As the journey to transition away from the London Interbank Offered Rate (LIBOR) continues to move forward, supervisors across jurisdictions have started approaching institutions to gain insights into their operational readiness. In Switzerland, a wide range of products with substantial contract volume is tied to LIBOR1. This includes lending products such as mortgages and derivatives.
The National Working Group on Swiss Franc Reference Rates (NWG) has since long selected the Swiss Average Rate Overnight (SARON) to replace the CHF LIBOR. While regulators are highlighting that the transitions should be market-led, FINMA recently published guidance detailing the risks associated with a transition away from LIBOR. The guidance recommends Swiss financial services firms to address the risks and challenges of the transition in good time. In terms of supervisory activities, FINMA will reach out to individual institutions in a risk–oriented manner, and conduct reviews on how risks associated with the LIBOR replacement are identified, monitored and mitigated.
In anticipation of the increase in supervisory activity in the context of LIBOR, it is vital that Swiss banks establish a clear transition roadmap as a disorderly transition will have adverse impacts.
The transition roadmap should address the following key blocks of activities in the absence of a formal regulatory or legal mandate to transform their business :
- Identify exposure to LIBOR across all product types
- Prepare for transitioning the back book/legacy trades and applying appropriate fallback language to new contracts maturing after 2021
- Understand the implications on systems and processes and identify legal, valuation, conduct and other relevant risks
- Anticipate buyside demand for products using new reference rates and define a strategy for new RFR linked products
If all market participants collaborate and do their part in the preparation, the transition to RFRs may well prove to be a less disruptive event. However, for this to be the case, financial institutions will need to carefully prepare for the LIBOR discontinuation.
In order to address the key blocks of activities listed above, the following six factors will need to be thoroughly considered by Swiss firms for a smooth transition.
The regulators are asking banks to appoint a senior representative of the firm to assume accountability for the LIBOR programme. In Switzerland, FINMA has requested banks to confirm whether a senior executive has been identified to support with the LIBOR transition. Furthermore, it is crucial for the programme governance to include stakeholders from impacted businesses and functions to allow required decisions to be identified quickly and escalated to a senior Steering Committee (and in some cases the Executive Committee and the Board). However, it should also strike the right balance between allowing for “business as usual” and ensuring the right degree of control.
Due to the wide scope of the programme, internal communications will be key. Therefore, the central programme should have the capabilities and channels to proactively engage across the whole organisation. The programme will also play a key role in monitoring national and international milestones and developments. This involves assessing their impact on the various transition scenarios, thus supporting appropriate decisions to be taken until specific developments occur.
2. Strategic scope
Ideally by now firms should have already reached an initial view on financial exposures and should have started to understand how they will manage these exposures and reduce them over time. Other key strategic decisions include deciding when to introduce RFR-linked products and when to discontinue the issuance of LIBOR-linked products. Market activity is picking pace for RFR linked products with larger currency markets leading the way. In Switzerland, the term sheet of the 3 months SARON futures has been defined and has started trading at EUREX.
Financial institutions will need to have appropriate tools in place to support the programme delivery. In particular, firms should closely track items including financial exposures to LIBOR and contract repapering to ensure strategic decisions are being followed through.
3. Financial risk management
Managing financial risks will require detailed analysis in areas such as accounting, valuation changes (e.g. mark-to-market on “day 1”), modelling changes, curve construction and hedging. Additionally, FINMA has highlighted that the high amount of payables and receivables in the derivatives and the loans contracts referencing LIBOR will result in valuation and basis risks.
One way of addressing these risks is redesigning valuation and risk management models. This is however, dependent on the firms current capabilities as the changes may extend beyond existing models and processes. The challenges are compounded by the fact that most markets for RFRs are nascent and therefore, relatively illiquid. Add to that the absence of term structures in the rates, the limited availability of historical data and the disparate nature of successor RFRs across jurisdictions and you have firms facing a significant challenge to make the necessary changes to their risk management systems and processes.
4. Product design and readiness
One major challenge that firms will encounter while transitioning away from LIBOR is to understand the demand from the buyside and the ability to swiftly respond to such demand. There is a risk that banks will lose market share if they are not adequately prepared to issue RFR linked products.
5. Customer communication
Firms will need to develop and implement a coordinated communication plan across business units and geographies to educate their end clients and inform them about the various implications. Where appropriate, communication should be tailored to different client and counterparty groups that banks operate with to ensure awareness of the LIBOR-replacement. Adopting a clear and consistent communication strategy towards customers and counterparties will help to increase transparency, reduce miscommunication and minimise the probability of legal issues2,3.
6. Engagement and monitoring streams
A key aspect of the programme will be the engagement with regulators. Banks should develop an engagement strategy taking into account the different approaches regulators are adopting. This will be key to help the organisation to pre-empt and prepare for the expected additional level of scrutiny. Banks should pay particular attention to assessing prudential and conduct risks under a range of different scenarios.
There is a range of events that will influence the transition and determine when firms can undertake certain activities. For example, in the derivatives market, ISDA is developing fallbacks for inclusion in its standard definitions for the main benchmarks5. Monitoring these market events from the outset will be critical so that firms can respond and adapt their plans accordingly. This will allow anticipating the direction of the transition and undertaking the required activities internally.
While firms may consider 2021 to be far away, the complexity of the transition allows no wiggle room for inertia. Establishing a robust programme governance will enable firms to address key strategic decisions in relation to their IBOR-related financial exposures as well as support the proper management of related financial risks. Further, firms will need to evaluate carefully the demand for RFR linked products in order to time their own introduction of these products. Finally, the programme must define a clear client outreach strategy and implement an ongoing monitoring of market events in order to be able to adjust and deliver a successful transition.