DerivSource LIBOR Transition Podcast Series – Episode 3 Transcript (Listen now)
Hello, and welcome to this DerivSource podcast. I’m Julia Schieffer the Founder and Editor of derivsource.com. You’re listening to episode three of our podcast series on the LIBOR transition. And in previous episodes, we had shared a high-level view of some of the remaining market-wide challenges followed by a deeper look at the legal challenges firms face with legacy trade, as they prepare for the transition away from LIBOR to alternative benchmarks. And in this final episode, we will explore operational and technological strategies to support the LIBOR transition. We will be taking a look at the common areas of complexity and strategies for achieving a flexible infrastructure and supporting procedures to meet the upcoming deadlines and manage the ongoing market changes. And with me to discuss this topic in depth is Alex Bon Group Co-Head LIBOR and Benchmark Reform at Murex. Welcome to the podcast, Alex.
Hi Julia. It’s a pleasure to be back.
So Alex, before we begin, can you share a little bit about yourself for our audience?
So, I work for Murex in Singapore, where I look after marketing and go to market strategy for solutions for Asia/Pacific. For audience members who might not know Murex, we are a leading provider of trading and risk management software to capital markets, covering all asset classes front to back and risk. So, our clients range from banks and CCPs to buyside and corporate treasuries. So basically anyone who might have seen a LIBOR swap. Now, I also wear a second hat, as you mentioned. Since exactly three years ago, my colleague Didier Loiseau and I launched the Murex Global Taskforce on the benchmark reform and LIBOR transition. And I must say there hasn’t been a single day since where we felt bored.
That’s great. Well, not everyone can say that about their jobs. So at least you’re keeping busy and challenged. So, let’s get right into the questions, Alex. First about looking at a high level about transition strategies from an operational perspective. Can you tell me a little bit about what the main operational and technological changes are that firms must contend with as they transition away from LIBOR to RFR’s?
I think the main challenge when we’re talking about preparations, is going to be around how you manage the transition of legacy LIBOR referencing transactions, which are typically expiring beyond the deadlines to alternative reference rate. And when you’re looking at that problem, it’s quite simply like replacing apples with oranges because fundamentally, the issue is that IBOR benchmarks and the new RFR’s or alternative reference rates, are fundamentally very different instruments.
IBOR rates contain credit risk premium. There are tenor rates and you have the LIBOR one month, three months, six months, which are fixed upfront. Whereas we’re looking at moving towards these RFR, which are risk-free rate overnight indices. So quite different and they are based on different underlying markets, so they may exhibit as well different dynamics. So really the first challenge is that there is no obvious like-for-like replacement. So, when you’re looking to replace and move away from these legacy positions, you do have different options as to what you will replace your IBOR rate with.
So, for instance, if we take the example of the very famous US dollar LIBOR, the recommended alternative reference rate is going to be SOFR, but you could look at different rates. You could also opt to use Fed Funds or Prime or Ameribor, which is another term rate. And even if you choose to go for SOFR, you also still have different options. You have the daily compounded option, which is the standards that we are discussing for derivatives, but you also have average rates and soon you’ll also have available what we call term SOFR. So, that’s the first I’d say, level of complexity in the choice.
The second one is that you would have different approaches to offsetting the fundamental changes of nature of that underlying rate and compensate for what we call this value transfer, as you’re replacing say apples with oranges. So, one approach is basically adding what we call an adjustment spread to the new RFR legs. And that’s typically the mechanism that plays in the ISDA fallback for instance. But another approach can be to settle the market-to-market difference by an upfront cash transfer. And you can imagine any kind of variations.
So, coming back to that apple and orange analogy, maybe the standard practice would be to exchange your bag of apples for a bag of oranges and maybe add in one extra orange to compensate for the average price difference that has been observed over the five-years, between the price per kilo of apples and a kilo of oranges. So, this might be fair to the market as a whole, but if you were holding these apples to make a pie you might prefer to have switched to pears or quinces. So in other words, the value and the risk impacts are different to you. And so that’s something that you want to anticipate and you want to plan for well ahead of the deadline.
And just to follow up on that, and firstly I have to say I love the analogies of pie and fruit there; that’s a first for DerivSource podcast but I like it. So just to follow up on that Alex, can you tell me what a typical transition plan would look like?
Well, it’s quite difficult to come up with a typical transition plan for any type of institutions, because this is of course highly dependent on the profile of the firm, the relative volume of positions they have which are going to be impacted, also to which IBOR index they are exposed to. If you’re just exposed to US dollar LIBOR you have a bit more time because now we’re looking at 2023 deadline, but if you are exposed to GBP LIBOR or JPY LIBOR, then the deadline is at the end of this year.
So, you have a different dynamic there. And of course, what type of contracts and position do you have? Some are obviously easier to manage than others. In the derivative space it’s obviously easier to deal with linear and vanilla derivatives than it is to deal with exotics and complex products, but I think generally speaking, you need to consider that there are various options available to you and you need to basically decide what is the transition path that you’re going to take.
And you need to recognize that there are differences across markets and across product segments. So for instance, derivatives and cash will have different fallback options and different approaches. So, you need to do your homework and analyze, what are the options and the constraints you’ll be facing there and then planning and signing on the transition strategy.
And I’d say that in terms of phasing that transition strategy, the first step would typically be about reducing your LIBOR footprint. So here in that first stage, you can use tools like multilateral compressions, you can operate innovations with your counterparty. Particularly reduce I’d say the DV01 footprint but most importantly, the number of contracts that you have that reference a LIBOR index and that are going to mature beyond the deadline.
Then the second step is going to be about actively engaging your counterparties to negotiate the terms of your transition with them; you need to understand what their own constraints are, what are their approaches to reach an agreement and particularly choose the optimal path for both parties. And finally, you need to prepare for the switch itself so on the day where an index is going to be deemed unrepresentative and the cessation period kicks in, you’ll need to manage the transformation of the large number of contracts. You need to, first of all, you need to anticipate the impacts that this will have across business processes, and you need to be ready to execute this large volume of contract modification at scale and safely.
So, we’ve talked about fallbacks. Is relying solely on the fallback a viable strategy as a way to simplify the operational burden?
That’s a good question. Generally speaking, if you listen to the speeches from regulators and major members of organization like the ARRC, you’ll see that relying blindly on the fallback is usually frowned upon. The fallbacks are really seen as for what they describe as a seatbelt mechanism; it’s your last resort insurance. So, it’s a way to introduce a mechanism that will manage the transformation of your contract on LIBOR when it ceases to be published.
Now, if you’re a small institution and you’re not practically too sensitive about how it’s going to be transformed, then certainly that’s a question that may be asked but it doesn’t solve all your problems. The first reason is that you also need your counterparties to sign to the protocol if you want to be able to use that mechanism.
So, if one of your counterparties doesn’t adopt that mechanism, then you need to still negotiate with them how are you going to manage those positions? So you might agree with them bilaterally to move them earlier or agree with them to introduce different fallback conditions.
Now, for the positions that are going to be governed by the ISDA protocol you still have a bit of work and preparation to do anyway because on the day this IBOR contracts will transform into their new alternative reference rate equivalent, they will have to follow the adjustment methodology defined by ISDA and Bloomberg. So this is of great help but it comes with some little specific challenges.
And the first one is that for practicality reasons, the resulting RFR referencing contracts, will be using some slightly different calculation and fixing conventions than fresh of the mill, new RFR contracts that will be typically using the standard market OIS conventions. So while the impact on value, those contract’s relative differences should be extremely limited. You will have to deal with differences in your processes to basically operate the fixing of those rates and also to deal with some cashflow difference potentially, either on the dates or the amounts.
Now, there also are a number of corner cases here and there regarding the handling of broken periods or you have the specific case of Asian FX implied indices like the Singaporean SOR, which can introduce a fair bit of operational complexities. And also finally, and I think that’s probably the most important piece, ISDA supplement and protocol for the fallback also grants you the option of carving out specific exceptions with your counterparties. And for instance, you have the ability to change the definition of the trigger or change the alternative reference rates for specific contracts.
In summary, what you need to prepare for even if you stick to using primarily the fallbacks, is you want to develop the ability to execute this large volume of contract fallback transformation on one day in an operationally controlled and safe way for the institution. You need, to manage the complexities inherent to the ISDA fallback mechanism on the execution date, but as well going forward, on how you manage the contracts that will result from that operation.
And you need as well to be able to keep track of the various exceptions that you would have to deal with and have negotiated with your counterparties. And also, what would you need to do with a view obviously, and that’s very important to ensure business continuity across department and systems.
I took the examples here of the derivatives, but you have to deal as well with potentially with other products. You have securities and here it’s becoming much more difficult to inject fallback language in securities and the terms can be different. You have to deal with loans as well, where you will have to negotiate on a bilateral basis with your counterparties as well. So again, each of those products will have its own specificities and its technical challenges.
We’ve talked about the bilateral side of things. Moving on to cleared, what about cleared positions? There’s differences going on in the market among CCPs. Can you talk a little bit about how firms should deal with this?
You’re right to bring that up because it’s an interesting time at the moment because initially the CCPs agreed to incorporate the ISDA fallback terms into their rule books. But more recently, they’ve also started to announce that they are looking at developing be their own transition mechanism ahead of the deadline. And so, we have had LCH running a consultation process and they recently shared the high-level feedback on that consultation on the mechanism they were looking to propose.
But typically, the issue for the CCP, I think is around two things. The first one, they are obviously a little bit wary of having to deal with a big bang transition on the market where absolutely every product cleared, uncleared, across all of the different indices will be transitioning at the same time. So they would prefer to offer kind in advance transition mechanism, close to the deadline a little bit earlier.
The second point, is due to this specific mechanism in the way contracts issued from the ISDA Bloomberg transition mechanism are managed, it means that the positions are non-fungible with other new RFR referencing swaps. So, a new swap, or a swap issued from the transition, uses slightly different calculation mechanisms so you can’t really offset them directly. You have a little bit of basis which is remaining. So, for them, it’s going to be an operational hassle, you can’t collapse things in one position and also, it introduces limitations as to what can be done from a compression ability point of view.
So, I think that’s where they’re coming from they initially proposed something which is to say, well we just move to a new RFR swap and instead of adding an adjustment spread, we just pay you up front the cash compensation for the change in market-to-market. That’s an option that has been rejected by the members, primarily because as they have cleared product which are hedging non-cleared product and loans in particular, they were worried that it’s going to break the hedge relationship for hedge accounting reporting.
So, there was a pushback and so in the end they converged on something which is much closer to the ISDA fallback mechanism by adding an adjustment spread. But the fixing mechanism is going to be different and there will probably still be a little bit of a cash compensation due to small valuation differences there. What this means is that positions that are cleared will transition in a specific way and they will look like something that is going to be quite similar to a newly transacted swap but incorporating an adjustment spread instead of being flat.
So we have kind of differences here as a result on the markets. Yeah.
We’ve covered kind the overview of a transition strategy for both a bilateral and touchdown cleared as well. Looking at the systems specifically, Alex how do systems need to be set up to support these different types of transition paths and to address some of the complexities that you’ve highlighted?
If I try to keep things simple, I think the first point you’re trying to address in terms of enabling infrastructure capabilities on that topic, is around dealing with the complexity of managing many variations in terms of processes and systems and different options in terms of transitions. So, first of all I mentioned that you will certainly have to deal with different transition or fallback conditions maybe because for complex derivatives the ISDA fallback terms are not satisfactory from an economic value point of view or because you have, for instance, the swap that is a hedging a loan and so you want the swap to transition using the same terms as the loan.
So, you have to basically track all those exceptions, so that when it comes the right time to execute a transition to a specific contract, we do so seamlessly. You have the ability to do that and automate it if you need to, if you have a large volume position, but to apply the right condition, have that properly audited and documented for your downstream processes. Because from an accounting or from a taxation point of view or even from an initial margin or clearing mandate point of view, if you were to terminate a contract and create a new contract, in general you have some implications. So that might force you to do early revenue recognition, it might force you to basically include the trade in a clearing mandate for instance but you have exemptions which have been granted specifically for that LIBOR reform context but you need to be able to document those so that you can prove that this transformation was done in that context, hence I have the rights to the exception. So, you need to be able in your system to basically keep track of all these things.
Also, when you’re starting to look at contracts which are going to transition under different terms, there are potentially valuation impacts. So, the way you’re going to price the trade which is going to be applying the standard ISDA fallback and that is going to be the market baseline is going to be one way. But if you have some variation, then you need to be able potentially to recognize that the value is different. And so that’s something you want to be able to price and that’s also something that you want to anticipate in your negotiation process. And the last part about the complexity is basically obviously about how you manage this across all the impacted business processes.
And that brings up the question of system interoperability, if you have multiple systems that need to talk to each other, it might be quite a challenge because they might have a different way of representing those changes.
So that’s potentially quite a big effort. And finally, I’d say, the other aspect of dealing with that complexity and system of operating that transition, is going to about ensuring a smooth operation of the transition event on the day itself, as well as managing the consequences beyond that date.
These can be large market events that you need to handle consistently and efficiently, front to back, because you have impact on valuations, you have impact on your risk management calculation, you have impact on collateral management – your VM and IM might change, that you need to be able to immediately exchange collateral and also address potential disputes, explain difference in valuation with your counterparties, because obviously there’s a risk that things can be a bit messy on that day. You have impact on the accounting and the hedge accounting in particular, you have impact in settlement, XVAs are obviously going to be impacted, questions around confirmations and so on.
So you need to be able to automate as much as you can this large number of operations in 100% secure way, over a short timeframe. It needs to be fully audited but also when you move beyond that, you need to be able to P&L explain from the day before, to account for your variations on P&L and in your margins for instance: what is the portion that come from the transformation of the contract, due to the fallback, which is the portion that comes from a change in market data for instance.
You also need to be able when you’re going to be doing that risk calculation or P&L as of past date, and so on and so forth. So, it’s quite a lot of technicalities and complexities to track around this.
And I’d say there is one aspect that I haven’t heard mentioned very often but you shouldn’t forget, which is technical performance of the system. So, if you have a very large number of transactions that need to fall back on one given day, you need to make sure that the process to automate this is going to be efficient from a performance point of view. So you probably want to test that well in advance. But you also have a question for the long term. Today if you have 100 swaps which are LIBOR swap, within two years these 100 swaps would have been replaced by 100 of new RFR swaps. But these are fundamentally different. Let’s say if you look at the LIBOR three-month swap, on one period I’m going to have one fixing. If I use let’s say the SOFR three month swap, what I’m going to do for instance if I use compounded in arrears, convention is now going to fix and observe the SOFR rate daily over three months and at the end of the period, I’m going to apply some compounding using convention to basically decide how I round, how I compound, how I add the margins in that period.
So even though these two calculations are very simple, obviously in the second case I have to deal with three months of fixing instead of one month and I have additional calculations. So, if you have heavy calculation processes, like a VAR calculation or an XVA calculation and you have to perform millions or hundreds of millions of re-valuations in a large Monte Carlo simulation, a small variation in performance can have a very big impact in terms of your hardware footprint.
So, that’s something that you want to anticipate. You can fix that as we have done at Murex by doing specific development to optimize performances. And that’s something that we’ve validated with already some of our customers who have very large risk calculation processes but otherwise you need to basically plan for that hardware impact.
So Alex, you’ve mentioned that obviously you’ve been living and breathing this for the last three years, in terms of the LIBOR transition, and you also deal with a variety of clients both buy side and sell side. So when you talk to your clients, what are some of the common questions that they ask you when they’re preparing their systems to address the challenges that we’ve talked about today and also update the system requirements that you’ve already mentioned?
I think at the moment, probably the most common question is going to be about how to support non-linear derivative and exotic derivatives on the new RFRs. So far, we’re just seeing trading of simple, non-linear derivatives like caps and swaptions just starting and there are some adaptations which are required in terms of models for those. But for more complex products, you have more question marks, and you have to deal with two types of issues there. The first one is that because we’re looking now at forward compounded rates, the forward view of backwards-compounded rate, it warrants in some cases, redefining the payoffs or adapting the pricing models and you have to deal with another issue, which is we don’t have much liquidity yet. So even if you have the adequate model to price something, you have the second question which is where do I get my inputs?
So, for instance, for the volatilities, typically you will want right now to proxy your RFR options volatilities from LIBOR options market. But further down the road you might have to deal with the other problem. So, you might still have some old legacy derivatives position that you couldn’t transition and then LIBOR will not be liquid anymore, so you will need to price them by proxying your volatilities inputs from the RFR markets.
So right now, we’re getting a lot of questions from clients on this, and as well as which are the emerging market conventions, especially regarding the more complex options. And some questions obviously about what are the typical ways our other clients are addressing the problem of fallback on those complex derivatives. Because you have a number of products where the ISDA standard fallback offer you a legal solution, but the product that will be resulting of that transformation does not make much economic sense anymore.
That’s going to be the case for instance, of the LIBOR-in arrears products or a Range Accrual for instance.
Thank you, Alex. Now, obviously you get so much feedback from your clients in terms of what their questions are and no doubt some of our audience members or listeners will have the same questions that you just answered. So thank you very much for that. My final question to you is really about looking ahead. Now, there is a great deal of uncertainty as to how this global move away from LIBOR will shake out and you’ve alluded to this a little bit. So what advice would you give to firms who are looking to both prepare for this transition and the deadlines of course, but also keep up with the market changes that you’ve alluded to as they happen.
I think you’re spot on. To me, this is probably the one unique challenge of this big transformation and that makes it very different from the other very big regulatory-driven projects we’ve lived through these last few years. And that is that this reform is impacting so many aspects of the business of our customers. Every single department is going to be impacted, but as well you have so many variations across markets, across indices and things are perpetually in flux and to deal with this, and that’s really a different type of risk you have to deal with, I think there are a couple of simple steps to take.
First of all, you want to plan early, and you want to engage everybody. Cross-team collaboration early is absolutely critical here because you change something in one corner, you’re impacting the other guys down the road. And you need to engage early with the business, your counterparties, to know what are the paths they are considering so that you know which are the scenarios that you have to deal with. And you need to engage your technology partners early as well, so that they can tell you how they can deliver those scenarios.
And lastly, the one big challenge is that you can’t manage this kind of big project where the fine details are constantly moving in the traditional kind of waterfall approach, you can’t look at it and basically say, “Well, okay. There’s a transition that happens in one year. So here it is. I write all the specs. I give them to an IT department that goes and disappear for one year and it comes back in a year with the system and then we have one month to test before we put it into production.”
It doesn’t work that way because every month there is something new. So you need to understand which are the big pieces, the fundamental elements, and start building on that. But you need to incorporate agility in your process. And that’s the way we try to do it in internally at Murex and it’s also why it’s so important that we’re able to support and be agile in the way we develop. We are delivering very efficiently customization changes, configuration patches to customers, to deal with things which are unforeseen and are evolving.
And from an organization point of view, that’s a risk and that’s what you want to be aware of and you want to mitigate early on. And I’d say one last thing, do not forget about validation and plan appropriate testing, because there’ll be a lot to look at there. Otherwise, happy transition!
Let’s certainly hope it is happy for most of them out there. Great. Well, I think that’s an excellent point to end on. Thank you very much Alex, for sharing your expertise with us today.
Thank you Julia. It’s a pleasure.
So, you’ve listened to the final episode of our LIBOR transition podcast series. You can find more information on this topic and links to other episodes in this series in our show notes page. Thank you for listening. Join us next time.