London interbank offered rate (LIBOR) is a UK regulated and administered comprehensive set of benchmarks across a number of standard maturities and major currencies. Given how pervasive LIBOR is in the global financial system, any discontinuation of LIBOR will have far reaching implications. 2018 has seen regulators increasing pressure on firms to prepare for the transition away from LIBOR to new risk-free/nearly risk-free rates (RFRs). While new interest rate derivatives and cash markets continue referencing LIBOR, public authorities and private sector working groups have jointly selected overnight RFRs options that are being adopted by market participants. The adoption of RFRs though remains at a low level to date.
Although market participants still have three years until the anticipated transition date, the complexity of the transition process and pervasiveness of LIBOR within firms’ systems and processes require firms to start taking concrete steps.
This blog discusses key challenges that firms are facing when adopting SARON. Similar challenges apply for the transition to RFRs associated with other major currencies.
Why is the LIBOR transition difficult?
- The use of LIBOR is widespread, with high volumes of outstanding contracts
The LIBOR benchmark rate is one of the most used rates in the financial services industry. An estimated value of USD 200 trillion contracts reference USD LIBOR, with a vast portion related to derivative products. Retail mortgage contracts are valued at USD 1.2 trillion in USD LIBOR, with 57% maturing by the end of 2021. Predominantly contracts maturing beyond 2021 should be assessed to include either fallback language provisions or to transition to a new RFR.
- RFRs are built differently than LIBOR
LIBOR reflects credit risk whilst RFRs are risk free with lower fixings than LIBOR. Admittedly, a trade transferred from LIBOR to a new RFR could have a different market value resulting in “winners” and “losers” in the market. This calls for amendments in valuation methodologies. Additionally, low liquidity in the early stages is another aspect that is likely to limit the move.
- Cross-jurisdictional coordination may be a challenge
Regulators expect the transition to be market driven, which could result in different market approaches. For a successful transition, the following topics need to be addressed (i) fallback languages, (ii) term structure for products, (iii) solutions to hedging and hedge accounting. On a larger scale, the transition will require active coordination between industry players, legal advisors and accountants.
- The future of LIBOR remains uncertain
There is no certainty that LIBOR will cease to exist after 2021. Firms should plan for the transition whilst also considering a scenario where LIBOR continues to exist in some form.
Why is the transition different to other regulatory changes?
- There is no legal or regulatory mandate
Although clearly and repeatedly stated by the regulators, the transition and timeline are not set out in the legislation, leading to regulated firms having varied viewpoints on actions and timelines. Moreover, unregulated firms may be reluctant to renegotiate LIBOR linked contracts and sluggish to engage due to low regulatory pressure. Slow response from counterparties and sell-side firms to provide RFR referenced products in line with buy-side firms’ requirements could affect a firm’s competitive position in the market.
In the absence of a legal or regulatory mandate, Swiss LIBOR transition leads may face challenges to increase awareness on the high importance of the transition, especially when the buy side demand for RFR products is limited. Having flexible plans with scenarios that evolve with the changing market events will be helpful. However, as fixed event dates have not yet been set, it is advisable that firms focus on assessing their financial exposures and operational impacts rather than on external events.
Additionally, client outreach should be cautiously planned and coordinated to avoid overlapping communication streams, especially in instances where a counterparty has different points of contact within the organisation.
Lastly, an estimated USD 500 billion in legacy bonds need to be the focus of renegotiation efforts. Bond renegotiations will be more demanding compared to derivatives, as they require majority bondholder consent.
- LIBOR is hardwired into the financial instruments
Transition will touch almost every part of a financial services group, including across subsidiaries, branches and countries. Moving away from LIBOR may be optimal for one part of the business but may have potential negative consequences for another area. For instance, transition to a new RFR is closely linked to IT and operational changes; as a result, IT programme dependencies should be assessed beforehand.
Key decisions affecting several parts of the business should be identified quickly and escalated through a robust governance framework in dedicated LIBOR meetings. To focus on a clear communication strategy, it is key to have the capabilities and channels engaged across the business divisions.
- Strategic decision making in light of industry uncertainty
Different areas of Swiss banks and their competitive position in the market will be impacted by the transition. A series of strategic decisions will need to be made by the boards and executive committees of Swiss based organisations in an environment of persistent uncertainty.
Swiss based organisations should elaborate different transition scenarios to evaluate industry developments and to gauge impacts on their business. The rationale for different scenarios may need to be updated and the impacts modelled regularly.
- Development of management reporting
Reporting tools such as Management Information (MI) and Key Performance Indicators (KPI) may be challenging to implement in the case of a LIBOR transition. This is predominantly because organisations are finding it challenging to assess and quantify its LIBOR related exposures, be it within products or documentation.
Estimating the right financial exposure of LIBOR-referenced products will be an iterative process where banks might start with a financial exposure view at the onset, but will need to evolve and refine it over time. As a result, it is key that firms are satisfied with the completeness and accuracy of the input data.
The LIBOR transition is a complex undertaking – like no previous transformation programme undertaken by financial organisations. Its success depends on active collaboration between market participants. Given the complexity and scope of tasks ahead, it is critical for Swiss based organisations to start taking actions to understand the impact across different areas and to liaise with other market participants.
 Source: Financial Times - Alternatives to scandal-ridden Libor are slow to catch on. 11 November 2018. Interest rate benchmarks review (Third Quarter of 2018 and Nine Months Ended September 30, 2018). November 2018 .
 Source: Financial Times - Scrapping LIBOR leaves USD 500 billion of bond contracts in limbo. 10 October 2018