US and UK regulatory authorities have ‘rung the bell’ in the last week. Both left the market in no doubt that firms need to ensure they have completed the transition to alternative reference rates by the end of 2021 – effectively, calling time on LIBOR. The PRA/FCA released feedback from the ‘Dear CEO’ letter sent in September 2018, setting out the key element firms need to consider over the next two and a half years.
Overall the message is clear. Accelerate. Firms cannot sit back and adopt the ‘wait and see’ approach. They need to have adequate preparations in place, with in-built flexibility to adapt to change, to meet an end of 2021 LIBOR cessation date.
Having reviewed the responses to the letter, the FCA and PRA have identified eight thematic areas, that all firms should focus on:
All firms, whether or not they received the original ‘Dear CEO’ letter, must take note of the publication and the increased regulatory focus that is likely to result from an inability to articulate a clear internal view, strategy and transition plan.
Given the timescales, 2019 remains the critical year for firms to build the platform and capabilities to enable a managed transition away from LIBOR. In our view there are key steps firms should be taking now to start mitigating the transition risk:
Comprehensive impact assessment: The reach of LIBOR within firms’ critical systems and processes including valuations, contracts and models can be wide ranging. Impact assessments are therefore critical to identify which business lines and products will be significantly impacted by the transition and where a firm needs to take action to mitigate potential risks as a result.
Detailed, flexible transition plan: Firms need to build a strategy and transition plan including key milestones and decision points but with in-built optionality and flexibility to adjust to the uncertainties surrounding the transition.
Management information and LIBOR exposure: Senior stakeholders and regulators will require regular updates to monitor the progress of transition and the level of outstanding LIBOR exposure. Firms should be in a position to be able to extract granular exposure data on a repeatable and regular basis.
Transitioning clients to new rates: Firms are starting to proactively transact in alternative risk free rates and are beginning to offer these products to their clients. Firms should be looking to reduce the amount of new exposure written against LIBOR. This means ensuring that the infrastructure and plumbing is in place to offer products referencing RFRs.
Legacy positions and fallbacks: Firms need to take an active approach in supporting the transition. There are a large number of legacy positions based on LIBOR with maturities post 2021, these positions need to be dealt with. Identification of these positions and contracts is key. Steps need to be taken to ensure the fallback language is robust or the contract is re-negotiated. This is, potentially, an enormous task and will require significant client education and outreach programmes to manage the risk of transition efficiently.
A summary of the key feedback from the PRA and FCA review of responses to the Dear CEO letter.
Key finding 1: Comprehensive identification of reliance on and use of LIBOR
In stronger responses, this went beyond a firm’s balance sheet exposure and also assessed, for example, whether LIBOR is present in the pricing, valuation, risk management and booking infrastructure firms use.
Key finding 2: Quantification of LIBOR exposures
Some firms lacked the management information to provide a clear understanding of current LIBOR exposures, including where contracts mature after 2021. Where appropriate, the PRA and FCA expect firms to consider a range of quantitative and qualitative tools and metrics to monitor their exposure to LIBOR and related risks. Firms with the most developed submissions had analysed their exposure across product lines, currencies, counterparty and notional value, and had identified the amount due to mature beyond 2021. The strongest responses included details of how transition plans were developing to allow firms systematically to extract this data set on a regular basis.
Key finding 3: Granularity of transition plans and their governance
Firms should develop a project plan for transition, including key milestones and deadlines to ensure delivery by end-2021.
Key finding 4: Identification and management of prudential risks associated with the transition
Stronger responses took a broad view and considered all risks that could be relevant to a firm’s operations. These risks had been clearly aligned to appropriate mitigating actions. Some assessments focussed disproportionately on the risk to transitioning contracts, with limited consideration of strategic balance sheet risks. The strongest responses provided a full assessment of all risks relevant to the firm’s operations e.g. FX-related risk, basis risk, operational risk, credit risk and liquidity risk.
Key finding 5: Identification and management of conduct risks associated with the transition
The strongest responses considered a range of conduct risks, including management of potential asymmetries of information and the potential for conflicts of interest, when forming and reviewing their transition plans. Firms should build the relevant mitigating actions to address these risks into their planning. Less strong responses lacked recognition of potential conflicts that could, for example, result in clients and third parties being misinformed and/or disadvantaged and did not acknowledge potential risks from market manipulation or insider trading.
Key finding 6: Scenario planning
Stronger responses used LIBOR discontinuation at the end of 2021 as a base case scenario for the purposes of planning and managing their risks. The PRA and the FCA have indicated that firms should plan based on the likely cessation of LIBOR at the end of 2021.
Key finding 7: The role of market participants in supporting transition
Stronger responses demonstrated a good understanding and engagement with transition issues and evidenced an understanding of the impact of LIBOR on their business. Firms that showed an up to date understanding of relevant industry initiatives and the timeline and probability of delivery of proposed industry solutions delivered stronger responses. Firms should engage with the various industry solutions. While we recognise some of these dependencies, we would urge firms proactively to consider not just how they engage with these initiatives and the role they have in helping deliver consensus but also what contingency plans they have in place if these solutions do not materialise or where the proposed use case is quite limited.
Key finding 8: Transacting using new risk free rates and building in fallbacks
Stronger responses evidence firms considering opportunities to proactively transact RFRs to reduce the risks from LIBOR discontinuation, or otherwise to take steps to incorporate robust fallback language.