Originally, but no longer, an acronym for “London Inter-Bank Offered Rate”, LIBOR is a formal, regulated, benchmark short-term interest rate.
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It is compiled and published on business days in London, normally at 11.55 am, by ICE Benchmark Administration Limited (IBA). It refers to a series of daily unsecured simple-interest-rate benchmarks in several currencies and maturities. Rates are rounded to 5 decimal places of a percent.
LIBOR provides an indication of the average rate at which its contributory Panel Banks could obtain wholesale, unsecured funding for a given period, in a given currency. Looking at the overall market, one would expect that some banks could fund at rates below the relevant LIBOR and many would fund at higher rates.
For actual rate series see [https://alfred.stlouisfed.org/category?cid=33003 LIBOR rates from 1986].
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[https://c2fo.com/ C2FO]
Given that there is no guarantee that LIBOR will continue to be published after 2021, corporates must start to prepare to transition away from LIBOR as soon as possible, to minimise the longer-term risks of referencing a 'dead' benchmark [https://www.treasurers.org/liborreform ACT: Benchmark reform - the clock is ticking].
==Definitions of LIBOR - Waterfall methodology==
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For each currency and maturity, LIBOR is calculated as the truncated average of rates provided by each of a panel of banks that submit for that currency. A panel varies from 11 to 16 banks. It thus goes without saying, then, that an individual bank does not have its own “LIBOR”.
==Introduction==
The traditional sources of liquidity can no longer be relied upon to provide adequate working capital for businesses. However, technological advances and innovations designed to solve liquidity problems are gaining momentum. As more and more forward-looking firms step up to put these new practices into place, it’s possible to foresee a future where this technology becomes the standard.
==Fundamental economic changes require new solutions==
The credit crisis severely impacted the global economy, which has been trying to recover ever since. Although progress has been made, there are fundamental inconsistencies that are hampering a strong recovery. On one hand, stock market growth has been significant, businesses have record amounts of cash on their balance sheets and banks have reduced the risk they carry while ensuring access to liquidity. On the other hand, Small and Medium-Sized Enterprises (SMEs) are still finding it difficult, if not impossible, to get access to the liquidity they need. Because SMEs represent a significant percentage of global GDP, they are vital to the health of the economy and their struggles impede economic growth.
==Liquidity excesses and shortages==
While many businesses have too little access to liquidity, others have access to significant levels of cheap liquidity. When you have large companies sitting on cash reserve stockpiles earning next to zero interest and small companies unable to affordably access the funding they need, it affects entire economies.
During the process of transitioning to the Waterfall methodology (discussed below), some panel banks were making LIBOR submissions using the LIBOR Submission question (see below) while others were making LIBOR submissions using the Waterfall methodology. Following the successful completion of the transition, announced on April 1, 2019, all panel banks will be making LIBOR submissions under the Waterfall methodology.
Various regulations designed to alleviate this problem have often unintentionally served to exacerbate it. For example, Basel III requires banks to de-risk their balance sheets by carrying adequate liquidity to cover their liabilities, should another financial crisis should occur. It is intended to strengthen economies and make them more resilient in the face of economic catastrophe.
However, the consequences of de-risking have fallen disproportionately on SMEs. Because they represent a greater risk than larger firms, lending to SMEs has dropped by half since 2008. Thus, the most cash-starved businesses have lost another tool that would previously have provided them with some of the working capital they needed.
==The second credit crisis: traditional liquidity solutions fall short==
Particularly in Europe, banks provide the majority of business funding. Even in the US, limits on access to business loans can chill economic growth and lengthen recovery from downturns. Although SMBs in the US have more sources of alternative funding available to them than their European counterparts, it is not enough to make up for the high cost or unavailability of bank lending.
'''''Waterfall methodology'''''
From mid-2018 a new, uniform determination methodology, the “waterfall methodology”, by which each contributing bank calculated the rates it submits was progressively introduced. The underlying interest - the market or economic reality that the benchmark seeks to measure - remains the same. The new methodology was widely consulted upon from 2015. The adopted waterfall methodology is set out by IBA in its LIBOR Evolution Report of April 2018, https://www.theice.com/publicdocs/ICE_LIBOR_Evolution_Report_25_April_2018.pdf. Appendix one to this Report includes the LIBOR Output Statement that effectively defines the new LIBOR.
US and UK central banks have introduced Quantitative Easing programmes to add liquidity to commercial banks by purchasing their assets in the hope that it will free up additional liquidity for SMEs. Unfortunately, this has not trickled down to the SMEs.
==Alternative liquidity solutions==
Banks were the first to provide solutions to treasurers with excess liquidity who are seeking alternatives to putting cash on deposit, or into money market funds that still allow them to maximise return, maintain desired levels of liquidity and manage risk. SMEs with limited liquidity look for affordable ways to smooth out their cash flow and gain liquidity as needed.
The “waterfall” methodology refers to the three bases for a bank’s rate submission. The idea of a waterfall of methods, with the first practical method being used in any case according to the information available, was included in the Wheatley Review of LIBOR, the UK government appointed 2012 enquiry into LIBOR following the scandal that became public from 2008 (https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/191762/wheatley_review_libor_finalreport_280912.pdf). The concept is also used in the EU Benchmarks Regulation.
The three bases in the LIBOR waterfall are:
Banks have increasingly been offering reverse factoring as a solution, accelerating accounts payable from a buyer to a supplier in return for a discount, based on the buyer’s credit rating. On the surface, this appears to be a good way to funnel much-needed cash to suppliers who are looking for affordable ways to smooth out their cash flow and gain liquidity as needed. But ultimately it is solving a different problem: delivering a better-looking balance sheet. Buyers get an increase in cash due to the extended terms of the programme, thereby creating a healthy cash flow. Suppliers do get early access to the cash flow they need. However, most companies offer reverse factoring to only a small percentage of their biggest or most important suppliers. Most of these select suppliers already have better access to liquidity than smaller SMEs, and the rest are left with lengthy payment cycles that leave them with even less cash flow. Lastly, unless the corporate recognises the programme as debt on their books, the bank’s P&L will benefit from the discounts, and not the corporate.
# Level 1: Transaction-based
# Level 2: Transaction-derived
# Level 3: Expert judgement
There are detailed provisions for these in the Roadmap Report and in the LIBOR Code (see below). Particular attention is devoted to ensuring that “Expert judgement”, Level 3, is “suitably framed” with contributing bank processes having to be agreed with the Administrator, IBA.
In summary, the new methodology is more rooted in actual transactions as far as possible. Using less “judgement” that can involve a (possibly unconscious) element of “smoothing”, contributed rates are expected to vary up and down more by small amounts each day. And, recognising the reality that banks short-term-fund in the wider money-markets now, rather just inter-bank, the range of transactions considered is being widened and this can mean small rate differences. These effects can be seen in the test data comparing the two methods’ outputs over a three month period published by IBA as the last consultation round in the methodology change. The Test Rates are available at https://www.theice.com/iba/libor/testfiledata/031718.
Following the successful completion of the transition period, LIBOR is now, for each currency/maturity combination, the rate output as the arithmetic mean of the relevant panel banks’ waterfall-methodology based submissions, excluding the highest and lowest quartile of submissions. Each panel bank’s submission carries an equal weight, subject to the trimming.
Despite these alternative options, corporates still have short-term cash earning little or no interest and SMEs are still in need of cheaper sources of liquidity.
==Freeing trapped cash==
A confluence of factors is changing the way a growing number of corporates are managing their liquidity. Slow economic growth has triggered the need for corporates to engage in cost reduction programs to ensure their margins are maintained, bringing a greater focus on P&L. The low-interest rate environment has challenged treasurers to find low-risk investments that produce higher returns to offset the inefficiency of short-term cash. Decreased lending and increased payment terms have squeezed suppliers to such an extent that they have become a greater risk of supply-chain disruption to the buyers.
'''''The LIBOR Submission question'''''
Some corporates have now realised that by taking some of their cash and offering it to their suppliers in return for a discount means solving all these problems in one go. Payment acceleration can be a good solution, but it can only be successful under a particular set of circumstances. One of the keys is maximising supplier participation, both in the number of suppliers using a given program and their frequency of use. Another important aspect is consensus between the buyer and supplier regarding the discount return that is acceptable to both. The discount needs to be both competitive with other lending costs for suppliers yet also improve gross margins for the buyers.
The LIBOR methodology introduced in 1998 and phased out by end Q1 2019 stipulated that LIBOR panel banks submit their estimate of the all-in, simple interest rate (including credit premium and liquidity premium) that answers the following submission question for each currency/maturity: “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”
We can note that LIBOR has thus been, since 1998, a hypothetical transaction rate and not an "offered" rate as such. On introduction in 1986, however, it was, using the question “At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11 am?” More of the earlier history of LIBOR is set out below.
So as long as corporates can generate a reasonable yield on their short-term cash, the idea of a dynamic discounting/payment acceleration programme makes good financial sense. Plus, there is no risk, since only approved invoices are paid early, the corporate benefits from the discount by reducing costs and improving gross margins and EBITDA, higher effective returns on cash are generated and the supply chain is strengthened (and de-risked) from a financial perspective.
==LIBOR Administrator==
The SMEs gain by accessing liquidity at rates lower than their borrowing options (assuming they have borrowing options at all). As they increase working capital, it gives them the opportunity to put money back into their operations, become more profitable and, ultimately, expand. Not only does this benefit the supplier-side SMEs, but it has a positive effect on the economy as a whole.
==Technology makes it possible==
Dynamic discounting has been around for a number of years based on the legacy banking approach of the buyer determining what rate the suppliers should pay for accelerated payment of invoices. This approach, although positive, is limiting. How can the buyer know the liquidity needs of their suppliers at any one point in time? How can the buyer know the alternative cost of financing for their suppliers, to make sure the rate they’re offering is attractive? These inefficiencies take their toll on the success of the model both from a buyer and a supplier perspective.
LIBOR is administered and published by ICE Benchmark Administration Limited (IBA) but prior to 1 February 2014 by the British Bankers’ Association (the BBA).
LIBORs are now published by ICE Benchmarks for:
The evolution of dynamic discounting has meant that true dynamic discounting now relies on a marketplace with objective supply and demand dynamics removing those inefficiencies to maximise benefits for both the buyer and the supplier. This type of exchange first gained popularity among firms that were already looking for technology solutions to move their businesses forward, including Costco Wholesale [https://c2fo.com/case-studies/costco-wholesale], Amazon.com and other innovative companies.
* CHF (Swiss franc)
* EUR (euro) (do not confuse with [[Euribor]])
* GBP (pound sterling)
* JPY (Japanese yen)
* USD (US dollar).
Australian dollar, Canadian dollar, Danish krone, New Zealand dollar and Swedish krona LIBOR rates were discontinued in early 2013.
As you can see from Figure 1, there is a progression related to accounts payable handling that offers far more options as technology takes off:
For each currency LIBOR is published for seven tenors: Overnight/Spot Next, 1 Week, 1 Month, 2 Months, 3 Months, 6 Months and 12 Months).
[[File:C2FO Figure 1 .jpg|700px|center]]
==Regulatory status==
From 1 April 2013 the compilation and distribution of LIBOR rates has been a regulated activity under the UK’s Financial Conduct Authority (FCA). From the same date, LIBOR is a “specified benchmark” under the Financial Services and Markets Act. The FCA Handbook (MAR) covers Benchmarks in MAR 8, with requirements for submitters (MAR 8.2) and administrators (MAR 8.3). UK Market conduct and fraud provisions continued to apply to LIBOR contributors.
The network effect of a market-based model results in many companies finding that their suppliers are already participating when they join, which accelerates the benefits for all parties.
==Conclusion==
Marketplace-based supply chain liquidity management can be the best way of helping businesses maximise the value of their short-term cash while providing liquidity to their supply chain.
The UK-specific regulation of compilation and distribution of LIBOR rates is being phased out as the EU Benchmarks Regulation (BMR), https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32016R1011 comes into effect in stages, starting from 30 June 2016. While it generally applied from 1 January 2018, older benchmarks such as LIBOR come fully under the Regulation by January 2020). IBA was authorised under the BMR on 27 April 2018. LIBOR has been a critical benchmark for the purposes of the BMR since 29 December 2017.
==LIBOR Code of Conduct==
For companies in the middle of the supply chain who are both buyers and suppliers, cash management is a constant challenge, and accounts receivable can be an inexpensive source of liquidity when and where it is needed.
The Code, published by IBA and confirmed by the FCA as Industry Guidance, particularly sets out or annexes the relevant governance and methodology and so on required of banks contributing rates. Issue 3 of the Code applies to banks submitting under the older methodology (see above) [https://www.theice.com/publicdocs/IBA_Code_of_Conduct.pdf]. Issue 4 applies to banks using the waterfall methodology [https://www.theice.com/publicdocs/IBA_Code_of_Conduct_Issue_4_From_17_March_2017.pdf].
Cash excess is a risk and it is difficult to maximise return in the short term, without increasing risk. With a marketplace-based payment acceleration programme, there is opportunity for significantly higher returns that impact EBITDA, thereby turning treasury from a cost centre into a value centre.
Consultation on a new Code issue 5, replacing 3 and 4 and consistent with the Benchmarks Regulation is taking place in Q2 2018 (comments by 11 May 2018) [https://www.theice.com/publicdocs/ICE_LIBOR_CODE_OF_CONDUCT_CONSULTATION_NOTICE_20180412.pdf].
==History==
===The idea of a panel of reference banks===
The idea for averaging short-term funding rates taken from a panel of banks to use in a syndicated revolving loan is attributed to Minos Zombanakis of Manufacturers Hanover Bank in London. He “devised a formula whereby a select group of ‘reference banks’ within a syndicate would report their cost of funds to the agent bank shortly before the rollover date, and the weighted average, rounded to the nearest 1/8th per cent plus a ‘spread’ for profit, would become the price of the loan for the next period.”<ref>The Story of Minos Zombanakis: Banking Without Borders, David Lascelles, Economia Publishing, 2011</ref> The idea was used contractually in 1969 in a syndicated bank loan to the Shah of Persia.
The rate produced from applying the idea became known as the London inter-bank offered rate (LIBOR). The phrase itself had been used since the mid-1960s.
The idea was first used for debt in 1970 in a floating rate note at the suggestion of Evan (“Van”) Galbraith for the first Euro-currency (US dollar) floating rate note.<ref>Speech, The Early Eurobond Market, Peter Spira, Chairman of Advisory Board, AGI, to the International Capital Market Association Eurobond Dinner, June 2013, https://www.icmagroup.org/assets/documents/About-ICMA/Eurobond-anniversary/Eurobond%20dinner%20speech%20Peter%20Spira%20June%202013.pdf, and remarks to John Grout, Policy and Technical Director of the Association of Corporate Treasurers, August 2014, by David Clark, Chairman of the Wholesale Markets Brokers' Association, who worked in 1970 for BTI on the transaction and was present at the signing and has approved citation here.</ref> This note was organised by Warburgs and Bankers Trust International in London for the Italian oil company ENEL."
Separate definition and calculation of rates by agent banks from inputs sought from groups of banks specified for each contract as new deals were entered into eventually proved burdensome. Development of over-the-counter interest rate swaps and forward rate agreements, each uniquely referencing inter-bank rates in some way, made the problem larger.
===Standardisation===
In the mid-1980s the BBA and other parties including the Bank of England established working parties that developed the BBA standard for Interest Rate Swaps, “BBAIRS terms”. These provided for the fixing of BBA Interest Settlement Rates that eventually developed into bbalibor™ - LIBOR. BBAIRS terms became standard market practice in 1985. BBA LIBOR rates were published from 1 January 1986, some trial rates having been calculated since 1984. This was when use of a standard panel of banks and excluding the outlying quartiles of contributed rates from the calculation of the average were introduced. The rate started with German marks, United Kingdom pounds sterling, and United States dollars.
LIBOR’s ready availability eased the further growth of the interest rate derivatives and syndicated loans markets. It was soon used for many purposes.
===Explicit regulation===
On 1 April 2013 Financial Conduct Authority (FCA) was formed to take over as the UK’s financial services regulator from the Financial Services Authority (FSA) and, on that day also, both compilation and distribution of LIBOR rates and contribution of rates for use in compiling LIBOR rates became regulated activities. Of course, even before then, the activities had been subject to normal fraud laws and to the FSA’s market abuse principles. It is under these provisions that the UK’s punitive actions against those involved in manipulating LIBOR in the early 21st century were taken (see below).
===New Administrator===
On 1 February 2014, the BBA was replaced as Administrator of LIBOR as the Wheatley Review of 2012 had recommended (see above). ICE Benchmark Administration Limited (IBA) took over. IBA made no immediate changes to the LIBOR process but it became primary publisher of the rates, taking over from Thomson Reuters. IBA took over from Thomson Reuters (Exeter England) in undertaking the collection, real-time surveillance and calculation services, later in 2014 [[https://www.theice.com/iba.jhtml]]. Since then IBA has invested significantly and put in place new governance, oversight, controls and technology to strengthen the benchmark.
In late 2014, IBA published a consultation [https://www.theice.com/publicdocs/ICE_LIBOR_Position_Paper.pdf] in the form of a Position Paper on the Evolution of ICE LIBOR that proposed a number of changes to LIBOR. Further consultations followed and the transition to the evolved waterfall methodology (see above) had been completed by 1 April 2019.
==Early 21st century controversy==
During the early stages of the global financial crisis in late 2007 and especially after the 2008 collapse of Lehman Brothers, concerns began to be raised about the good faith of rates contributed by banks for use in the compilation of LIBOR (and other ~IBORs). The first publicly available reference to this that has come to attention is in the minutes of the Bank of England Sterling Money Markets Liaison Group of Thursday 15 November 2007 – no longer on the Bank of England website but in the National Archive. Minute 2.1 starts: “Several group members thought that Libor fixings had been lower than actual traded interbank rates through the period of stress.”
As the scandal developed, suggestions were twofold:
*that bank staff running interest-rate-affected positions tried to influence rate contributions up or down to suit their own books and/or
* particularly following the collapse of Lehman Brothers in 2008, banks tried to disguise the market’s falling confidence in the banks’ individual credit standings by submitting lower rates than the actual rates at which they were being offered and accepting funds.
Enquiries in the US and the UK and other countries resulted in administrative and criminal action against some banks and brokers and individuals. Also, in the UK, Martin Wheatley produced a report on the future of LIBOR recommending a change of administrator, governance and oversight and, eventually, methodology (see above).
On 2 April 2013, UK secondary legislation came into force amending the Regulated Activities Order (RAO), making “the administering of, and providing information to, specified benchmarks” a regulated activity under the FSMA (the UK’s Financial Services and Markets Act 2000 as amended). Initially, the first benchmark specified was BBA LIBOR (now ICE LIBOR). The approach to regulation was set out in a Policy Statement PS13/6 [http://www.fsa.gov.uk/static/pubs/policy/ps13-06.pdf] of the UK’s Financial Services Authority (FSA) the predecessor of the Financial Conduct Authority (FCA) that took on its responsibilities in April 2013.
In July 2013 the FCA first approved the British Bankers Association’s April 2013 Code of Conduct for Contributing Banks to LIBOR as Industry Guidance – following which gives regulated bodies some protections [http://www.bbatrent.com/download/9070] (BBA Trent Ltd is the re-named BBA LIBOR Ltd). The BBA gave up responsibility for LIBOR to ICE Benchmark Administration as of 1 February 2014. IBA initially adopted the text of the BBA Code but has made changes since (see above).
In August 2014, the Fair and Effective Markets Review of HM Treasury, the Bank of England and the Financial Conduct Authority recommended that other [[FICC]] benchmarks be brought under the RAO, namely [[SONIA]], [[RONIA]], ISDAFIX (now [[ICE Swap Rate]]), WM/Reuters 4 pm London Closing Spot Rate, London Gold Fixing, LBMA Silver Price and ICE Brent.
==Alternative rates projects==
Banks have had very substantial administrative penalties and fines imposed on them. The regulatory and reputational risks to banks from staff misconduct as they operated it in the early 2000s has made them reluctant to contribute rates. Cessation of the publishing LIBOR rates has been seen as a threat to financial stability, given the high nominal values referencing the rate. Furthermore, there is concern at the limited number of transactions underpinning some LIBOR currency/maturity combinations given the changes in bank funding and in their capital and liquidity regulation.
The FCA has power to compel contributions under UK law and similar powers under the BMR. It has secured banks’ agreements to contribute rates until the end of 2021 after which it expects not to use its powers of compulsion for LIBOR. The changes made to LIBOR by IBA, among other effects, have the objective of significantly reducing the opportunities for rate manipulation and so reducing the risks to banks from contributing rates.
The LIBOR Roadmap Report of 25 April 2018 (see above) says “IBA intends to continue developing and evaluating frameworks that would enable the continued publication of a robust and sustainable LIBOR. Although there is no guarantee that LIBOR will continue to be published after the end of 2021.” Obviously that will depend on the willingness of banks to contribute information for LIBOR and on sufficient users showing demand for using the rate to make it viable for particular currencies and maturities – and on regulators not shutting it down for a quieter life.
Over time, in any case, a reformed [[SONIA]] is likely to supersede LIBOR as the primary sterling benchmark rate, particularly, and to start with, for those purposes not needing to include maturity and bank credit premiums. Similar relatively risk-free rates are being developed for the other LIBOR currencies. The ACT and the LMA have published a guide to the new rates under development, available at https://www.treasurers.org/ACTmedia/ACT_LMA_Future_of_LIBOR_Guide_0318.pdf. These should become clearer as work goes on in the various countries for their currencies.
== See also ==
* [[ARRC]]
* [[Base rate]]
* [[Benchmark]]
* [[Benchmarks Regulation]]
* [[Cost-plus loan pricing]]
* [[Day count conventions]]
* [[Effective annual rate]]
* [[EURIBOR]]
* [[euro LIBOR]]
* [[Eurocredit]]
* [[Financial Conduct Authority]]
* [[FRAND]]
* [[Floating rate note]]
* [[Forward rate agreement]]
* [[ICE LIBOR]]
* [[ICE Swap Rate]]
* [[LIMEAN]]
* [[LIBID]]
* [[London InterBank Offered Rate]]
* [[New York Funding Rate]]
* [[Official Bank Rate]]
* [[Reference rate]]
* [[SARON]]
* [[Simple interest]]
* [[SIBOR]]
* [[SOFR]]
* [[SONIA]]
* [[TED spread]]
* [[TIBOR]]
* [[TONAR]]
* [[Total return swap]]
==Other links==
[http://blogs.treasurers.org/libor-transition-summer-reading-and-some-actions/?cmp=NEWS-GEN-1808&_cldee=ZG91Z0Bkb3Vnd2lsbGlhbXNvbi5jb20%3d&recipientid=contact-61e01a18fd04e61180d1000d3ab15408-5835b624a3464495b43a7dcf409be52c&utm_source=ClickDimensions&utm_medium=email&utm_campaign=NEWS-GEN-18&esid=776b1316-9a94-e811-8109-000d3ab15408&urlid=8 LIBOR transition reading (and some actions), Sarah Boyce, Associate Policy & Technical Director, ACT, July 2018]
[[Media:ACT LMA Future of LIBOR Guide 0318.pdf| The future of LIBOR: what you need to know, ACT & LMA, March 2018]]
[[Media:Slaughter and May interest rate benchmarks.pdf| 2021: A Benchmark Odyssey, Practical Guidance for Treasurers on interest rate benchmarks, Slaughter and May]]
[[Media:The_Treasurer_-_LIBOR_-_Goodbye_to_all_that.pdf| LIBOR: Goodbye to all that, The Treasurer]]
[http://www.bankofengland.co.uk/markets/benchmarks Bank of England: SONIA and other benchmarks]
[http://www.treasurers.org/icelibor Briefing note: LIBOR Administrator change to ICE Benchmarks from BBA LIBOR, January 2014]
[https://alfred.stlouisfed.org/category?cid=33003 LIBOR rates from 1986 on, including for discontinued rates] (Available from the Archival Economic Data maintained by the St. Louis Federal Reserve Bank (ALFRED) - select LIBOR Rates from Categories.)
The traditional sources of liquidity can no longer be relied upon to provide adequate working capital for businesses. However, technological advances and innovations designed to solve liquidity problems are gaining momentum. As more and more forward-looking firms step up to put these new practices into place, it’s possible to foresee a future where this technology becomes the standard.
Fundamental economic changes require new solutions
The credit crisis severely impacted the global economy, which has been trying to recover ever since. Although progress has been made, there are fundamental inconsistencies that are hampering a strong recovery. On one hand, stock market growth has been significant, businesses have record amounts of cash on their balance sheets and banks have reduced the risk they carry while ensuring access to liquidity. On the other hand, Small and Medium-Sized Enterprises (SMEs) are still finding it difficult, if not impossible, to get access to the liquidity they need. Because SMEs represent a significant percentage of global GDP, they are vital to the health of the economy and their struggles impede economic growth.
Liquidity excesses and shortages
While many businesses have too little access to liquidity, others have access to significant levels of cheap liquidity. When you have large companies sitting on cash reserve stockpiles earning next to zero interest and small companies unable to affordably access the funding they need, it affects entire economies.
Various regulations designed to alleviate this problem have often unintentionally served to exacerbate it. For example, Basel III requires banks to de-risk their balance sheets by carrying adequate liquidity to cover their liabilities, should another financial crisis should occur. It is intended to strengthen economies and make them more resilient in the face of economic catastrophe.
However, the consequences of de-risking have fallen disproportionately on SMEs. Because they represent a greater risk than larger firms, lending to SMEs has dropped by half since 2008. Thus, the most cash-starved businesses have lost another tool that would previously have provided them with some of the working capital they needed.
The second credit crisis: traditional liquidity solutions fall short
Particularly in Europe, banks provide the majority of business funding. Even in the US, limits on access to business loans can chill economic growth and lengthen recovery from downturns. Although SMBs in the US have more sources of alternative funding available to them than their European counterparts, it is not enough to make up for the high cost or unavailability of bank lending.
US and UK central banks have introduced Quantitative Easing programmes to add liquidity to commercial banks by purchasing their assets in the hope that it will free up additional liquidity for SMEs. Unfortunately, this has not trickled down to the SMEs.
Alternative liquidity solutions
Banks were the first to provide solutions to treasurers with excess liquidity who are seeking alternatives to putting cash on deposit, or into money market funds that still allow them to maximise return, maintain desired levels of liquidity and manage risk. SMEs with limited liquidity look for affordable ways to smooth out their cash flow and gain liquidity as needed.
Banks have increasingly been offering reverse factoring as a solution, accelerating accounts payable from a buyer to a supplier in return for a discount, based on the buyer’s credit rating. On the surface, this appears to be a good way to funnel much-needed cash to suppliers who are looking for affordable ways to smooth out their cash flow and gain liquidity as needed. But ultimately it is solving a different problem: delivering a better-looking balance sheet. Buyers get an increase in cash due to the extended terms of the programme, thereby creating a healthy cash flow. Suppliers do get early access to the cash flow they need. However, most companies offer reverse factoring to only a small percentage of their biggest or most important suppliers. Most of these select suppliers already have better access to liquidity than smaller SMEs, and the rest are left with lengthy payment cycles that leave them with even less cash flow. Lastly, unless the corporate recognises the programme as debt on their books, the bank’s P&L will benefit from the discounts, and not the corporate.
Despite these alternative options, corporates still have short-term cash earning little or no interest and SMEs are still in need of cheaper sources of liquidity.
Freeing trapped cash
A confluence of factors is changing the way a growing number of corporates are managing their liquidity. Slow economic growth has triggered the need for corporates to engage in cost reduction programs to ensure their margins are maintained, bringing a greater focus on P&L. The low-interest rate environment has challenged treasurers to find low-risk investments that produce higher returns to offset the inefficiency of short-term cash. Decreased lending and increased payment terms have squeezed suppliers to such an extent that they have become a greater risk of supply-chain disruption to the buyers.
Some corporates have now realised that by taking some of their cash and offering it to their suppliers in return for a discount means solving all these problems in one go. Payment acceleration can be a good solution, but it can only be successful under a particular set of circumstances. One of the keys is maximising supplier participation, both in the number of suppliers using a given program and their frequency of use. Another important aspect is consensus between the buyer and supplier regarding the discount return that is acceptable to both. The discount needs to be both competitive with other lending costs for suppliers yet also improve gross margins for the buyers.
So as long as corporates can generate a reasonable yield on their short-term cash, the idea of a dynamic discounting/payment acceleration programme makes good financial sense. Plus, there is no risk, since only approved invoices are paid early, the corporate benefits from the discount by reducing costs and improving gross margins and EBITDA, higher effective returns on cash are generated and the supply chain is strengthened (and de-risked) from a financial perspective.
The SMEs gain by accessing liquidity at rates lower than their borrowing options (assuming they have borrowing options at all). As they increase working capital, it gives them the opportunity to put money back into their operations, become more profitable and, ultimately, expand. Not only does this benefit the supplier-side SMEs, but it has a positive effect on the economy as a whole.
Technology makes it possible
Dynamic discounting has been around for a number of years based on the legacy banking approach of the buyer determining what rate the suppliers should pay for accelerated payment of invoices. This approach, although positive, is limiting. How can the buyer know the liquidity needs of their suppliers at any one point in time? How can the buyer know the alternative cost of financing for their suppliers, to make sure the rate they’re offering is attractive? These inefficiencies take their toll on the success of the model both from a buyer and a supplier perspective.
The evolution of dynamic discounting has meant that true dynamic discounting now relies on a marketplace with objective supply and demand dynamics removing those inefficiencies to maximise benefits for both the buyer and the supplier. This type of exchange first gained popularity among firms that were already looking for technology solutions to move their businesses forward, including Costco Wholesale [1], Amazon.com and other innovative companies.
As you can see from Figure 1, there is a progression related to accounts payable handling that offers far more options as technology takes off:
The network effect of a market-based model results in many companies finding that their suppliers are already participating when they join, which accelerates the benefits for all parties.
Conclusion
Marketplace-based supply chain liquidity management can be the best way of helping businesses maximise the value of their short-term cash while providing liquidity to their supply chain.
For companies in the middle of the supply chain who are both buyers and suppliers, cash management is a constant challenge, and accounts receivable can be an inexpensive source of liquidity when and where it is needed.
Cash excess is a risk and it is difficult to maximise return in the short term, without increasing risk. With a marketplace-based payment acceleration programme, there is opportunity for significantly higher returns that impact EBITDA, thereby turning treasury from a cost centre into a value centre.
