David Bull, Director of Data Management and Strategy at Refinitiv, analyzes what needs to be addressed during the LIBOR transition, including identifying a suitable replacement, LIBOR legacy issues, and why the financial services industry needs to act sooner rather than later.
- The long-anticipated retirement of LIBOR (the London Interbank Offered Rate) will occur at the end of 2021, and market participants need to act to transition their portfolios to one of the new risk-free rates (RFRs).
- A number of alternative reference rates have been identified as potential replacements. However, none was designed to replace LIBOR — regulators, benchmark administrators, and industry participants need to adapt in order to transition away from LIBOR.
- Organizations must pay full attention to the deadline and use the right data and tools to help ensure that the LIBOR transition causes as little market disruption as possible.
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At this point, not even a pandemic can derail the long-anticipated retirement of LIBOR (the London Interbank Offered Rate) at the end of 2021. That means time is running out for market participants holding trillions of dollars’ worth of LIBOR-based contracts to transition their portfolios to one of the new risk-free rates (RFRs).
Meeting this fast-approaching deadline will require the full attention of all organizations — along with the right data and tools to make this switch with as little market disruption as possible.
Finding a replacement
While no single alternative has been identified that can provide the global reach of the LIBOR, public and private working groups have been quick to create or identify alternative reference rates across major currencies.
- Secured Overnight Financing Rate (SOFR) for U.S. dollar
- Sterling Overnight Index Average (SONIA) for Sterling
- Euro Short-Term Rate (€STR) for euro
- Swiss Average Rate Overnight (SARON) for Swiss franc
- Tokyo Overnight Average Rate (TONAR) for Japanese yen
However, none of these RFRs was originally designed to be LIBOR’s direct equivalent, and all are based on overnight rates. LIBOR is typically quoted at forward-looking points, which makes it easier to adjust to fluctuations in global interest rates.
For instance, in the United States, SOFR is derived from the large volume of transactions in the overnight repo (i.e. repurchase agreement) market, creating a backward-looking rate. So for some interest rate products, a three-month SOFR rate will be derived by compounding the overnight rate in arrears.
Regulators and benchmarks administrators are looking to address some of these issues by creating forward-looking term rates that could be used as an alternative in certain workflows. Determining how the rates and cash flows are calculated and whether or not they include a credit component remain under discussion.
The lack of dynamic credit risk within SOFR has raised some concerns.
For example, in times of market stress, tying interest rates to LIBOR made it easier for banks to manage their interest rate risk because higher payments on their assets helped offset the pressure of increased funding costs.
Replacing LIBOR with SOFR is likely to tighten already thin margins. As a result, issuers may need more compensation via higher spreads for bearing the risk that their asset yields could shrink at the same time their funding costs rise.
Addressing legacy issues
A key hurdle making this transition is in legacy LIBOR contracts that provide no ability to revise fallback language.
Fallback language outlines the terms of how a product is impacted if LIBOR is not available. While some asset types, such as derivatives, are able to address through fallback rates and protocols being introduced by legislative bodies and working groups, others, such as bonds for example, will automatically fall back to terms outlined in bond prospectus documentation. And that prospectus was written in a world where a long-term unavailable LIBOR was not foreseen.
Some progress has been made. In June, the UK’s Financial Conduct Authority (FCA) announced it is working on a policy statement that will outline how it could exercise its change in LIBOR’s methodology to address these tough legacy issues.
The proposed changes would enable the continued publication of a LIBOR number “using a different and more robust methodology and inputs.”
However, as trillions of dollars’ worth of contracts move away from LIBOR, contract modifications and hedging arrangements may be expensive and extremely burdensome.
For accounting purposes, changes made to contracts and other arrangements, such as debt agreements, lease agreements and derivative instruments, will have to be evaluated to determine if the modifications result in the establishment of new contracts or the continuation of existing contracts.
In addition, changes in a reference rate could disallow the application of certain hedge accounting guidance, and certain hedging relationships may not qualify as “highly effective” during the period of the market-wide transition to a replacement rate.
The LIBOR transition: Why you need to act now
The ability to revalue existing assets based on new RFRs is critical.
Because LIBOR is so deeply embedded across myriad processes throughout the financial services industry, organizations will need a multitude of data points and tools to support a transition to alternative reference rates and benchmarks.
With time running out, market participants need to act now to have the appropriate plans in place to manage this transition efficiently and meet the 2021 deadline.
Consider taking these four steps to prepare your institution — and your customers — for these changes.
1. Understand your risk and identify your exposures
A good starting point is to develop an understanding of the organization’s exposure to LIBOR. Where is LIBOR currently being used, or which reference rates are currently being used? Which processes and functions are LIBORs feeding into? What fallback conventions are applicable?
Once the touchpoints have been identified, alternative benchmarks and reference rates need to be assessed. Scenario analysis tools can help firms measure the impact of interest rate swaps and floating-rate notes on LIBOR-based contracts in your existing portfolios.
A calculator for compounded rates for major RFRs can help firms keep up as more market-standard methodologies continue to be developed.
2. Start reducing reliance on LIBOR now
Begin trimming your legacy exposure wherever possible and start talking to your clients now about the changes going in on in the market and any new products that are being developed.
Then start integrating RFR-based tools into your pricing models and calculators so that you can begin transitioning current transactions that go beyond 2021 to alternative rate structures.
3. Engage with your employees, advisors and regulators
A smooth transition away from LIBOR will require effective leadership from the top down. Establish LIBOR migration programs across front, middle and back offices, and identify senior executives who will be accountable for managing the transitions.
Despite the looming deadline, many core issues surrounding the global move away from LIBOR remain fluid. That means organizations need to stay on top of the news, along with communications from regulators and industry groups, so that they can make informed decisions about their own transitions.
4. Find the right data — and the right data partner — to help you make a more seamless transition
Data is — and will remain — at the heart of navigating these changes. Newly available data and new RFRs will drive new curves, pricing and content sets. But data is just the beginning.
As the move away from LIBOR gathers momentum, being able to access robust, trusted data, along with relevant insights and tools, from a single source will become an invaluable necessity for a smooth and effective transition.