Interbank Offered Rates (IBORs), including the London Interbank Offered Rate (LIBOR), serve as widely accepted benchmark interest rates, and the forthcoming transition is one of the most significant changes for the financial services industry. The unparalleled scale of this industry-wide transition presents considerable challenges, including potential financial, legal, operational, conduct and reputation risks. This blog explores the challenges and risks of navigating the IBOR transition and the adoption of alternative reference rates.
Current Status of the IBOR Transition
IBORs play an important role in the functioning of the global economy, which is why the away from LIBOR is one of the biggest challenges that many financial firms have ever faced. To start, let us briefly recap the story so far.
The LIBOR reform has been ongoing for more than two years, since it was announced by the Financial Conduct Authority in 2017. The transition timeline below outlines the key milestones; the financial services industry has used these milestones to split the work required into various components.
The first step, from a chronological point of view, was the development of alternative risk-free rates (RFRs). This component was mostly achieved in 2018, with the alternative rate for Euro LIBOR being the last to join the financial scene when the Euro short-term rate (€STR) was published by the European Central Bank in October 2019. Table 1 sums up the details regarding reference rates and the corresponding alternative in various jurisdictions.
Another component identified by industry groups was the development of transition strategies in order to adopt benchmark alternatives. This involved many steps to increase market liquidity, and important stages in achieving this are also featured in the timeline above. This included the beginning of trading secured overnight financial rate (SOFR) and Swiss Average Rate Overnight (SARON) futures in 2018 and continued with the introduction of dealing cleared swaps in various benchmark alternatives, as well as the discounting switch at major clearing houses. This discounting switch from Euro Overnight Index Average (EONIA) to €STR for Euro-denominated products was also quite important in increasing liquidity. Still to come is the discounting switch from the Effective Federal Funds Rate (EFFR) to SOFR at major exchanges in October 2020.
Another consideration are the cash and derivatives markets, which currently reference LIBOR. For many derivative contracts there are structural differences between LIBOR and alternative RFRs. For example, the lack of term structure in alternative RFRs requires adjustments to be made in order to ensure that contracts will happen as they were initially intended, as soon as fallbacks are in effect. In the timeline of the LIBOR transition process, the publication of the fallbacks via Bloomberg constitutes a major milestone, which was achieved in July 2020.
Table 1 summarises the publication of the 11 fallback rates for each LIBOR rate tenor. Converting tough legacy positions to the new benchmarks will be an ongoing process throughout this migration and is expected, and encouraged by benchmark administrators, to be done by the end of the third quarter of 2021.
A final component identified by industry groups was to increase contractual robustness. In its role as a regulator, the International Swaps and Derivatives Association (ISDA) has long been working on providing amendments that include fallback language between the 2006 ISDA definitions, and such fallback provisions should begin to be integrated between framework agreements in the fourth quarter of 2020.
Update on ISDA Fallback Supplement and Protocol
On 29 July 2020, the ISDA board encouraged financial institutions to adhere to the forthcoming ISDA fallback protocol. At present, this is still a work in progress and is expected to be published in December 2020. The idea of a fallback is not new; in this case it a set of contractual provisions that lay out the process through which a replacement rate can be identified if a benchmark (e.g., USD LIBOR) is not available. The difference is that now we are not talking about a temporary replacement but a permanent one, whereby Sterling Overnight Index Average (SONIA) will replace GBP LIBOR. Overall the ISDA fallback outlines three components: the fallback trigger event—that is, the point beyond which IBOR cannot be used, the benchmark replacement, and the benchmark replacement adjustment.
Key Elements of ISDA Fallback
Trigger events include the fixing date and a pre-cessation event based on a ‘non-representativeness’ of IBOR. The fixing date is important because this is used to calculate the new RFR. A pre-cessation event would provide the derivatives market with the ability to insert triggers into derivatives contracts to allow fallbacks to risk-free rates if such a regulatory announcement were made prior to the cessation of LIBOR. This has been a very delicate topic because of the potential transfer value it can trigger.
The ISDA protocol will apply to new derivatives contracts, but the regulators are aware that legacy derivative contracts pose a significant challenge—which is why it is expected that a protocol to facilitate the transition in legacy derivative contracts will be put together.
It is important to mention that adherence to the protocol would be voluntary; as an alternative the counterparties can negotiate on a bilateral basis, however this would be time-consuming for legacy contracts.
The first challenge in the valuation of financial products is the review or reconstruction of the interest rate curve environment for each financial institution. This is something that also lies at the very heart of derivatives pricing, as well as having a significant impact on infrastructure and models.
Since various LIBOR quotations form the basis of the construction of yield curves, the transition away from LIBOR is similar to recreating a parallel interest rate multi-curve environment, and this raises several issues with many cross-dependencies. When reviewing the curve environment throughout a bank’s complex infrastructure, there are several key steps. This includes identifying all trading systems, interest interfaces, processes, calculation engines and stakeholders linked to them. Another very important task is to stratify the valuation portfolio by exposures and instrument types, as well as setting up new benchmark rate curves for all impacted products. Similarly, adjusting valuation of processes and validation methodology, as well as reporting proceeds throughout a financial institution, can take a long time.
These valuation challenges are further compounded in non-linear products. Another valuation risk is posed by there being no market consensus in terms of compensation schemes for non-linear products. This is actually a direct impact of one of the milestones highlighted in the transition timeline—the discounting switch at major clearing houses. This switch will not only affect cleared derivatives but also uncleared over-the-counter derivatives. For example, swaptions that are referencing cleared swaps with start dates after 27 July 2020 will most likely be subject to a different valuation and hedging strategies than initially planned. This is strongly linked to the fact that at the valuation and hedging date, a different discounting curve would have been in use by the CCPs than at exercise time. Therefore a value transfer should take place in the bilateral swaption—something that’s not established in the industry.
While these two points are LIBOR transition specific, the conversion to alternative benchmarks is not completely independent from other industry-wide regulations and their impacts and validation adjustments. To identify cross-dependency to regulatory requirements such as CCR II, FRTB or the finalisation of Basel IV is also a key task and can be very challenging. From the point of view of the timeline, regulatory requirements such as CRR II are partly due next year. Needless to say, these validation risks are further compounded in computing XVAs, XVA hedging, XVA sensitivities and XVA Explain procedures.
Challenges Created by COVID-19
As if all these challenges would not have been enough, the global COVID-19 pandemic has them. First and foremost, for financial institutions with outdated technology infrastructures, the pandemic created a very big overhead and probable delays in operational readiness for the transition process.
The fear of the virus worsening has also put a lot of pressure on credit spreads, whilst trading in interest rate swaps had also declined. As a result, market liquidity was relatively oppressed at the end of March and beginning of April 2020.
In this context liquidity risk could be the perfect storm. IBOR will not be published from January 2022 so it was reasonable to expect that liquidity for IBOR would decrease. However, the RFR are new rates, so in most cases they do not have sufficient liquidity. As a result, there may be a situation where essentially the IBOR are not liquid enough and at the same time the RFR are not liquid either. Financial institutions need to monitor this situation closely and make sure there is a solution in place to deal with this scenario. In a recent Sterling Working Group there was discussion about a synthetic LIBOR, specifically for legacy contracts, but at the moment this is only a possibility.
From a currency and rates perspective, SONIA is in good shape and doing well in terms of liquidity and similarly the liquidity situation for SOFR and ESTR is improving. However, this is definitely something for risk managers to take into consideration.