THE CURRENT STATE OF LIBOR TRANSITION
LIBOR transition programs are rapidly gaining momentum among small, mid-size, and global enterprises, enabling them to be operationally ready in the absence of IBOR*. In the US, by the end of 2019, there were almost $250 billion SOFR-linked cash securities outstanding, greater than $600 billion of outstanding notional value in SOFR swaps, and today, there are over $2.5 trillion of open interest in SOFR futures11. Most players are disposed towards SOFR adoption despite concerns about the volatility of SOFR.
RESHAPING The Industry
While the real goal of the transition is to move the market away from rate speculation, the exchanges will benefit from this move as they can eliminate credit risk and focus purely on clearing fees. The shift refocuses the banks from their primary role of market-making and can further narrow trading margins on rates trades. Banks have to now concentrate on RFRs (risk-free rates) and invest in systems, trades, and processes that support the new RFRs, as per regulations. The trading platform vendors will have to recalibrate pricing and valuation models. The alternative reference rates committee (ARRC) is a primary regulator that sets the language for several million in outstanding contracts. The legal language on these contracts has to be changed by the firms, and the due legal process specific to each type of contract must be followed. This transition affects commercial and retail banks as well, not just the players in the investment industry.
THE EFFECT OF THE PANDEMIC
As of Q4 of 2019 and in Q1 of 2020, several industry players have said that although they are willing for this transition, they are not prepared2. Optimistically, if the COVID-19 curve remains flat in Q3, the transition efforts will resume. The pandemic has put the systems through a real test. Although unfortunate, it has served as a real-time testing scenario, helping to achieve exhaustive testing for models based on the new benchmark rates set by the market players. Fed rates may not see a spike for a while, but the liquidity in the market will help to execute trades on debt and securitized products. LCH and CME are issuing new product offerings in the market. The volume of SOFR-based trades is growing continuously, but it showed a prominent decrease in volumes after a record high in March.
THE ROLE OF A CONSULTING PARTNER
Management consulting firms have played a key role in helping their clients prepare for this large, global initiative that affects multiple products and business lines. The transition efforts are a huge undertaking that could leverage AI (NLP) technologies for efficiency, but require constant supervision and advice from compliance and legal. The process requires continuous risk mitigation (the key risks being market, technology and operational, legal, conduct, and transition risks). It also requires a special program set up, and the need to effectively unwind the program, once executed. Engaging your consulting partner in program coordination during the implementation phase can enable successful program delivery. Executing special projects that may otherwise need critical staff to diverge from their BAU functions, calls for involving your consulting partner.
Common roadblocks that firms encounter are difficulties in interpreting the details of the individual processes, communicating with exchanges and regulators, and relaying information accurately across different functional groups. Overall subject matter expertise in trade lifecycles and trade contracts is the key skill required to overcome these challenges. Several questions about the processing of cash compensation and basis risk compensation are provided by the exchanges in response to discount curve switching. The wider implications of tax treatment related to compensation and contract changes are not easily comprehensible and the extent of valuation change resulting from contract changes must be determined internally in each firm.
The discount switch to RFRs
The EONIA to €STR switch happened at LCH at the time of writing this article3. The switch is straightforward due to the well-planned separation of EONIA from EURIBOR. As a result, €STR has a constant spread to EONIA, avoiding any basis risk in the transition. It resulted simply in cash exchanges with firms. In cases where the RFR was not fully decoupled from IBOR (e.g. EFFR, the Fed Funds Reference Index), there exists a basis risk for the products that will switch to the new RFR. SOFR had been settling at around 2.10 to 2.20% for a few weeks but jumped to 5.25% in April 2020. The spreads have been narrowing and widening, leading to anticipation of long term basis risk by participants4. The spikes on SOFR happen at the end of the month as expected, due to funding challenges. If the SOFR and EFFR generally move together and the spikes are averaged out over the different tenors, then the charts should show a reasonably constant value for the difference between them over time5.
While firms are concerned about the SOFR switch and about overall LIBOR cessation for US markets, the regulators and the exchanges are continuously pushing towards trading of these new products, clearly discouraging firms holding IBOR exposures. The transition is inevitable and firms must plan for this sooner than later.
6 steps to a sure transition from LIBOR6
- Identify products that reference IBOR, their replacement benchmark (whether it is secured or unsecured). Estimate the difference to the portfolio upon switching to the new benchmark.
- Quantify exposure these products have to IBOR, including the ones that mature after the end of 2021.
- Produce an inventory of relevant systems used (e.g. trade booking, risk systems) that may be affected when IBOR is no longer published in the future, and evaluate changes that will allow those systems to use alternative rates, including discount curve switches, forward curve switches. The process might be different for cleared and bilateral OTC trades.
- Ensure that the reference data is set up correctly across the board for the new benchmarks. Understand the effects of opening and unwinding trades.
- Examine, and if necessary, amend existing products to ensure that robust language is in place that sets out the steps to be taken, (or the interest rate to be applied), in case IBOR is no longer available. (In this case carefully evaluate the terms for the product and identify any required consent processes).
- Ensure that appropriate documentation is in place to adequately disclose or mitigate risks associated with the discontinuation of IBOR for new products. Consider using RFRs, and if using IBOR, check if a robust language in place that sets out the steps to be taken, or the interest rate to be applied, in case IBOR is no longer available.
These steps have to be performed for each jurisdiction that the firm operates in. It is prudent to incorporate flexibility into the milestones to adjust for any changes in the target dates for each jurisdiction.
IBOR transition is unavoidable7. The efforts to transition have become mandatory as the regulators and the exchanges embark upon ‘IBOR cessation post-2021’, as a step towards encouraging funded risk-free rates. With a RFR, the rate is derived from actual data and hence does not rely on a predicted rate established and agreed upon by the participants themselves. The benefit of adopting a flexible transition strategy that can be fine-tuned for changing timelines and milestones is that it replaces the up-front capital investment with a step-wise transformation to match jurisdictional requirements. It is also helpful in mitigating possible delays in this multi-partite effort involving many stakeholders.
*IBOR is a term that encompasses all reference rates that depend on LIBOR. LIBOR and IBOR are used interchangeably in this article
- Survey: Futures Industry Association and Greenwich Associates
- Infosys Projects
- FS Research – Infosys
Kavita has over 19 years of experience within in-scope delivery of complex technology and operations as well as business-focused solutions for global capital markets. She has enabled the path to value realization for various financial services clients. She has worked extensively with leading banks and capital markets firms executing complex transformations in the area of business, technology, and regulatory change management.