Interbank offered rates (IBORs) have served for decades as the reference rate at which banks borrow in the interbank market. During the last financial crisis however, significant fraud and conspiracy connected to the rate submissions led to the London Interbank Offered Rate (LIBOR) scandal. This triggered concerns on the sustainability of certain IBORs in the unsecured bank funding market. In 2013, the Financial Stability Board (FSB) started reviewing major interest rate benchmarks due to concerns on their reliability and robustness. In 2014, the FSB opined that risk-free reference rates (RFRs) could be more suitable than reference rates containing a term credit risk component.
In November 2017, the UK’s Financial Conduct Authority (FCA) accelerated the need for financial institutions to move to alternative reference rates (ARRs) by announcing that they will no longer compel or persuade banks to submit quotes to support the LIBOR after 20211. In the same year, the Swiss National Working Group on Swiss Franc Reference Rates has opted for the Swiss Average Rate Overnight (SARON) as an alternative reference benchmark. At the European level, the Euro Overnight Index Average (EONIA) and EURIBOR are expected to be replaced by the Euro Short-Term Rate (ESTER) by the beginning of 2020.
The transition to an ARR will influence hundreds of trillions of US Dollars’ worth of financial products globally, as IBORs are hardwired into the valuations of financial products. This does not imply that IBORs will entirely cease to exist in 2022 but infers that market participants will need to be cautious of the ARRs implications for their existing and new portfolios.
Timeline of major development stages in the transition:
Source: Deloitte internal research
Challenges and impacts
It is clear that the move away from IBORs will have wide-ranging impacts on financial services firms, market infrastructure as well as the end customer as not all IBORs will transition simultaneously across the markets.
Over-the-counter (OTC) derivatives and Exchange-Traded-Derivatives (ETDs) represent the largest volume of financial products referencing IBORs, accounting for almost 80% of the exposure. However, market participants will also need to consider the implications on other asset classes to prepare for the journey ahead, including for example lending products, Floating Rate Notes (FRNs) and securitisations among others.
Estimated total notional volumes for reference rates:
Source: Estimation based on Deloitte research
It is vital for market participants to understand that the IBOR transition will influence the organisation as a whole across business processes, functions as well as IT. Key impact areas that Swiss and other market participants face when adopting the new ARR include:
- Valuation and risk management implications – Banks need to assess their direct/indirect exposures to financial products referencing LIBORs by product types to define and prioritise specific transition tasks. This also involves assessing the suitability of the new ARR as well as the impact on the value of cash flows settled after the ARR transition. Moreover, financial institutions will need to determine a solid approach for legacy portfolios referencing IBOR (i.e. keeping some form of IBOR in existence instead of moving to the new ARR) and subsequently measure the value of the portfolios triggered by the change.
- Accounting and tax challenges – The application of the new RFRs may not be consistent across all financial contracts in the global economy. This may lead to mismatches between a derivative and its underlying hedged exposure for hedge accounting and may call for increased volatility in the P&L. Treasury functions will need to assess the continuity of their hedge relationships along with the probability of cash flow hedges to IBOR post 2021. Tax functions will need to evaluate scenarios triggering double taxation in cases where each jurisdiction arrives at a different price by applying a different ARR. Assessing the end-to-end process of the transition to the new ARR will be key in reducing tax risks arising due to insufficient coordination among different tax authorities.
- Systems, processes and controls – Core banking systems and the functions involved in a trade’s lifecycle will require updates to reflect the trades referencing RFRs. This will be critical to ensure the correct risk is captured within accounting and valuation tools as well as collateral systems. Operating procedures, policies, guidelines, business processes as well as the control framework will need modifications.
- Documentation concerns – Contractual documentation with counterparties will require updating to the ARR as most legal documentation contain fallback provisions for short term rather than long-term disruptions to IBOR. Although IBORs are foreseen to cease at the end of 2021, as per the transitional arrangements of the EU Benchmark Regulation, firms have until 1 January 2020 to make the necessary modifications to contracts2. Contract reference rate negotiations, repapering alongside client outreach efforts will not be easy, especially in light of the market uncertainty around the practicalities of the execution of the new ARR.
The Swiss Franc in focus – Significance of SARON
On national and international levels, working groups have identified ARRs in five major currencies3, in accordance with the International Organization of Securities Commission’s (IOSCO) principles. The ARRs are based on robust, hard to manipulate liquid markets making them reliable and less ambiguous than IBORs. In Switzerland, the National Working Group on Swiss Franc Reference Rates has opted in 2017 for the Swiss Average Rate Overnight (SARON), a reference price based on transactions and quotes of the Swiss Repo market4.
SARON is an overnight secured, IOSCO compliant benchmark rate, which is continually calculated in real time and administered by the SIX Swiss Exchange. Moreover, SARON is already being used in the Swiss market since the discontinuation of Tomorrow/Overnight Interest Swaps (TOIS) fixing in 20175.
Despite the knowledge and expertise developed by the Swiss market to replace TOIS, it is critical for financial institutions to assess the complexities of transitioning from CHF LIBOR to SARON in light of the differences between the ARRs and the pace of progress across jurisdictions6.
Each market participant will need to evaluate their exposure to IBOR referencing financial products maturing post 2021 in order to assess the adoption of the new ARR, as they are not direct replacements of the IBORs.
The transition from IBORs to RFRs such as the Swiss SARON as benchmark reference rates has a significant impact on financial market institutions. This impact affects a firm’s risk management, hedging set-up, internal systems and processes as well as all sorts of existing and future contracts and related documentation. Considering the size and scale of this change, financial institutions need to start raising awareness internally to identify specific challenges and define a roadmap for an orderly, efficient and coordinated transition. This initial phase should focus on:
- Understanding the scale of the impact of recent Swiss and international developments
- Undertaking impact assessments in relation to the current IBOR exposure
- Defining the roadmap for the Target Operating Model design and transition period
In order to further address the magnitude of the challenges faced in the Swiss market, Deloitte has been invited to moderate the “LIBOR to SARON: Are you ready?” event jointly hosted by SIX and International Capital Market Association (ICMA) at the SIX convention point in Zurich on 1 November 2018. Join us in this panel discussion about what is one of the major changes in recent financial services history.
Please find more information about LIBOR on our webpage: Interbank offered rate (IBOR), the journey ahead.
3In addition to SARON, the other ARRs for existing LIBORs are: GBP LIBOR - Reformed Sterling Overnight Index Average (SONIA); USD LIBOR - Secured Overnight Financing Rate (SOFR); EURIBOR - Euro short term rate (ESTER); JPY LIBOR - Tokyo Overnight Average Rate (TONAR)