For many financial institutions, benchmark reform is clearly an agenda item for 2019; however, given the sheer scale of work required to transition away from interbank offered rates or IBORs to alternative reference rates or ARRs, firms need to be hitting the ground running. Over the summer of 2018, a group of trade associations including ISDA, AFME and SIFMA, published a Global Benchmark Report which surveyed 150 organisations and found largely that although the awareness of benchmark transition issues is at a high level, the level of preparedness among those surveyed was at an early stage.
DerivSource spoke with Shankar Mukherjee, UK Financial Services Partner and IBOR Lead at EY about some practical steps and timelines that firms should be working towards to get their benchmarking reform programmes underway. With 2021 looming and with the magnitude of the change being compared by some to Brexit and Y2K, firms will need all the time they can get to complete the transition successfully. Listen to the podcast.
Q: Why is it important that financial institutions start preparing for IBOR replacement now?
Mukherjee: IBORs and LIBOR, in particular, have been in use for the last 40 years, and it’s not widely appreciated how deep the systemic footprint of IBORs is across the financial system. Most large global firms would struggle to say what their exposure to LIBOR was across the different rates, currencies or tenors, and how much of that exposure is expected to mature before 2021, which is the timeline that Andrew Bailey drew out in his speech. The scale of the challenge makes it really important that firms start to take steps now.
It is not well-understood what the financial implications of the move are going to be. In many ways, this is a change in the underlying structure of the market. Firms are moving away from LIBOR for multiple types of transactions to different reference rates, which are very different from LIBOR as it stands today. It is fundamentally going to alter the nature of these transactions, and that is why acting now is really important.
Q: What is the first step firms should be taking as they prepare to transition away from LIBOR?
Mukherjee: One of the first things is to carry out an impact assessment, which involves looking at the impact across four dimensions. The first dimension is, do firms understand what the exposure looks like across their different products, different currencies, and across the contractual maturity of different transactions? Can they say how much of their derivatives population reference 3-month dollar LIBOR, and what the maturity of that trade looks like?
The second part is looking at which contracts sit behind those products. That’s really important because a critical part of the market transition is improving fallback language. Consider a scenario where LIBOR is permanently discontinued after the end of 2021. How will firms settle the payments on their existing contracts that reference LIBOR once LIBOR is no longer published? The fallback language in contracts tells firms what they should be referring to in that stress scenario.
The third part needs to identify all the impacted processes and systems across the entire firm. Funds transfer pricing, for example, is likely to be heavily impacted because most firms don’t have FTP systems that can deal with a multi-rate environment. Firms also need to identify the impact on the systems environment. Making any kind of change in the technology stack is a really complex processes for banks, and they already have a full book of work for changes to their technology for various regulatory and business-driven reasons. This effort is analogous to the Y2K process—firms literally have to go through the code for every single system and find out whether LIBOR was hard-coded into the system. Because this rate has been around for the better part of 40 years, it is used widely within firms as a proxy for short-term interest rates.
The fourth part of the impact assessment is around risk and valuation models. A mortgage might not reference LIBOR, but the prepayment model for that mortgage book is very likely built using LIBOR. The calibration of a VaR engine used to calculate market risk capital is very likely built using LIBOR. The footprint of LIBOR across the risk finance capital models is extremely significant and not well recognised.
The impact assessment would also seek to understand what the model inventory landscape is, which are the heavily impacted models and what is the process to change them.
Firms also need to put in place a transition plan. They need to have a roadmap to say how they are going to manage this transition away from LIBOR. Then they need a project plan and a governance structure to deliver that on time.
Another critical thing firms should be preparing now is a client engagement and outreach strategy. While banks are heavily impacted and will have to process all of these changes for their contracts and their systems, there is a counterparty on the other side that’s also impacted. In some cases, those counterparties are relatively sophisticated, particularly in the derivatives market; but when it comes to cash products, bonds, loans to SME clients, these exposures are very widely distributed through the system. Banks need to get on the front foot, engaging with their clients and explaining to them why a change is happening, how banks are proposing to go about the change, and what the likely impact on their clients is going to be.
Q: What are the realistic timelines firms should be working towards?
Mukherjee: The most important one is that after the end of 2021, the FCA will no longer compel banks to contribute to LIBOR. We have to entertain a scenario where, after the end of 2021, LIBOR is no longer published. Firms therefore need a transition plan which allows them to migrate all or substantially all of their new transactions onto the new reference rates and away from LIBOR. They also need to understand, plan, and agree what they are going to do with their legacy portfolio. They don’t want to be in a situation at the end of 2021 where LIBOR is discontinued, and they have a big legacy portfolio that is referencing LIBOR and they are unable to settle the payments.
Firms need to have a strategy and a transition plan, both for new products and for legacy products, and that needs to be executed before the end of 2021. But there are potentially other deadlines before that. The current timeline for compliance with the EU benchmark regulation is the first of January 2020—two years before the LIBOR deadline. The Euro Risk-Free Rates (RFR) Working Group has petitioned the European Commission to extend that timeline by two years, but we are still awaiting the formal response from the European Commission, and it will need an act of European Parliament to make this happen. Firms should not underestimate the challenge of that actually coming to pass.
Again, firms need to have a backup plan. What if an extension of the EU Benchmarks Regulation (BMR) timeline is not granted? Given the scale of the challenge, most banks recognise that three years between now and the end of 2021 is not a lot of time to execute something of this scale.
Q: Can you give us an idea of what an IBOR transition plan should or will look like?
Mukherjee: The transition plan needs to consider a few elements. Firstly, what are firms planning to do with their new products? One of the current challenges is that the stock of LIBOR products is actually increasing every day—it’s not declining. For example, the volume of Eurodollar futures, which references 3-month dollar LIBOR, hit a record on CME in April 2018. The stock of contracts continues to increase, which is important for two reasons. One, the scale of challenge for the banks to implement that change is growing not diminishing. Two, FCA CEO Andrew Bailey said in his July speech that banks need to be very aware when they are transacting in products that reference LIBOR, that that index may not exist in three years’ time. How are banks ensuring that their clients are not adversely impacted by that change? There is a conduct/legal/reputational risk associated with continuing to transact in LIBOR products.
A big part of the transition plan needs to be how, for different types of products, firms plan to transition away from LIBOR-denominated products to alternative reference rates. The sequence of that would likely be the derivatives market going first, followed by the wholesale funding market, with wholesale lending after that, and then retail products. That is both in increasing order of complexity of execution as well as decreasing order of sophistication of the clients banks are dealing with.
A key part of that challenge is going to be how to set up the operating infrastructure to make sure that firms are able to price risk-managed trade products denominated in the new alternative reference rates, whether that’s cash products or derivative products. Setting up and testing that operating infrastructure is a key part of the transition as well.
Firms also need a strategy for how to manage legacy contracts. Firms will have a portion of their portfolio that will mature before 2021, which will probably roll off naturally. But they will have to have a strategy for how to migrate new contracts to the new rates. Do they have a strategy to make sure that the fallback language in the portfolio is strong enough that it will survive a post-LIBOR world? Or do they need to go back and repaper those contracts, which is a tremendous challenge for most firms?
In the bond market, for example, because bonds are held through nominee accounts, through Euroclear, Citadel, or ClearStream, firms often don’t know who the end investors are. Changing economic terms of bonds is a very complex process, typically requiring a quorum of investors, two-thirds, three-quarters, sometimes a unanimous investor vote. That process is both legally and operationally very complex. There needs to be a physical meeting of bond-holders. Thinking about how to address the problem with the legacy portfolio is really important as well and one of the things that banks need to think about straightaway.
Q: And as firms work towards these transition plans and programmes, what are some of the challenges that they may face?
Mukherjee: This is one of those transitions that impacts every product and business area within the firm, as well as every enterprise function as well: risk, finance, treasury, legal, ops, technology. Implementing a programme which cuts across all of the business lines for the banks – global markets, global banking, retail banking, insurance, asset servicing, as well as all of the enterprise-functional areas, like risk, finance and so on, is a very complex job.
A bank with a global footprint also has to deal with the additional challenge that different currencies are going to transition at different times and also different products are going to transition at different times. The challenge firms have with a Spanish mortgage or a US retail mortgage is going to be very different from changing the terms of a swap with a large corporate.
This is not like the introduction of the euro, where you had a fixed date, agreed terms at which every currency would switch over into the euro, and a legal framework under which every contract would be changed. A better analogy is Brexit, where there is a lot of uncertainty about what that end state looks like, but nevertheless, banks need to take action in order to prepare for whatever that end state might be.
This is not like the introduction of the euro, where you had a fixed date, agreed terms at which every currency would switch over into the euro, and a legal framework under which every contract would be changed. A better analogy is Brexit, where there is a lot of uncertainty about what that end state looks like, but nevertheless, banks need to take action in order to prepare for whatever that end state might be.
Firms need to outline very clearly up-front what their assumptions are. They need to have a very robust process of testing those assumptions as they move through the process. Some defined milestones serve as trigger events, for example, when ICE Benchmark administration concludes its consultation around which banks might continue to contribute to LIBOR post-2021. If the conclusion is that most of the panel banks will not contribute, firms might need to accelerate their contingency planning. Not only is it complex in terms of the spread of business and products and enterprise function, but it’s also subject to a lot of moving parts in the environment, and firms need an assumption-driven plan that they test regularly at a central level. Organising and executing this complex program in and of itself is a big challenge for firms.
Q: Does the uncertainty surrounding benchmark reform pose a challenge for firms?
Mukherjee: It’s fair to say that some firms were thinking about whether this transition is really going to happen, just given the level of uncertainty associated with the change as well as the size and scale of impact. In that context, the “Dear CEO” letter jointly issued by the PRA and the FCA has been extremely helpful. A number of banks said they welcomed the letter because it allowed them to ensure that it gets senior management attention and the appropriate level of sponsorship.
The letter specifically asks for a senior individual to be named as responsible for this transition plan and for the transition plan to be approved by the board. Both of those things served to raise the importance of these issues within the banks, to make sure that it’s a part of their overall planning and very importantly, to allow firms to start budgeting for some of the costs of execution. That is really critical as firms go through their budgeting and planning exercise around this time of the year.
Q: Lastly, what are some of the benefits firms can achieve if they prepare early?
Mukherjee: There is a temptation to see this a regulatory-driven change, but that view is not entirely correct because this is a fairly fundamental change in the market structure. It’s going to change how derivatives, cash products, loans and retail products are priced, risk-managed, and valued. There are important pricing strategy questions to be addressed up front, in the absence of which there is potential for firms to lose market share in the new products that are going to be introduced, in their ability to service their clients’ requirements, and, indeed, for some of the early movers to take advantage of some of the market dislocation, to both protect their market share and indeed grow it.
Firms also need to think about the fact there will be some impact to banks’ balance sheets. LIBOR currently is a contra-cyclical index, which means that, in times of stress, LIBOR tends to go up and banks’ net interest income tends to go up. When LIBOR is replaced by the new alternative reference rates, they behave very differently in times of stress, so this has important financial impacts on the bank. Firms need to think about the change, both in terms of the operational cost of implementing the change, but also, what does that mean from a P&L perspective for the banking book, for the trading book, and for the treasury?
The other part of doing it right and getting started early is being able to address conduct issues early on. Identifying potential conduct and client issues early on, having a strategy to address them, being able to demonstrate to the regulators that you have thought about how you will mitigate potential adverse client impacts is a critical part of getting this right.
Shankar Mukherjee will be presenting on this topic at the DerivSource Community Forum event in London on Nov 14th. Register to attend the event here.
