(First of two parts)
Financial markets globally are preparing the shift from referring to Interbank offered rates (IBORs) as a benchmark for financial products and services to alternative reference rates (ARRs).
For decades now, IBORs have been the reference rates for variable-rate financial instruments with the London Inter-bank Offered Rate (Libor), the most widely used IBOR, underpinning trillions of dollars’ worth of financial contracts. Libor is referred to worldwide for many financial products — bonds, loans, derivatives, mortgage-backed securities, and others. It represents the average rate at which internationally active banks obtain funding from wholesale and unsecured markets. Libor is also used to gauge market expectations on central bank interest rates, liquidity premiums in the money markets, and even on the state of a banking system during periods of stress.
In 2012, however, a group of banks was accused of manipulating their IBOR submissions during the financial crisis and a series of scandals ensued. In 2017, UK and US regulators simultaneously declared the uncertainty of the use of IBOR as a benchmark rate after 2021. Initiatives to reform the benchmark were made but actual transactions supporting Libor rates continued to dwindle and markets further questioned the integrity of the rates as a benchmark. Regulators proposed the solution to develop and adopt instead ARRs. These ARRs are believed to be more appropriate as reference rates as they are “near-risk free” and are based on actual transaction volumes.
Regulators worldwide began laying down concrete policy steps for the transition. Relevant ARRs have been selected for major currencies with strategic transition plans to minimize market disruptions. The US Alternative Reference Rates Committee (ARRC), for example, has issued a 4-year timeline starting in 2018 for the transition from the US Libor to the Secured Overnight Financing Rate (SOFR). ARRs for other major currencies include the Reformed Sterling Overnight Index Average (SONIA) for GBP Libor, the Swiss Average Rate Overnight (SARON) for CHF Libor, and the Tokyo Overnight Average Rate (TONAR) for JPY Libor and JPY Tibor.
As ARRs are selected and regulators provide for a transition procedure, financial institutions must assess early on the potential impact of the change of benchmark in order to re-assess their business strategies and make the uncertain, certain. As discussed in a recent EY publication titled End of an IBOR era, the top 10 challenges that banking, capital markets organizations, and other financial market participants will face in transition to the ARRs include:
1. Client outreach, repapering and negotiating contracts. Institutions should consider the necessity to re-negotiate existing contracts that will mature past 2021 based on the new reference rates.
2. High litigation, reputation and conduct risk. Spreads should be re-assessed based on the differences between the IBOR and the ARRs.
3. Market adoption and liquidity in ARR derivatives. The market must account for a transition in the adoption of ARR derivatives, thus affecting the liquidity in the market.
4. Absence of ARR term rates. As most ARRs will initially be an overnight rate, defining term rates for ARRs needs to be accelerated to facilitate the timely and smooth transition of cash products.
5. Differences in ARR and transition timelines across G5 currencies.
There is also the need to harmonize the timing of the transition and publication of daily ARRs across the G5 currencies (dollar, euro, pound, Swiss Franc and yen) to address the impact on the FX swap markets.
6. Regulatory uncertainty. There is a need for regulatory guidance to be issued early on if only to allow markets to plan and work on their transition plans.
7. Operations and technology changes. As IBOR has already been embedded deeply in operational procedures and technological infrastructures, changes to systems may have to be planned early.
8. Valuation, model and risk management. A wide range of financial and risk models will have to be developed, recalibrated, and tested in order to incorporate the new reference rates. This poses a challenge given the lack of available historical time series data.
9. Accounting considerations. Financial institutions will need to review changes against accounting standards.
10. Libor may yet survive. The Financial Conduct Authority recently hinted at the potential use of synthetic Libor for existing contracts that may go beyond 2021. Additionally, the ICE Benchmark Administration also indicated the possibility that Libor may still be used for selected currencies and tenors. The lack of clarity and firm decision pose a challenge for institutions given the huge amount of “To Dos” needed to prepare the onset of year 2021.
The Philippines should keep up with, if not be ahead of, these changes and prepare early as well. The domestic financial industry can see this as an opportunity to accelerate the Philippine Capital Market Agenda by establishing local reference rates. Regulatory guidance will play a crucial role at this point. Institutions also need to understand the structural differences between the IBOR and the ARRs and re-assess the impact to ensure their business models are abreast with the industry developments.
In the next article, we will continue the discussion on expected IBOR transition, looking at some of the other business areas that institutions should start re-assessing, such as operations, risk management and regulatory frameworks, accounting and procedures that companies can adopt to ensure an efficient and effective transition.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.
Janice Joy M. Agati and Redgienald G. Radam are Senior Directors from SGV & Co.’s Financial Service Organization service line.
