Financial Markets

Despite Brexit uncertainty and the demands of ongoing compliance with regulations such as MiFID II, financial institutions are ramping up their planning for life after Libor. But are they moving fast enough? By Michael Robertson, director at JDX.

At a speech in London on July 2018, Financial Conduct Authority (FCA) chief executive Andrew Bailey reiterated that the discontinuation of the London interbank offered rate (Libor) was inevitable and that organisations must prepare for the orderly transition to alternative interest rate benchmarks.

Banks under the supervision of the FCA and the Prudential Regulation Authority (PRA) also received a letter probing the extent to which senior management are cognisant with the implications of life without Libor.

These banks have been asked to provide – by mid-December – an overview of how the transition to the new risk-free rates will impact their operations and how they plan to take to mitigate these risks.

Depth of preparations

The FCA/PRA intervention reflects an apparent lack of awareness around interest rate reform. Firms need to plan so that they fully understand the impact of reform across their business – be it data systems, documentation, models, process flows and/or operating procedures. This inventory-like assessment is necessary to answer questions around the impact and the resources needed to address the issue.

While progress has been made in publishing a reformed Sterling overnight index average (Sonia) alternative rate, there remains a feeling that the immediacy of the issue is still not fully understood. Ibor exposure continues to increase across markets and more is required to ensure adoption across user type (banks, buy-side, pension, insurance or non-financial firms) and markets (derivatives and cash markets).

The challenges

With much work still ahead, it is difficult to summarise all the current challenges. We do know, however, that Libor reform will potentially have an impact across all key functions, from sales, trading and risk management to treasury, legal, operations, compliance and IT.

Consistent pain points are emerging from client conversations. The first of these relate to legal issues and documentation, specifically the obvious challenge of contracts with maturities beyond 2022 referencing Libor. This is likely to be addressed by shifting to the replacement rate or amending fallback language. The International Swaps and Derivatives Association (Isda) consultation on fallbacks represents a significant step forward  but firms still need to understand the inventory of documentation impacts (legal master agreements, collateral service agreements) to fully quantify the extent to which any repapering, renegotiation or rewriting of legacy contracts is required. Firms should plan communications with affected individual clients.

Then there is the infrastructure challenge, where reform could require accounting, risk management and third party pricing models and systems to be planned and implemented internally. Technology and infrastructure changes will need budgeting.

Fragmentation is also an issue. Previously, all rates were published by a single authority (the Intercontinental Exchange) but the proposed reform will see the introduction of more domestic regimes, predominantly administered by central banks and likely staggered over a period of time. Harmonisation and consistency of approach will be challenging, given the scale of change across market participants, regulatory bodies and governing trade associations.

Some market participants believe Libor reform is impacting other regulatory initiatives, such as the fundamental review of the trading book (FRTB). There is a risk that some of these risk-free rates (RFR) contracts become treated as non-modellable under current FRTB rules or that – depending on adoption timelines – Ibor contracts end up being treated as non-modellable. Either way, this would lead to a capital charge add-on or use of the standardised approach under FRTB, which leads to more capital requirements for banks.

Then there is the issue of liquidity – regulators will want to get RFR products up and running so as to create sufficient market liquidity. At the outset, central banks will only be publishing a reference overnight rate and there is uncertainty around the term structures or yield curves in these new rates. Bank risk management and valuation engines rely on term structures to build curves.

The new rates will be calculated differently from Libor and are truly riskless in contrast to Libor, which carries an inherent credit risk to the quoting bank. As such, there is a small basis difference between the two rates and so the risk profile and value-at-risk (VAR) of portfolios will change on repapering.

The absence of historic rates or correlation data for the new RFRs raises questions as yet unanswered regarding how to price options or calculate VAR in these products. In addition, there is a question over RFRs as part of standard initial margin model calculations, which also requires historic data for calculating initial margin on uncleared over-the-counter positions.

Where from here?

Most firms will have established central Libor reform programmes. Where applicable, jurisdictional business and function owners must be plugged into these internal change groups so they have the requisite visibility and awareness of the topic. Business units should undertake their own system and model impact assessments to understand the full functional and economic implications of reform.

Industry RFR working groups will continue to play a pivotal role in achieving the objective of a market led transition to Sonia by the end of 2021. Working groups, and any technical sub forums, will provide the requisite transparency, direction and decision making on this initiative.

A Speakers’ Corner is an area where open-air public speaking, debate and discussion are allowed. The original and most noted is in the north-east of Hyde Park in London