Insights

Living without LIBOR: Managing the transition to risk free reference rates

Written by Jon Szehofner
05/06/2019

Introduction

In the face of uncertainty we tend to do nothing. This has proven to be the case for many firms when it comes to the transition away from LIBOR. Despite the risk of LIBOR’s discontinuation in 2021, many affected businesses have yet to put in place plans to move to the alternative risk-free rates (RFRs).

In this article we will take a closer look at the risks arising from inaction, and discuss ways in which firms can in fact make a smooth transition to new arrangements. The message is clear, firms need to determine their current LIBOR exposure – how it is used and why – across the entire organisation. This will then set them on the path towards forming an exhaustive transition roadmap and clear communication strategy.

What are the challenges posed by the transition from LIBOR?

“[The LIBOR transition is] something we need to work through carefully and fully understand the risks before landing on a way forward”
Sarah John, Head of the Bank of England Sterling markets Division

There are a number of closely connected challenges that firms face in replacing LIBOR. Although the focus of this article is on LIBOR, the issues identified are just as relevant to other IBORs which are undergoing similar transitions.

A state of paralysis

Affected institutions have in general been unable to pay sufficient attention to the LIBOR transition, among the other issues they have to address and enduring uncertainty about the target state for a number of currencies. This is only storing up, and exacerbating, problems for the future. Due to the scale of the transition away from LIBOR and ongoing uncertainty about how this can be achieved, firms instead seem to be operating on the default assumption that LIBOR will continue in some form. Publication of LIBOR rates will not necessarily be discontinued after 2021; although panel banks will no longer be compelled to submit rates, there will be nothing preventing them from continuing to do so. Therefore many firms have yet to initiate and substantially progress their planning for a transition away from LIBOR.

A survey in January 2019 found that 83% of firms with exposure to LIBOR have yet to make changes to their contracts.[1] In June 2018, the Bank of England pointed out that in the previous 12 months the stock of Libor-linked sterling derivatives stretching beyond 2021 had in fact grown.[2]

This lack of progress increases the risks of inadequate preparation and resultant future costs. For example firms may have to rely on fall-back provisions intended for short term-contingencies, not extended periods, leading to unintended results that could dramatically alter the very structure and economics of the product. Suggestions for enduring LIBOR stand-ins for legacy contracts, such as synthetic LIBOR, have yet to be seriously pursued by the market and there is a question over whether synthetic LIBOR would actually satisfy the definition of LIBOR included in the contracts, which could give rise to legal challenges or indeed conduct risk. The crossover will also raise financial, tax and legal issues which will take time to be addressed. By not acting expeditiously to transition firms are building up a back book problem of financial instruments continuing past 2021 that is worse than it needs to be.

Status of alternatives

Chart

Table 1. Alternative RFR for the remaining five LIBOR currencies

An important aspect of the uncertainty about the alternative rates is the lack of established term structures for RFRs, because they are currently overnight rates. The lack of term structures is a particular issue for the loan market. In practice the emergence of term structures will be supported through the expansion of a market for interest rate futures and swaps in applicable RFRs.

Expanding trade in the RFRs is key to growing these markets and incentivising banks to design new RFR-linked products. Therefore the slow crossover to the new rates actually increases the very uncertainty about the alternatives, which inclines firms towards inaction in the first place. This could result in a lack of liquidity in these rates and slow progress towards establishing term structures for them. The Working Group on Sterling Risk-free Reference Rates anticipates term rates for SONIA could be available in the second half of 2019.[3]

Since mid-2018, the issuance of SONIA- and Secured Overnight Financing Rate (SOFR)-linked securities has gradually picked up and in the last few weeks of 2018 more than a third of the issued floaters referenced the new RFRs. Some corporates were deterred from issuing SOFR-linked securities in early 2019, however, by the volatility of SOFR.[4] Moreover, of the $54 trillion of interest-rate derivatives traded in the third quarter of 2018, just 3.3% were tied to LIBOR alternatives, and in November just 18% of the notional cleared sterling swap market used SONIA as its reference rate.[5]

Although regulators have reaffirmed that the discontinuation of LIBOR is “something that will happen and which [firms] must be prepared for”, they have left the transition to be a voluntary, market-driven move. Lack of clear regulatory guidance on the best route to achieve this has left many firms adopting a wait and see strategy until the market provides greater clarity on the alternative RFRs. The result of this inaction is the build-up of more legacy LIBOR-linked contracts for future transition.

Client communication and conduct risk

There are an estimated 200,000 LIBOR-linked residential and buy-to-let mortgages in the UK. This represents 1-2% of the outstanding mortgage market.[6] Firms will have to reach out to those whose LIBOR-linked mortgages extend beyond 2021. Yet this is only a fraction of the consumers and counterparties that firms will have interact with in their transition from LIBOR.

Firms need to carefully consider their communications strategy so that changes are adequately explained to customers and the appropriate consents obtained from them. This will be essential to protecting firms from potential legal liabilities during the transition. They should take into account the type of customer, type of financial instrument, and timing of the switch in their interactions. At the same time, it is important to ensure the consistency of treatment across customers. Firms have an obligation to treat customers fairly and provide products which best suit their needs. They should therefore communicate clearly the differences between LIBOR and the alternative RFR suggested to customers and counterparties. This will help to avoid potential conduct risk issues arising if customers and counterparties feel disadvantaged by the new rates. For a number of financial products, the shift to an alternative RFR would create a winner and a loser among the bank and the customer. GBP 3M LIBOR is on average 30 basis points higher than a computed forward-looking 3M SONIA rate, because of structural differences between the two rates. The peak difference between the two rates in the last 10 years was 398 basis points. So even factoring in the average difference, payments made under 3M LIBOR and 3M SONIA priced contracts will rarely be at the same level.[7] This raises conduct risk issues if the firm does not prioritise their customer’s financial benefit over their own or keep them adequately informed of the implications of the change. If transitioning to the alternative RFR breached contractual terms or negatively impacted the counterparty, this could result in legal challenges and reputational cost to the firm.

Financial cost

It is estimated that updating systems and switching from LIBOR to alternative benchmarks could cost the largest financial institutions $300 to $400 million each.[8] This sum would cover the necessary changes to infrastructure and systems, and the costs of repapering LIBOR-linked contracts.

Significant administrative work will be required to identify all the relevant LIBOR-linked contracts on the firm’s books. The terms of contracts dating beyond 2021 will then have to be amended to the alternative RFR, or to include an appropriate fallback provision. Unlike derivatives which have standard contract language, products for corporate and retail end-users have limited standardization, making their amendment more time intensive. In addition, firms need to update the fallback language in contracts to reflect the risk of LIBOR’s potential permanent discontinuation. An indication of the potential expenditure is revealed by the estimates of tens of millions, potentially up to more than $50 million, that firms have spent on the MiFiD II repapering process.[9]

The significant up-front costs and increased operational risk arising from switching to an alternative rate disincentivises firms from tackling the transition away from LIBOR head on.

How best to prepare for and undertake this transition

“Ensuring that the transition from LIBOR to alternative interest rate benchmarks is orderly will contribute to financial stability. Misplaced confidence in LIBOR’s survival will do the opposite.”
Andrew Bailey, Chief Executive, Financial Conduct Authority (FCA), July 2018

LIBOR transition will be like few other transformation programmes that firms have undertaken. Despite this, firms can draw on their experiences from other large scale transition programmes such as those for the euro transition and MiFiD II.

All LIBOR users are required under the EU Benchmarks Regulation to have ‘robust written plans’ for a benchmark’s cessation.[10] In September 2018 the FCA and Prudential Regulation Authority (PRA) wrote to the CEOs of major banks and insurers they supervise asking about the preparations and actions they are taking to manage transition from LIBOR to alternative interest rate benchmarks.[11] The FCA has not mandated one particular approach to achieve the transition away from LIBOR.

Such a plan will have to take account of the firm’s current state regarding the volume of LIBOR linked contracts with maturities beyond 2021. It will also need to define a target state for the firm’s exposure to LIBOR linked contracts. Therefore the suggested approach here is centred on performing an impact assessment for the transition. This would establish the current and target states within the firm, and help shape the roadmap for moving between them. An effective transition plan could adopt the following staged approach:

Mobilise

The first step for firms is to establish a defined programme and governance structure dedicated to the delivery of an efficient transition to the new RFR. As part of this, firms will be required to appoint an accountable Senior Manager Function.

The programme will create the design principles that determine the firm’s transition programme, identifying key risks as well as ensuring consistency with industry developments, market adoption and infrastructure. It is also critical for firms to ensure there is an appropriate oversight structure to monitor progress.

Assess

The current usage of benchmarking rates can be captured through executing a cross-function impact assessment. The impact assessment should examine LIBOR-linked activities (processes, systems etc.) across client and product areas.

The impact assessment will inform an organisational gap analysis by providing a snapshot of the current state within the firm. The governance structure can then use this and the transition programme’s design principles to determine the best way of moving to the target state. The analysis would also highlight the relevant key risks which will need to be mitigated.

Firm’s will need to assess the exposure to LIBOR linked contracts with maturities beyond 2021 and must be able to separate their contracts into those that are linked to LIBOR and those that are not. They will also need to identify any fallback provisions (and the replacement rate they prescribe) present in existing contracts.

Software tools can be applied to the task. They can extract contract terms and compare them against the transition programme guidelines. Such tools have already been applied to interpret tens of thousands of credit agreements and amendments.

Roadmap

Once firms complete the impact assessment, they can then effectively determine a detailed roadmap and transition approach. This roadmap needs to take into account:

  • Managing key risks i.e. financial, legal, conduct
  • Wider market approach and adoption
  • Ongoing communication strategy for clients and staff
  • The availability of appropriate alternative benchmark for contracts
  • The timing of internal LIBOR cessation and transition to a substitute (i.e. Big Bang or phased approach)
  • The impacts on the firm’s people, processes and systems
  • The approach for amending client contracts (as per treating customers fairly)

Where there is not yet clarity about an aspect of the replacement rate, for instance the term structure for SONIA, firms can develop interim contingencies. Firms can already plan for contract changes that should be implemented if SONIA does not adopt the same term structure as LIBOR.

Firms should tailor their roadmap to their own specific circumstances. This should take account of the scale of the firm’s stock of LIBOR-linked contracts, the contracts’ lifespans and the tax implications of the changes for them. There are also less readily apparent considerations for firms to reflect upon. For instance EU-supervised institutions could be prevented from using LIBOR in a “no deal” Brexit scenario. If this was the case, and no regulatory equivalence agreed, LIBOR could be treated as a third-country benchmark under the EU Benchmarks Regulation. In this case, before 2020, the administrator of LIBOR would need to re-apply under the recognition or endorsement options within the Regulation.

The finalised roadmap underlines the benefit of adopting this overall staged approach. This is because it can be informed by the initial design principles set for the transition programme, the impact assessment and the gap analysis resulting in a practical roadmap for the firm.

Summary

Let’s make a bet; LIBOR will lose its pre-eminence.”
Richard Sandor, creator of Ameribor, 2012

The challenges posed by the transition away from LIBOR have inclined firms towards inaction. Uncertainty about the existence of LIBOR post 2021 has fed a hope that the rate will simply live on. This, however, ignores the more likely outcome: that while there will probably not be a complete and instant LIBOR cessation, it will gradually be phased out as contracts expire. Regulators promotion of alternative RFRs, in particular, indicates that LIBOR is not long for the financial world. If firms (including financial institutions and other corporates) do not face up to this reality, their LIBOR-related problems and the costs of transitioning will only increase. The transition process need not be something to fear, as the suggested approach illustrates. Firms can draw up tailored and pragmatic road maps for their own transition, by assessing their current LIBOR exposure and envisioning their desired end goal through a robust gap analysis. The resulting transition roadmap, effectively implemented, can leave a firm well prepared for the post LIBOR future.

What is LIBOR?

“The World’s Most Important Number”
The British Banking Association (BBA), which was responsible for the administration of LIBOR until 2014

The London Interbank Offered Rate (LIBOR) is the benchmark interest rate reflecting how much it costs banks to borrow from each other. The panel banks submit the rate at which it would cost them to borrow in various currencies and for a variety of periods. The Intercontinental Exchange (ICE) then calculates a trimmed average (the highest quarter and lowest quarter of submitted rates are discarded before an average is taken) for each currency (the British pound, US dollar, euro, Japanese yen, and Swiss franc) and maturity (overnight, one week, and one, two, three, six, and 12 months). The resultant 35 LIBOR rates are published daily.

Beyond acting as a measurement of interbank lending costs, LIBOR underpins a broad range of financial products. This includes common interbank products, as well as syndicated loans, individual mortgages and student loans. Therefore LIBOR is woven into the regular business of banks, financial institutions and the broader economy as far more than simply a measure of interbank lending.

If it’s so important, why is it being replaced?

“It’s just amazing how libor fixing can make you that much money”
Text message between senior yen traders involved in manipulating the LIBOR rates

“if you’re going to transition from [LIBOR] to something else, that’s $300 trillion of potholes that are potentially coming.”
Ward McCarthy, chief financial economist at Jefferies LLC

These two quotes encapsulate both the primary motive for the move away from LIBOR, and the reason why such a transition is so complex.

LIBOR has been thrust out of the world of obscure financial arcana and into public and media attention in the last few years due to revelations of fraud and collusion by member banks in rate submissions. This has resulted in criminal prosecutions and regulatory action. These scandals, and the significantly lower volumes of interbank unsecured term borrowing since the 2008 financial crisis, led the Financial Conduct Authority (FCA), to announce in 2017 that it after 2021 it will no longer persuade or compel panel banks to submit the rates required to calculate LIBOR.

As a result, LIBOR regulators around the world are trying to wean markets off Libor in favour of overnight RFRs. These rates are based on actual transaction figures, and so are less prone to manipulation. The regulators have established working groups on the topic, which have endorsed a variety of alternative rates. In April 2017, the UK Working Group on Sterling Risk-Free Reference Rates recommended the reformed Sterling Overnight Index Average (SONIA) as its preferred RFR. SONIA is calculated based on the overnight interest rate that was paid by banks in actual unsecured transactions in the British sterling market.

Despite the announcement of LIBOR’s potential impending discontinuation, however, its centrality has only been further affirmed. Total outstanding notional IBOR exposure is estimated at over $370 trillion, from derivatives, loans and other products (MPG Final Report on Reforming Interest Rate Benchmarks, FSB, July 2014). This illustrates the size of firms’ business that potentially has to be converted to the new rates, and thus the scale of the task they face.

This Article was Co-Authored by James Fraser

Click below to download a PDF of this article.

GDFM – Living without LIBOR

Sources

[1] Source: Industry survey highlights need for renegotiation of Libor-based contracts, JCRA, 10 January 2019

[2] Source: Financial Stability Report Issue No. 43, Bank of England, pg. 57, June 2018

[3] Source: Consultation on Term SONIA Reference Rates, The Working Group on Sterling Risk-Free Reference Rates,   pg. 4, July 2018.

[4] Source: Andreas Schrimpf and Vladyslav Sushko, Beyond LIBOR: a primer on the new benchmark rates, BIS Quarterly Review, 5 March 2019.

[5] Source: Libor, the $370 Trillion Zombie That the Watchdogs Can’t Kill, Washington Post, 21 December 2018.

[6] Source: Response by the council of Mortgage Lenders to the Wheatley Review of LIBOR, Council of Mortgage Lenders, 28 September 2012.

[7] Source: Changing the World’s Most Important Number: Libor Transition, Oliver Wyman, pg. 7, February 2018.

[8] Source: Breakdown: Libor Habit is hard and costly to kick, Reuters, 23 October 2018.

[9] Source: Fighting the Paper Tiger: The Challenge with MiFiD II Repapering, Finextra, 27 September 2017.

[10] Source: Regulation (EU) 2016/1011, EUR-Lex, Article 28.2, 8 June 2016.

[11] Source: Dear CEO LIBOR letter, FCA, 19 September 2018.

Contact the Author

Profile image of Jon Szehofner

Jon Szehofner

I am a co-founder of GD Financial Markets LLP, and an experienced management consultant who specialises in delivery oversight and client relationship management. I ensure that our portfolio of client engagements are risk managed and delivered on-time and to budget. I have led numerous high-profile engagements for global investment banks and market utilities, with a focus on post-trade services, risk management, regulatory reform and managed services.

Gordon Dadds