The London Interbank Offered Rate (LIBOR) underpins in the order of $300 trillion in financial products and is one of the most significant reference rates used by financial market participants. However, during the last financial crisis the inadequacies of LIBOR became evident, which in turn triggered a concerted effort by market participants and authorities to fix them. Despite these efforts, in July 2017, the UK Financial Conduct Authority (FCA) announced a transition away from LIBOR as the key interest rate index used in calculating floating or adjustable rates for loans, bonds, derivatives and other financial contracts. The FCA’s intention is that, at the end of 2021, it will no longer seek to persuade, or compel, banks to submit to LIBOR.
LIBOR reform is part of a wider plan, established through the work of the Financial Stability Board, that interest rate markets will, in future, be centered on Risk Free Rates (RFRs). Although the focus of this blog is on LIBOR, the issues are just as relevant to other IBORs. LIBOR reform will have a wide ranging impact across financial services firms, market infrastructure, corporates and customers. A range of working groups has been set up, both on national and global levels, that are driving the discussions around the selection of alternative RFRs and identifying solutions to the challenges that the transition poses. The expectation is that alternative RFRs will have high transaction volumes underpinning them and will be centrally administered by the relevant central banks. But the pace of progress across jurisdictions differs, causing further uncertainty.
Key impacts that market participants are working through as they shape their operational response to LIBOR reform include:
- From a product design perspective a term structure needs to be established for RFRs, given they are currently overnight rates. This is perceived as a particular issue for the loan market. Term structures will be supported by the growth of a market for interest rate futures (for shorter tenors) and interest rate swaps (for longer tenors) across applicable RFRs. Central Counterparty Clearing Houses have been taking initiatives in the last few months to facilitate the clearing of RFR products. Many view demand from the buy side as being key to growing these markets and providing the incentive for banks to design new RFR-linked products. It is not yet clear whether LIBOR will exist post-2021. Should this uncertainty persist, markets may be reluctant to move to RFRs and this could result in a lack of liquidity in these rates. Without sufficient liquidity, transition to these rates may prove difficult.
- The transition will necessitate changes to internal systems, processes and controls within firms. Additionally significant challenges may arise when the required institutional infrastructures (e.g. trading and clearing data, systems, and operational procedures) are established to support the transition to the alternative RFRs. Uncertainty about the existence of LIBOR post 2021 also adds to the operational complexity of running parallel processes across multiple benchmarks.
- The transition from LIBOR to alternative RFRs may create a valuation change for LIBOR-linked legacy contracts, and where bank or fund portfolios have big sensitivities to interest rates, this can lead to significant, unplanned volatility in the financial statements. The transition may result in complications related to fair value designation, hedge accounting and inter-affiliate accounting structures. If LIBOR is not effectively offset by the alternative RFR, financial instruments and their respective hedges may need to be booked separately. Having hedges booked separately and recorded at fair value may result in net income volatility and growing balance sheets. Transition may result in changes to firms’ risk profiles and this may, in turn, lead to changes to valuations and risk models, which in turn, may have an inadvertent effect on considerations such as regulatory capital and stress testing scenarios.
- There will be a significant bank administrative effort associated with identifying affected contracts, relevant fall-back provisions and transitioning these trades to the alternative RFRs. The conversion of legacy contracts to alternative RFRs may require consequent amendments to other contractual terms, resulting in significant up-front transition costs and increased operational risk. If transitioning to the alternative RFR would result in a breach of contractual terms or the obligation to take certain actions, parties may not agree to move to the alternative RFR and cases could be escalated to court.
- Customer management will be fundamental for firms in both how they communicate the change to customers as well as how they go about implementing the changes. Dimensions that add to the complexity include type of customers, type of financial instruments, ensuring consistency of treatment across customers, and timings of switch.
The transition to alternative reference rates forms part of the continued focus on enhancing the robustness and reliability of the benchmark rates. However at present, there is a risk that regulatory uncertainty, a low level of awareness and relative inertia in pockets of the market affected by a transition may lead to inconsistencies in approach on an industry and regional level. These risks may be compounded where there is a lack of liquidity in the alternative RFR market, and a lack of clarity on dealing with the operational challenges posed through this transition. The impact of these risks on the resilience of the financial system and broader economy should therefore not be underestimated.