Five key activities firms should consider when transitioning from IBOR to RFRs.
The transition to alternative benchmarks
Benchmark rates are changing and this is having a massive impact on financial markets and market participants around the world. Yet, with little clarity on the plan for transitioning away from the established Interbank Offered Rates (IBORs), many financial services organisations are struggling to manage the risks and develop their transition strategy.
The end of an era
Concerns about benchmark rates have been swirling for years. Indeed, even before the LIBOR scandal hit in 20121, unsecured wholesale borrowing activity had been in decline. And that meant that the rates were becoming increasingly subject to ‘expert judgment’. As the LIBOR scandal made immensely clear, the potential for manipulation was high.
When, in July 2017, the UK’s Financial Conduct Authority (FCA) announced it would no longer compel panel banks to make LIBOR submissions after 20212, the writing was on the wall: the IBORs’ days were numbered.
Over the past year, it has become increasingly clear that global regulatory preference was a benchmark replacement favouring risk-free rate (RFR) based on transactional data. Central banks have encouraged industry working groups to form to help solve issues arising from establishing and then transitioning to a new more trustworthy benchmark rate.
In the run-up to 2021, working groups and several industry advocates have been working diligently to ensure that the new rates have established robust underlying cash markets, sufficient liquidity in hedging instruments, broad acceptance from market participants and are devoid of past issues.
No small feat
While on the surface this may seem like a ‘find and replace’ exercise, the reality is that the shift from IBORs to RFRs will be significant. IBORs currently underpin a huge range of financial products and valuations, from loans and mortgages through to securitisations and derivatives across multiple jurisdictions. They are used in determining all sorts of tax, pension, insurance and leasing agreements. And they are embedded in a range of finance processes such as renumeration plans and budgeting tools.
Not surprisingly, the volumes that will be impacted by this change are enormous. According to the Financial Stability Board, there were more than US$370 trillion worth of notional contracts that – in some way or other – were tied to LIBOR, EURIBOR or TIBOR in 20143. And that number has grown since then.
The impact will also be felt far and wide. The challenge will be particularly acute for central counterparties, exchanges, investment banks, retail banks, insurers, broker-dealers, hedge funds, pension funds and asset managers. But the ripple effects will also be felt by corporations and consumers as the shift changes valuations on everything from derivatives and corporate bonds through to business and consumer loans.
New challenges emerge
There is still significant uncertainty about how the transition to RFRs will pan out. There are currently Working Groups for each of the five LIBOR currencies4 (representing the US dollar, the UK pound sterling, the Japanese yen, the Swiss franc and the Euro) with responsibility for developing alternative RFRs to LIBOR within their home jurisdictions.
The market challenges that this is creating seem daunting. Working Group members, key end users and other market participants are working hard to create markets for new instruments that are underpinned by the RFRs. Liquidity in these rates need to build to ensure a successful transition. This ultimately requires impetus from end users to transition away from IBORs, which have been embedded in systems and processes for over 3 decades.
For multinational and global financial institutions, the task will be exponentially more complex. In part, this is because there will likely be significant regional differences, timelines and approaches to the transition. In the US, for example, the Alternative Reference Rates Committee (ARRC) is tracking against a ‘paced transition plan’ for moving USD LIBOR exposures to SOFR (the alternative RFR proposed for the US)5; in the UK, urgency has been heightened by a Dear CEO letter circulated by the PRA and the FCA6; for the Euro area, the ECB Working Group is currently looking to mitigate the potential of a ‘cliff edge event’ for EONIA and EURIBOR when the EU Benchmark Regulation transition period finishes on 1 January 20207.
Most financial institutions will also need to grapple with some of the ‘knock-on’ impacts of the shift away from IBORs. Consider, for example, how the new rates may influence hedge accounting practices at many financial institutions. In the US, the FASB has already proposed adding SOFR to the list of interest rates that may be eligible for hedging. How the other new RFRs will influence hedge accounting remains to be seen.
Yet, while the timing and transition to RFRs may seem uncertain, our experience suggests that there is much that firms can be doing to prepare. The key is to position the organisation through dynamic and early-stage planning while still maintaining the agility required to pivot against a range of potential transition options. This is about taking the ‘no regret’ actions that will support the transition regardless of the final timing and approach.
Planning for the transition will require firms to take on a series of key activities such as:
- Identifying exposures and developing a transition strategy: Firms will need to identify all of the products that will likely be in scope and start analysing the legal language in order to both assess the scale of the challenge and to determine the most appropriate strategy for achieving contractual changes and mitigating franchise and client risks through the transition.
- Assessing the initial impact: All business units will need to assess their models and systems to analyse the areas currently impacted by IBORs. Firms will need to consider how best to alleviate potential operational, legal and conduct risks involved in changing a complex infrastructure that is currently heavily reliant on LIBOR.
- Setting up the RFR program: This will require the development and management of an organisational, cross-functional RFR program that handles all business lines and jurisdictional differences while also ensuring alignment and coordination across critical issues.
- Creating the right governance and awareness: Organisations will need to develop internal governance processes that allow them to properly oversee changes to policies, systems, processes and controls while also ensuring employees are educated on the implications of the transition.
- Communicating with clients: Firms will need to conduct clear and early communication with their clients in order to educate, inform and – eventually – renegotiate contracts. Managing the conduct risk with clients through the transition will be key, particularly given the potential for value transfer as existing positions are re-referenced to RFRs.
While the task at hand may seem overwhelming, it is clear that those who can use their data effectively and develop a flexible strategy will ensure a more efficient transition plan. The uncertainty of timing and the complexity of the change will require continual re-evaluation of the sequencing and prioritisation of activities over the next 2 to 3 years.
Many firms may also want to consider how they might leverage newer technologies to help drive their transition program. For example, some firms are already incorporating smart technologies to help them identify where changes might need to be made across their various systems, models and databases. Where firms have large volumes of unstructured contracts, AI tools are being piloted. In particular, the digitalisation of contracts will have benefits to firms beyond the IBOR transition.
For smaller firms, however, the greatest challenge will likely come down to resources and skills. The planning and transition process will require a significant investment of time and manpower. Running it in parallel to ‘business as usual’ will be a challenge for resource-light firms. Some global financial institutions are estimating transition costs at between US$400 million to US$500 million; smaller institutions should not underestimate the magnitude of this transition.
Make the most of the time
Clearly, there is still much uncertainty surrounding the discontinuation of the IBORs. But, even so, we believe it is possible for firms to move forward by creating a plan that includes flexibilities to accommodate the transition to RFRs as the approach and timelines become better established.
Those that move quickly, smartly and flexibly today will have the opportunity to make the transition efficiently and minimise potential downside risks. Those that wait for full clarity before taking steps will almost certainly struggle to meet the deadline before the IBORs potentially disappear at the end of 2021.
- My thwarted attempt to tell of Libor shenanigans, The Financial Times, 27 July 2012.
- The future of Libor, Speech by Andrew Bailey, Chief Executive of the FCA, 27 July 2017.
- Market Participants Group on Reforming Interest Rate Benchmarks Final Report, Financial Stability Board, July 2014.
- Developments regarding Interest Rate Benchmarks across Jurisdictions (five LIBOR currencies), Bank of Japan.
- Alternative Reference Rates Committee.
- Firms’ preparations for transition from LIBOR to risk-free rates (PDF 277 KB), Joint letter from the Bank of England's Prudential Regulation Authority and the Financial Conduct Authority, 19 September, 2018.
- Working group on euro risk-free rates, European Central Bank website.
Frontiers in Finance
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ASPAC LIBOR Readiness Report
Overview – as at the end of September 2019 – of the readiness of banking systems in the Asia Pacific region to transition away from LIBOR
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