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 organizations are struggling to manage the risks and develop their transition strategy.
Concerns about benchmark rates have been swirling for years. Indeed, even before the LIBOR scandal hit in 2012, 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 2021, 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 favoring 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.
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 securitizations 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 2014. 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.
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); in the UK, urgency has been heightened by a Dear CEO letter circulated by the PRA and the FCA; 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 2020.
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 organization 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:
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 prioritization 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 digitalization 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 resourcelight 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.
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 minimize 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.
The Financial Times, My thwarted attempt to tell of Libor shenanigans, 27 July 2012
The Financial Stability Board, The future of Libor, 27 July 2017
The Financial Stability Board, Market Participants Group on Reforming Interest Rate Benchmarks Final Report, July 2014
Developments regarding Interest Rate Benchmarks across Jurisdictions (five LIBOR currencies)