Client:

African Trade Lender

Challenge:

Identify, select, and operationalize a new reference rate to replace LIBOR in its Trade Finance business

Solution:

Transitioning to CME Term SOFR

Overview

An African Commercial Bank’s (ACB) Trade Finance products include export and import financing, receivables purchasing, supply chain financing, and trade-related Letters of Credit (LOC). Historically, USD LIBOR has been referenced to structure and price these products. However, as of July 1, 2023 USD LIBOR will no longer be published, and globally many institutions/markets have already moved to new reference rates. ACB, and many of its regional peers, have not yet and need to establish a roadmap to execute the transition. As such, ACB seeks to design and launch its LIBOR transition program to:

  • Identify the rate most likely to replace LIBOR in African trade finance,
  • And operationalize it with respect to corporate clients, especially large commodity exporters.

The Bank recognizes that CME Term SOFR was formally endorsed by the Alternative Reference Rates Committee (ARRC) in 2021, and that its use in Trade Finance was emphasized. While this is relevant information, ACB is not regulated by the U.S. Federal Reserve Bank, so it’s not required to follow its guidance. In addition, the Bank is aware that the Loan Market Association (LMA) has prepared a ‘Term SOFR Exposure Draft’ loan agreement for developing markets, which has not yet been finalized/published. Again, this contrasts with the developed markets where loan documents have been substantively standardized beginning in Q4 2021.

CME Term SOFR Reference Rates provide an indication of the forward-looking measurement of overnight SOFR based on market expectations, published daily for 1-month, 3-month, 6-month, and 12-month tenors. They are derived from CME SOFR futures, an increasingly robust and resilient underlying data set bolstered by a deep and diverse pool of market participants. As such, CME Term SOFR is a readily available solution to replace USD LIBOR.

Scenario

ACB issues USD denominated loans and Letters of Credit (LOC) to its corporate clients who are active in international trade markets. Its largest corporate clients are commodity exporters, a business which is crucial to Africa’s economy and is conducted almost exclusively in USD. As these loans and LOCs are priced and executed at a discount, their reference rate must be set at the beginning of the accrual period so that the discount can be calculated at that time and deducted from principal. With USD LIBOR cessation imminent and migration to alternative reference rates in developed markets at an advanced stage, the Bank is now planning its own transition away from LIBOR, without the advantages of the digital trade finance platforms that are well established by Banks in developed markets.

The Bank’s LIBOR transition objectives include:

  • Identify a replacement rate that allows for operational ease and simplified price consistency; therefore, the rate should be a forward-looking term rate set at the beginning of the interest accrual period so that interest costs are certain and discounts calculable in advance.
  • The replacement rate’s conventions should be consistent with the Bank’s established systems and risk management processes that are based on LIBOR.
  • ACB should actively avoid use of ‘in arrears’ rate sets because its own systems and those of its clients can’t accommodate them.
  • Maintain or improve the Bank’s current competitive position in core markets.
  • Manage liquidity, funding, and asset impairment risks.
  • Limit and eventually eliminate new LIBOR business, while identifying for remediation any longer-dated (mostly project) loans.
  • Rationalize price adjustments needed to reconcile new and old reference rates.

Over many months, the Bank gathers information from market participants to understand likely outcomes. This includes discussion with Trade Finance market leaders such as Afreximbank, industry groups, such as the International Trade and Forfaiting Association (ITFA), and the Bankers Association for Trade and Finance (BAFT), correspondent banks, other development banks, as well as CME Group and other market infrastructure providers.

Information and analysis:

  • CME Term SOFR is a forward-looking term rate that enables cost certainty and comparative pricing and thus fits with ACB’s transition objectives.
  • There is a need internally for education around IBOR Transition and CME Term SOFR. While ACB’s Treasury and Legal functions are somewhat familiar, the rest of the bank is not.
  • This need extends to clients, external counsel, bank peers, and Export Credit Agencies (ECAs), and may include information about CME Term SOFR, its methodology, and robust management by CME Benchmark Administration (CBA).
  • Legal Documentation – while standardized CME Term SOFR documents are available in developed markets, they have not yet been adapted to the unique issues of developing markets. Uniformity across loan agreement documentation is essential, so the seeming lack of urgency among African market participants to finalize these drafts is of concern.
  • Operations – while CME Term SOFR’s conventions are consistent with prior reference rates, there are some slight differences, which require operational adjustments alongside the documentation considerations noted above.
  • Asset Value, Liquidity, and Funding – Over the course of 2022, and the first half of 2023, LIBOR instruments will become gradually less liquid, while SOFR instruments will become gradually more liquid. While the pace of this dynamic is subject to debate, as well as to numerous market forces, its occurrence is almost certain. Most of the Bank’s loans and other LIBOR assets mature in less than one year, but some (e.g., project loans) don’t. Especially for these longer-dated assets, there is real risk that asset value may deteriorate due to these factors, everything else being equal.
  • Product pricing – the uptake of Alternative Reference Rates (ARRs) in developed markets has been robust and may provide a model for African market participants, providing them an opportunity to align themselves with certain precedents being set in other global regions. However, further delays in implementing LIBOR Transition programs by ACB and others in developing markets could pose unwanted and unforeseen difficulties.
  • Some loans to local Small and Medium Size Enterprises (SME) are denominated in local currency, while much of ACB’s funding is in USD. Methods of managing foreign currency exposures will need to be adapted to accommodate the new reference rates.

Action steps are formulated:

  • Engage with CME Group regarding CME Term SOFR licensing and to gather in-depth information about the rate calculation methodology and its management.
  • Discuss with CME how to provide educational content for internal and external use.
  • Dialogue with external counsel and ECAs, such as Afreximbank and the African Development Bank, to best understand market dynamics and developments specific to the African Trade Finance market, especially regarding pricing and documentation consensus.
  • Adapt existing systems to operationalize CME Term SOFR and to develop product pricing capabilities.
  • Bank Treasury and Risk Management teams launch a detailed analysis of LIBOR asset risk and an evaluation of SOFR liquidity with emphasis on CME Term SOFR. By engaging CME Rates, Sales, and Product professionals, a better understanding of the SOFR market emerges and its growing liquidity is monitored by the Bank, informing prospective decision-making.
  • Potential changes in foreign currency exposures are also discussed with CME, with an eye towards using CME FX futures as needed.

Conclusion

The Bank has a clearer picture of the post-LIBOR Trade Finance landscape and how to navigate it. It has concluded that CME Term SOFR is a robust solution for much of the Trade Finance market to replace USD LIBOR and has implemented a process to operationalize it and reconcile pricing adjustments with customers. With the support of CME Group client service, it understands, and has initiated, the CME Term SOFR licensing process, as well as further research on how CME ‘s portfolio of risk management products can help control unwanted rate and currency exposures.


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