On 1 January 2020 EURIBOR and EONIA will no longer be compliant with the EU Benchmark Regulation (EU BMR). LIBOR will be sustained by the Financial Conduct Authority (FCA) only until 2021. The question in focus is: can alternative risk free rates be established to replace existing Inter-bank offer-rates (IBORs) in such a short period, and can banks handle the transition in time?
Initiatives to develop alternative benchmarks have been taken on by supranational committees, central banks and representatives of the banking sector. The ECB working group on euro risk free rates1 was inaugurated in that prospect on 26 February 2018. This industry-led working group was established to identify and recommend risk-free rates that could serve as a basis for an alternative to current benchmarks used in a variety of financial instruments and contracts in the euro area. Amongst others, the group recommended the Euro short-term rate (ESTER) as reference risk free rate for the euro area (September 2018), and is currently exploring different approaches) for ensuring a smooth transition from EONIA to ESTER. Sub working groups are asking whether a market for derivatives based on ESTER can be established, thereby building a term structure, and what transition paths from EONIA to ESTER might look like.
The challenges of creating alternative benchmarks and their corresponding markets within the next 13 months - and for banks to successfully adapt their processes and systems - are enormous. The difficulty of addressing the full legal and operational complexities within that timeframe, and market concerns that the remaining time to transition to ESTER is insufficient, were two key topics reported by the ECB working group. However, the EC has indicated that an extension beyond 2020 is not foreseen at the moment, sticking to the initial timeline.
In the meantime, the FSB published on 14 November 2018 a progress report stating that although progress has been made since 2017, a great deal of work remains in Europe, notably regarding the strengthening of EURIBOR existing methodologies and transition planning and preparation towards new risk-free rate ESTER.2 The next progress report will be published by the FSB in late 2019. Finally, supervisory bodies have already begun asking firms for information on their awareness and implementation status. For example, the PRA and FCA have written CEO letters3 to seek assurance that senior managers and boards understand the risks associated with this transition, and that their firms are taking appropriate action now so they can transition to alternative rates before the end of 2021.
Lastly, the recent remarks made by Benoît Cœuré4, Member of the Executive Board of the ECB, that “Financial market participants, on their part, should redouble their efforts to ensure a smooth transition” and by Cornelia Holthausen5, ECB Deputy Director General of Market Operations, saying “I do feel that many banks are pretty complacent and they think the public sector will solve the issue for them”, show the concerns for a scenario where the transition fails and EONIA/EURIBOR become non-compliant. Given these statements, banks under supervision of the ECB should assume that a letter challenging their preparedness for the IBOR reform is on its way.
We therefore recommend that individual financial institutions must not wait any longer to carefully design a “transition plan”. As a first step, this plan must include an assessment of potential direct and indirect impacts of the different transition scenarios on products, infrastructures, and customers. In addition, we think that not only financial actors must be concerned by the transition, but also non-financials (such as corporates and public entities) will be impacted in their daily financing operations.
KPMG can provide you a tailored support in this complex process by guiding you though each phase of the transition plan, from “quick scans” and gap analysis to detailed impact assessment and development of technology solutions to enable the implementation of the plan (e.g. AI tools for the automatization of contract scanning).
The challenge on making the transition in time is on. Let’s get to work.
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