Reform of interest rate benchmarks
July 2018 | SPOTLIGHT | BANKING & FINANCE
Financier Worldwide Magazine
July 2018 Issue
The Principles for Financial Benchmarks, published by the International Organisation of Securities Commissions (IOSCO) in 2013, have initiated the regulatory follow-up to the LIBOR scandal. The EU has transferred these principles into European law, via regulations EU 2016/1011 and EU 2017/1147, and set a deadline of 2020, after which new transactions are allowed to refer only to approved interest rate benchmarks. It is also clear that neither the current LIBOR, EURIBOR nor the Euro Overnight Index Average (EONIA) are compliant. An unchanged continuation of these interest rate benchmarks is therefore not possible, which is why measures are required.
The implementation of these regulations will be accompanied by significant implications for all market participants over the next two years. In many cases, market participants have not yet realised the scope of the associated changes and consequences. Depending on an institution’s individual situation – portfolio of products, counterparties and IT infrastructure are particularly relevant in this context – the necessary transition could come with significant costs and risks.
There is no easy solution
Benchmark administrators are already working on IOSCO-compliant solutions for today’s IBOR sets. Because money markets underlying the IBORs lack sufficient liquidity for a robust fixing process, based on real transactions, new methods are required: the so-called ‘evolved IBOR’. An initial test phase of a compliant EURIBOR method has failed and hybrid methods will be tested until 31 July 2018. An evolved EURIBOR is expected to be available by Q4 2019. Currently it is unclear whether it is possible to implement suitable methods and this approach has already failed for the EONIA. An evolved LIBOR is expected to be available in Q1 2019.
The question remains as to whether banks will continue to participate in the IBOR quotation and whether instruments based on these interest rate benchmarks will be liquid in the medium term. In July 2017, Andrew Bailey, chief executive of the UK’s Financial Conduct Authority (FCA), said that the FCA would no longer compel a LIBOR quote by market participants from 2022 onward. He also prompted market participants to start planning and implementation now. In a March 2018 speech, he said, “I do not consider a synthetic LIBOR as an alternative to RFRs as the best benchmark for interest rate risk.” Thus, it seems clear that the FCA, as regulator in charge, does not view a reformed LIBOR as a permanent solution, but wants to see it being replaced by risk-free rates (RFRs). For the EURIBOR, the situation is such that the Financial Services and Markets Authority (FSMA), as the regulator responsible, can issue an obligation to participate in the panel, which, in turn, would be limited to a period of two years.
Alternatives are being developed
At the same time, a new family of reference rates is being worked on: the RFRs. The RFRs are being developed as medium-term successors to the IBORs. Presumably, they will be available from 2019 onward and will gradually be integrated into the markets. Different methods could be used to map the required term structures, for example by means of Overnight Index Swaps (OIS) or Repos.
The US dollar LIBOR can serve as an example to outline the process. Concrete planning is already underway on how to develop a US dollar LIBOR successor, including central counterparty clearing (CCP), on a Secured Overnight Financing Rate (SOFR) basis.
A step in this direction is also the establishment of a new European Central Bank (ECB) rate for the uncollateralised overnight rate, the euro short-term rate (ESTER), which will be made available as an EONIA successor by 2020. In the event that the EURIBOR reform fails, a EURIBOR fallback will be developed on this basis.
In our baseline scenario, we assume that there will be LIBOR alternatives based on RFRs from 2020 onward. The importance of LIBOR will decrease and the rate will successively be replaced as underlying by RFRs. There is a risk that in the medium term, liquidity will only be available in alternative RFRs or that LIBOR may no longer be available at all after the end of FCA support.
The transition increases the basis risk and leads to operational complexity. In the course of the reform, two aspects are of central importance: the different basis of IBORs and RFR-based interest rate benchmarks, and the parallel phase of IBORs and RFR-based reference rates.
IBORs represent the interest rate that banks pay when they borrow on an unsecured basis, including credit risks and liquidity costs, for the corresponding tenor. Alternative RFR-based reference rates are based on either collateralised or uncollateralised overnight rates. In order to reflect the corresponding IBOR tenors, OIS transactions are expected to be used. Thus, it is clear that there will be a significant implicit basis between IBORs and RFR-based reference rates.
Various institutions will seek to develop universal standards, such as the International Swaps & Derivatives Association (ISDA) protocols, to facilitate the transition for market participants. In some cases, contracts have already been supplemented with corresponding provisions. However, the large number of different products, including loans and derivatives, and stakeholders, complicate the situation. Given the high volume of outstanding transactions, profit and loss effects are to be expected. This is likely to result in a need for negotiation with the respective counterparties.
Operational complexity due to parallel phase
Scenarios in which existing transactions cannot be migrated immediately to new and liquid reference rates have a high probability of realisation. This means that a parallel phase of IBORs and RFRs for comparable transactions can be expected. How long such a parallel phase will exist is difficult to anticipate, but ultimately is not crucial for the preparation. It is relevant for institutions to meet all critical requirements on their IT infrastructure for such a phase. This does not only apply to the complete information mapping in the data repository. Along the entire value chain, from pricing to hedging and risk management to hedge accounting, suitable processes must be defined and systematically implemented. In particular, a parallel phase thus represents a significant increase in complexity in comparison to a global conversion to a fixed date. At the same time, this is the LIBOR baseline scenario.
Operational implementation of the transition
Operational readiness is optimally completed by the time the new interest rate benchmarks are introduced, for example by Q1 2019, the planned start of the LIBOR successor. From then, the scenario of a liquidity shift from LIBOR to alternative RFRs can no longer be ruled out. The actual transition should be fully implemented by the end of 2021 at the latest, the date on which continuation of the current IBORs is considered uncertain.
Transactions due to mature in 2020 are likely to be directly affected. Contract changes to RFRs can begin as soon as the corresponding products are available in clearing. Initiatives by associations and authorities should be monitored closely, as there have been strong efforts to harmonise market practices.
Establishing operational readiness for a possible parallel phase requires action in the following areas in particular: portfolio and risk management, contracts and legal issues, and internal processes and IT.
All market participants should aim to be prepared for all processes in the parallel phase by mid-2019. We recommend a centralised project setup, as the implementation affects not only single value chains of different products, but has cross-connections between products as well.
The complexity of the transition is largely due to the high number of affected counterparties and heterogeneous products, as well as the expected parallel running of old and new interest rate benchmarks. In the case of individual market participants, adjustments to processes and systems pose the risk of unexpected challenges. Last but not least, it is important to keep an eye on the quantitative effects of the transaction when converting portfolios and negotiating with counterparties in order to avoid adverse profit and loss effects. An examination of the current positioning in different interest rate benchmarks is recommended. As different products possibly are dealt with differently in the context of the transition, a product-wise view instead of a global portfolio view may be adequate.
Christian Behm is a partner at Lucht Probst Associates GmbH. He can be contacted by email: firstname.lastname@example.org.
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