In July 2017, the UK Financial Conduct Authority (FCA) reported that the London Interbank Offered Rate (LIBOR), will be phased out as the interest rate index used in calculating floating or adjustable rates for loans, bonds, derivatives and other financial contracts by the end of 2021. LIBOR underpins approximately $300 trillion in financial products and is one of the most significant reference rates used by financial market participants.
It has been recommended by a separate working group, the Sterling Risk-Free Reference Rates Group (“Sterling RFR Group”), that GBP LIBOR should be replaced by the Sterling Overnight Index Average, SONIA. The confirmation of this replacement on 29 November by the FCA1 further underlines the importance of understanding the potential impacts, and practical considerations, of the change in what has been such an important reference rate of modern times. A key near-term priority for the Sterling RFR Group will be to make recommendations relating to the potential development of term SONIA reference rates. This work is already underway and a public consultation is planned for the first half of 2018.
Why is it changing?
The decision to replace LIBOR followed a review initiated in 2013 by the FCA to address concerns regarding the long-term sustainability of LIBOR as benchmark, given the well documented issues and reforms to which the benchmark has been subject in recent years.
The FCA’s decision was based on a number of reports and consultations. In 2013, the G20 commissioned the Financial Stability Board (FSB) to review the major interest rate benchmarks following concerns raised in the market regarding the reliability and robustness of benchmarks such as EURIBOR, LIBOR and TIBOR. The FSB concluded in 2014 that the nearly risk free reference rates (RFRs) can be considered in many cases more suitable than reference rates which include a term credit risk component, such as LIBOR.
More recently, Andrew Bailey (Chief Executive Officer of the FCA), made clear that the underlying market that LIBOR seeks to measure – the market for unsecured wholesale term lending to banks – is no longer sufficiently active. He also noted that over the past years, the FCA has spent a lot of time persuading panel banks to continue submitting to LIBOR (signalling their discomfort at providing submissions).
The Bank of England established the Sterling RFR Group in 2015 to identify a preferred RFR for sterling markets to replace GBP LIBOR. In April 2017, the Sterling RFR Group announced reformed SONIA as its recommended RFR. This followed a two year process of consultation with various stakeholders in sterling derivatives markets, including pension funds, hedge funds, corporates, infrastructure providers and banks.
The Sterling RFR Group defined a set criteria for the selection of the sterling RFR:
- the availability of sufficient and reliable underlying market data;
- robustness to changes in market structure;
- appropriate controls and governance; and
- the extent to which the RFR reflects actual market funding rates.
The selection criteria also outlined the importance of actual and potential end-user demand for RFR-linked derivatives. Other considerations included the ease of market adoption and the consistency with RFRs being developed in other international markets.
The Group preferred reformed SONIA on the basis of the following considerations:
- reformed SONIA will be calculated using data from a significant number of actual transactions. Furthermore, the benchmark calculation methodology will be periodically reviewed (with representations taken from users of SONIA) to ensure it continues adequately to measure the underlying interest in the market.
- the market for wholesale unsecured deposits is deemed conceptually straightforward and movements in the rate are likely to be stable and highly correlated with Bank Rate; and
- the sterling Overnight Indexed Swaps (OIS) is based on SONIA, thus avoiding the difficulty of establishing a secured RFR as the primary overnight reference rate.
Potential impacts for firms’ before 2021
The FCA has made it clear that firms exposed to LIBOR will be required to consider the next steps to address the implications of the upcoming LIBOR cessation,2 and support an effective transition to the LIBOR alternative benchmarks post 2021.
A significant proportion of financial institutions and corporates hold financial assets and liabilities, including derivatives, which reference GBP LIBOR (as noted above) and will, therefore, be impacted by this transitional change.
Whether this exposure takes the form of variable rate loans and deposits, floating rate debt in issuance, or risk management and structuring via interest rate derivatives, it is important for market participants to engage early in understanding the potential impact on them, and plan accordingly.
Below we highlight a sample of potential impacts for firms, along with an approach to planning and managing this transition.
Understanding the extent to which firms reference, and hence are exposed to, movements in GBP LIBOR is a vital first step in identifying and prioritizing tasks for transition to the replacement rate.
Firms should start by making an assessment of:
- suitability of the new RFR, including the engagement in the industry discussion on the construction of the curve across maturities;
- the impact on the value of the cash flows to be settled after the reference rate changes;
- the strategy they will take with regard to legacy portfolios: can they remain referenced to LIBOR (should some form of the benchmark remain in existence post 2021), or do they need to be reconverted to reference the new RFR? and
- the mechanisms in place under contract to absorb any mark to market movements on transition.
The new RFR may not be consistently adopted across all types of financial contracts and therefore an economic mismatch could arise between a derivative and the underlying hedged exposure (for example, if a firm has issued variable rate debt linked to GBP LIBOR, which is then hedged using GBP LIBOR IRS). Where hedge accounting is adopted by firms, this mismatch may also lead to a broken hedge, and the need to make various accounting entities, increasing volatility in the P&L as a result of interest basis differences.
Treasury functions will need to evaluate the impact of the transition on any existing hedge relationships, including key considerations such as:
- for hedge relationships designated as a cash flow hedge of LIBOR, can the cash flows beyond 2021 be considered as being “highly probable”?
- whether the hedged relationship should be treated as a continuing hedge relationship upon transition to the new RFR or whether it will be necessary to de-designate and re-designate a new hedge relationship; and
- the impact on inter-company funding trades and reconciliation processes.
Firms should seek to undertake an impact assessment of their current economic and accounting hedges in order to assess potential exposure, raise awareness of the impact of the transition, and prioritise practical next steps.
Systems, processes and controls
The transition will necessitate changes to a swathe of internal systems, processes and controls within firms. Trade capture and booking systems will need to be updated to reflect the booking of trades which reference the new RFR. The impact will need to flow downstream in order to ensure that the risk is captured correctly within derivative accounting and valuation tools, risk management, and collateral systems. Payment systems at firms will need to be adapted to reflect the change in reference rates, and firms can expect impacts on key reconciliations, such as Nostro and cash reconciliation. Firms holding intercompany loans and deposits that reference LIBOR will also have to consider the impact on intercompany funding arrangements, and the infrastructure for intercompany funding reconciliations.
The raising of finance (through the loan and/or bond markets) will be widely impacted by the transition from GBP LIBOR. Whilst the impact of the transition on these markets will be the same, the practicalities of addressing them may differ:
- For loan agreements, fall-back provisions in existing legal documents can substantially ease the process of transition, particularly where there is majority lender consent. However, the choice of SONIA may create structural difficulties in transitioning to a replacement rate which at present is yet to be tested as a forward-looking rate, and may also potentially create significant impacts on margining requirements on transition.
- On the other hand, the impact on debt issuance can be broadly categorized into existing debt in issuance (which would require agreements with the bondholders to make changes to existing terms and conditions), and new debt issuance, where firms should be aware of and alive to the fact that variable rate lending issued today referencing GBP, but due for redemption post 2021, will change after that date.
Existing industry bodies and working groups in the loan and debt market have already started to engage with investors and lenders to identify the potential impacts.
Forthcoming EU Benchmark Regulatory requirements (EU BMR), as well as the LIBOR transition, will require firms to review and amend a wide range of contractual documentation with counterparties, updating for alternative benchmark rates, and in the case of GBP LIBOR, agreeing on the contractual alternative. Under the transitional arrangements of EU BMR, firms have until 1 January 2020 to make such amendments, whereas the cessation of LIBOR occurs a year later, in 2021.
In times of market uncertainty, contract reference rate negotiations and subsequent repapering exercises will not be easy, and will be made more difficult where there is a lack of definition on the practicalities of execution.
Industry bodies have started to consider the contractual requirements of LIBOR replacement and wider benchmark reform. We encourage firms to engage in this dialogue and discussion, in order to plan a structure and framework on contractual changes, and define a critical path over the coming years, in order to prioritise practical steps.
Considering the size of the market which is likely to be affected by a withdrawal of the LIBOR benchmark, it is important that awareness is raised within firms and across the Financial Services industry and beyond. Existing working groups are examining the potential for transition to give rise to major negative impacts to the financial markets, and are looking to reach consensus on the best approach to the transition, which would cause the least amount of disruption.
We encourage firms to start planning their approach and impact assessment, across the following key pillars of activity:
- Discovery – an initial assessment of the potential impact of the benchmark cessation, under a defined governance structure focused on delivery of an efficient transition to the new RFR. Benchmark-linked products typically include fallback provisions (which are usually intended to provide short-term cover) in the event of cessation of a benchmark. Firms should identify whether these, or any successor rates, are incorporated in existing contracts, as part of a broader review of the legal provisions.
- Planning – definition of a more detailed roadmap for transition to the new RFR, including the following key considerations:
- determine the potential impact on clients and other stakeholders;
- review of feedback from clients and other stakeholders as well as emerging market best practices;
- determine of the alternative benchmark for contracts;
- assess the impacts on systems, processes and control infrastructure; and
- analyse the timing aspects of the Benchmark cessation and transition to a substitute.
- Execution – Establish the correct oversight under current governance arrangements, and execute planned work steps over a dedicated timeframe, providing internal and external feedback on progress where needed.