LIBOR transition: what firms need to do, and what are the risks
From 2022, the London Interbank Offered Rate will be replaced by alternative reference rates (ARRs). An expert view of the alternatives, plus next steps for firms in managing conduct, legal and programme risk.
The London Interbank Offered Rate (Libor) has survived since 1986, with almost $200trn of transactions spanning derivatives, loans, securities and mortgages. But, after courting controversy during the 2008 financial crisis, Libor is set to be replaced by alternative reference rates (ARRs) from 2022.
Libor’s much-discussed end will lead to significant impacts for banks, corporate clients and governments as products referencing it become less available. The move to ARRs, typically risk-free rates (RFRs), is fast becoming one of the hottest financial services topics.
The demise of Libor began during the aforementioned financial crisis as unsecured interbank lending effectively dried up. This lack of liquidity highlighted the vulnerability of Libor and its reliance on expert judgements.
Due to the systemic importance of Libor, policymakers tried to address the deficiencies. They transferred administration from the British Bankers Association to the Intercontinental Exchange, moved its regulation to the Financial Conduct Authority (FCA) and tried to limit the number of currencies and maturities being quoted.
And they defined and implemented a waterfall methodology to create a rate based on derived historic transaction data before turning to expert judgements as a last resort. However, these measures have failed to address the underlying issue of a decline in unsecured lending between banks. Libor is therefore increasingly seen as unrepresentative of the underlying market and potentially not fit for purpose for the clients who rely on it.
New kids on the block
This has led the industry to seek out alternative reference rates. For example, the Secured Overnight Financing Rate (SOFR) records the cost of borrowing cash overnight in US dollars. It inherently differs from Libor as it is a secured, risk-free, transaction based rate. Libor is unsecured, it includes bank credit risk and is only partially transaction based.
SOFR has been successful with daily volumes of transactions approaching $800bn (versus $500m for Libor). Similarly, the Sterling Overnight Index Average (Sonia) and Swiss Average Rate Overnight (Saron) have emerged as alternative reference rates for pound sterling (GBP) and Swiss Franc (CHF).
However, as these new RFRs are transaction based, they reflect historic overnight rates and do not provide the forward-looking term structure that Libor did (eg, one day, one month and 12 month interest rates). This is a particular challenge to corporate clients who are accustomed to using Libor’s term rates and thus being able to predict their payments or receipts for intervals into the future. This can make alternative reference rates, based on overnight rates, more volatile than when using Libor rates as the basis of products.
The Libor endgame
These challenges, to name a few, do not mean that the industry can delay its transition planning from Libor. Despite the fact that we see some firms continuing to use Libor and waiting for certainty as to which way their peers will be moving. Indeed, although the FCA has committed 20 panel banks to continue submitting Libor rates through to the end of 2021, there is an acknowledgement that Libor will come to an end, with 50% of those banks expecting this to happen by 2022.
Some firms are leveraging the shift from Libor to build a first mover advantage in the alternative reference rate space, investing resources into new products and issuances to gain early market share.
As such, it’s possible to envisage a scenario where the industry reaches a cliff edge for using Libor far sooner than 2022, as both corporate clients and banks look to shift to replacement rate products. If transactions in Libor rates continue to decline we could reach a tipping point at which point liquidity in these products will dry up and firms will look to offload their Libor products rather than be left with illiquid exposures on their books.
The reality though is likely to be a little more nuanced. Transactions in Libor products will only dry up when suitable replacement RFR products are available and so banks and corporate clients alike will be looking for opportunities in the market place.
Shutting it down
In terms of their ‘front-book’, firms will need to address issues such as requiring new pricing feeds, models and system builds in order to offer clients an ARR-linked product.
For example, the legal documentation for newer Libor products typically contains disclaimers in the contracts informing clients that its due to be discontinued in the future and may not be as liquid. Industry groups, such as the International Swap and Derivatives Associate, are defining standardised protocol language for derivative products containing Libor rates. Between themselves, banks are also trying to come to a consensus on suitable contingency wording for bilateral transaction contracts to address the event that Libor rates may not be available.
Further to this, corporate clients should be considering the impact to their accounting practices. The International Accounting Standards Board has recently proposed reliefs in the accounting standards to help firms navigate through these choppy waters.
A real challenge also remains as to how to address the legacy positions for the banks where clients may have agreed to products such as long dated swaps where, for example, the rates were designed to be based on the rolling three month Libor. The original agreements may not have envisaged a permanent end to Libor. Typically some contracts may have contained wording to the effect that where Libor rates were not available then the last published rate should be used thereafter. Converting these to effectively fixed rates would risk creating both winners and losers.
Firms will need to carefully consider which contracts need to be migrated and start discussions with their clients about switching their contracts from one rate to another. This is likely to lead to differences in the payments made to and from clients as the rates reset, which presents significant challenges for the firm.
The business will need to ensure it minimises any impacts to existing clients while compliance departments may need to consider developing plans to include the oversight of these migrations within their monitoring activities in order to ensure that the business are not using curve transfers as a profit making exercise to the detriment of their clients. Banks will need to demonstrate that these migrations are fair and consider how best to evidence this publicly.
Financial firms face considerable risks, costs and administrative burdens to ensure that the transition occurs smoothly and that clients are treated fairly as they review their market risk profiles, models, valuation tools and hedging practices. However, as the US Department of Justice decrees, they will need to ensure they do not “tilt the economic system in their favour”, subvert the marketplaces, or “enrich themselves” at the expense of their clients.
On the flip side, opportunities will arise as banks develop new products to meet the needs of clients. Laggards in the market could see themselves at a significant commercial disadvantage and struggling to play catch up if they’re unable to provide competitively priced, equivalent products.
To make this transition a success banks and clients alike should be mobilising their Libor transition programmes, lest they be left behind.
About the author
Elliot Hand, senior manager, banking and capital markets, PwC
Next steps: Five key risks and mitigating actions
Following the FCA’s call that market participants should treat the withdrawal of Libor as definite, Deloitte’s Steve Farrell, Mark Cankett and Ed Moorby outline five of the key risks that firms are facing and some actions that might mitigate them.
Global Divergence Risk
The RFRs for the five Libor-based currencies (USD, GBP, CHF, EUR and JPY) have been agreed and live (with the exception of the EUR rate) for some time. However, their suitability and use for new ‘front book’ financial products, along with the replacement of historic ‘back book’ financial products, is still not clear. There is debate about development of a term structure, how fallback calculations for derivative products may impact and the legal and regulatory practicalities of transitioning Libor-linked products held by retail customers. Some market participants are therefore considering ‘alternatives to the alternatives’ (ie, alternative rates to the RFRs, which may address some of these issues). This could give rise to increased market segmentation and a wider range of benchmarks coming into use across the financial system. Divergence creates an additional layer of complexity for firms. Firms will have to contend with assessing risk, developing scenarios and planning for change, across a multitude of differing rates, which may vary by geography, customer type and product.
Firms should participate in the debate across all key working groups, track divergence and create strategic solutions to identified risks. Firms should also ensure their progress in the issuance or take-up of RFR-linked products does not stall because of the ongoing debate.
New Product Development
Regulators are keen on market adoption of the RFRs. The transition away from Libor therefore requires the adoption of appropriate fallbacks in legacy contracts, as well as the issuance of new contracts that refer to RFRs. As above, market participants have started to issue RFR-linked products for both cash and derivatives, but the picture is varied depending on currency and geography.
Firms should continue to educate and build awareness across the market around the transition. Look at commercial opportunities, the design of new products, as well as the operational elements to support them.
Conduct and Legal Risk
The conduct and legal risk in respect of Libor transition is significant. This links to a fundamental point that Libor continues to be used in both existing and new contracts despite clear messages that it will be discontinued. Moreover, many market participants acknowledge that a ‘PV neutral’ transition, while perhaps theoretically possible, will be difficult to achieve in practice.
Firms should establish governance that captures consideration of these risks and promotes accountability. They should focus on awareness building for:
- client-facing teams.
- support staff to ensure that everyone has an understanding of the transition and is aware of how the firm wishes to engage its customers.
- legal teams so that the fallback language in contracts, as well as the documentation of new products and decisionmaking around their development and sale is appropriate.
Externally, the focus will be on raising awareness with customers and being clear on the messages that firms can give today.
Firms in the UK have been asked to provide a comprehensive assessment of the risks arising from transition. But there is the risk that the increased awareness of senior executives is not necessarily translating into the speed and level of activity needed to prepare firms to launch new RFR products and be ready to transition their back books.
Programme leads continuously need to educate staff, raise the significant risks that arise from not acting now and challenge the board to make key decisions, such as agreeing dates for ceasing to issue Libor products. Effective governance should help ensure the central team responds to the needs of regional teams where local challenges may be different. Firms should ensure the responsibility and accountability are clearly assigned to senior managers.
Impact of Existing Regulatory Requirement
There are many risks associated with the end-to-end operating model of firms. Some of the key areas in which existing regulatory requirements may affect transition and create challenges include:
Customer communications and outreach: regulatory requirements regarding pre-sale product disclosures (for example, under MiFID II) require careful consideration in the context of transition. In addition, firms should also consider best execution requirements.
Model risk management: regulatory requirements supporting change management (eg, material changes), testing and model validation require consideration and will drive a significant body of work for firms.
Capital and liquidity reporting: an area of recent scrutiny in the market, it will be important for firms to establish the knock on impact of risk measurement on the as yet unaudited capital reporting requirements.
Financial reporting: while hedge accounting considerations are the primary concern, broader financial reporting requirements, including risk disclosures, financial instrument measurement and recognition/ derecognition, are still key.