a benchmark rate, however in practice this also has its challenges as it is harder for a third party (e.g. a borrower) to determine whether the lender’s cost of funds are correct or appropriate.

Any queries emanating from this paper can be addressed to Paul Coles, ITFA Board Member - Market Practice.

Disclaimer: This information does not constitute legal advice and is for educational purposes only.  You should not rely on this opinion as an alternative to seeking legal advice.