Interest Rate Benchmarks: Tackling the Achilles' Heel of the Global Financial System
Regulators globally are making the reform of interest rate benchmarks, and the transition to alternative rates, a key priority over the next two years.
In the U.K., the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) have already pressed banks and insurers to set out the preparations and actions they are taking to manage the transition from the London Inter-bank Offered Rate (LIBOR) to alternative interest rate benchmarks. In Switzerland, the Swiss Financial Market Supervisory Authority (FINMA) has launched a similar exercise. The U.S. Fed has said it also will be scrutinising banks’ preparedness for the LIBOR transition, and monitoring ongoing progress.
Firms, therefore, need to demonstrate that they understand the risks associated with this transition and are taking appropriate action.
This is not simply a matter of a straight switchover from LIBOR (or any other IBOR) to an alternative rate – delete the one and insert the other. No, the transition will entail the creation of a whole new set of market microstructures, each with different definitions, back data, volatilities, derived markets, liquidities, and behaviours. That is a big challenge, both for the collective market to construct, and for individual firms to understand and adapt to.
What’s the problem?
The existing IBORs are not sustainable, and regulators doubt they can be reformed. After the LIBOR-fixing scandal, regulators want reference rates to be based on observable market data, not expert judgement. Unsecured interbank lending has shrunk dramatically and is no longer deep enough to generate sufficient data points for a robust benchmark. Hence the need for a transition.
The clock has been ticking. U.K. authorities will cease compelling banks to contribute to LIBOR by the end of-2021. Euribor has to be fundamentally reformed to meet the demands of the EU Benchmark Regulation from January 2022.
New risk-free reference rates are being established for each major currency. Regulators are pushing for these rates to be used from now on, especially where bank credit risk and term risk is not relevant, and for market participants to develop term liquidity, and to address legacy contracts, with approaches derived from risk-free rates.
The range of areas where IBORs are currently used is very wide indeed. The use is direct – as the rates used to determine interest payments for the full range of credit products and derivatives. But also indirect – as the technical parameters inputting to broader processes for valuation, accounting, asset management performance benchmarks, project and trade finance, late payment clauses in commercial contracts, price escalation and adjustment clauses, and regulatory cost of capital calculations. All these uses will have associated infrastructure, IT, documentation and so on, that has been built around IBORs, and which will need to be modified or replaced if alternative rates were to be used.
Transition, therefore, raises multiple interconnected issues, with major dependencies on market consensus solutions being found in a timely way.
The seven things firms need to start doing now
Design and set-up a project
Firms will need a dynamic strategy which coordinates internally across all affected areas and links externally to the major market transition milestones. That will enable the inevitable “course correction” through the transition to be managed more easily. This will include the need to conduct data mapping and data collection across the organisation.
Draw up an inventory of exposures and uses
IBORs are used in a wide range of agreements and products offered to clients, but also internally for trading, valuation and accounting. Exposure is thus likely to span a firm’s activities from vanilla retail offerings to sophisticated customised products for wholesale clients and counterparties. A comprehensive assessment of prudential and conduct risk will be challenging, particularly for complex global institutions. This will include the need to ingest, analyse and report on the data going forward and throughout the transition.
Quantify these exposures
Once the inventory of instruments, processes and models that reference IBORs is complete, a detailed and finely graded risk analysis for each exposure based on all relevant factors is needed.
Model the different possible scenarios
There are still multiple possible scenarios for IBOR transition. These range from imminent disorderly cessation of a benchmark, to a managed state where a successor IBOR rate that is acceptable to regulators and investors is available for certain uses for the long term, with a wide range of scenarios between these extremes. Models based on IBOR rates will become obsolete and essential benchmarks will move from being forward looking to backward looking. New models will be needed to encompass the new world – for example some RFRs are secured (SOFR, SARON), others are unsecured (SONIA, €STR, TONAR).
Develop a set of risk mitigations
This is a critically important step, encompassing several areas to ensure a robust remediation plan:
- planning and executing a switch to using alternative rates for new products;
- replacing use of IBORs in existing contracts;
- or otherwise developing robust fallbacks across all asset classes if IBORs unavailable;
- designing transitions to minimise potential transfers of economic value, not just at the point of transition, but also thereafter.
There are important dependencies in all these market-wide developments, such as: the availability of suitable term rates, developed from RFRs, which align to existing IBORs; settling on standard fallback terms for derivatives, credit agreements and bonds; and the development of deeper liquidity in these new benchmarks.
Amend documentation, and communicate clearly with clients
Firms will need to develop and publish suites of documents on IBOR transition for customers and regulators, both for existing agreements and instruments, and for new products. These will need to be aligned to risks and challenges and will likely need to be dynamic. There are significant reputational and conduct risks in relation to IBOR-linked products still being sold now, as well as the transparency of communication on legacy contracts. New documentation should sit within a broader strategy for communicating with clients and regulators to ensure an efficient and effective remediation effort.
Fully engage senior level management, and train staff
IBOR transition is a major risk which will need significant Board and senior management ownership. Due to the ubiquity of IBOR use, staff in many areas of each firm will require ongoing training on benchmark regulation and IBOR transition.
How can A&M help?
A&M has the expertise and experience to help across all these areas. Our team:
- understands the regulatory imperative and perspective, having been senior regulators involved in these issues;
- understands the financial management implications, having held senior Treasury roles in major banks;
- understands the design, construction and use of benchmarks, having been responsible for the management, design and reform of benchmarks in all major asset classes and territories;
- understands the operational challenges of transition, having delivered major operational change programmes both in line roles in the industry, and in A&M engagements;
- understands the processes required to design, identify, collect, process and analyse the vast arrays of relevant information in virtually every format imaginable spread across an organisation;
- understands and utilizes the technology available to ensure an efficient and cost-effective transition;
- has the diagnostic tools to assess the risks inherent in all exposures, whether these are economic, reputational, conduct or other. We can partner with technology providers to enable rapid assessment of existing contracts;
- has deep experience from other industry wide initiatives that have required large scale amendments of financial contracts (Dodd-Frank, QFC Rules, Uncleared Margin etc.).
For more information relating to the topic covered in this article, please feel to contact one of the authors.
