Some would argue the global interbank offered rates (IBORs) had it coming. Marred by scandal and post-crisis liquidity concerns following the sharp decline of interbank lending, the benchmarks entered the cross-hairs of global regulators. The result: A phase out of the major IBORs – most notably the London Interbank Offered Rate (LIBOR) – in favor of risk-free rates (RFRs) by 2021. The impact of this migration is widespread, touching a variety of areas from the obvious financial products such as interest rate and currency swaps to credit cards and student loans.
For the past few years, the financial services industry has faced a daunting task. How can it wean itself off its reliance on IBORs, which for the past 40 years have been a daily, integral part of the global financial system? Today, the London Interbank Offered Rate (LIBOR), the largest IBOR, underpins an estimated $350 trillion worth of financial contracts. So far, the migration to RFRs is a work in progress. With roughly two years until IBORs are phased out and replaced by RFRs in 2021, it’s a great time to check in to see exactly where we are and to remind asset managers of the main areas of focus in order to move into this new world.
Following a 2013 G20 mandate for financial regulators to review global markets’ reliance on interest rate benchmarks, the Financial Stability Board (FSB) released multiple recommendations and progress reports. Although it may appear the market can continue with the status quo until IBORs are replaced by RFRs, managers shouldn’t see 2021 as a guaranteed fail-safe date. The reason for this is that banks are no longer required to operate IBORs and are only continuing to maintain it voluntarily. As such, transition work should be well underway to ensure managers are no longer relying on rates that are susceptible to the goodwill of banks.
What should already be underway?
Asset management firms need to have compiled inventories of their end-to-end exposure to IBORs and should already be making progress with transitioning new products, renewals, and references to RFRs. This task is not to be underestimated and re-documentation will require serious project management. But some trade associations, such as the International Swaps and Derivatives Association (ISDA), are working to create an all-encompassing protocol method to amend legacy IBORs contracts – which will be welcomed by the industry.
However, loan market documentation, including facility agreements, may face additional challenges given the potential number of parties involved in such arrangements and all new documentation should reference the new RFRs. While some IBORs exposures are obvious, such as the pegging by derivative instruments, securitized product offerings, bonds, and hedging strategies, others are less apparent, such as facility arrangements, late payment clauses, discount rates, and variable-rate mortgages. Equally, firms must make adjustments to internal risk, pricing models, performance targets, and balance sheet management.
Managers should also further consider remediation. What should happen to legacy references? The market should look to the relevant working groups that have been established to oversee the transition to RFRs in the euro, sterling, US dollar, Swiss franc, and Japanese yen.
Many firms may already have documented “fallback” provisions to account for cases in which an IBOR is unavailable, but regulators specifically identified them as insufficient replacements for meaningful transitional arrangements. The UK’s Financial Conduct Authority (FCA) considers the best and smoothest transition from LIBOR to be one in which contractual references are either replaced or amended before placing significant reliance on fallback provisions.
Going a step further, the FCA recently stated at the recent Association of Luxembourg Fund Industry conference that a clear priority for the asset management community this year should be the transition from IBOR. Global regulators are working together and coordinating expectations from the market, so firms should have plans at the ready to demonstrate that they have made effective progress. And there is evidence of the transition stepping up pace with a large handful of new sterling bond issuances already referencing the LIBOR replacement SONIA this year.
What else should managers consider?
In addition to the work managers are already doing, they should also analyze their processes around tax and accounting, especially in relation to loan agreements and inter-company arrangements. This means thinking through every amendment to existing arrangements which implicate an IBOR; such changes to contracts could be viewed as a termination and entry into a new contract which should be analyzed for potential tax implications. Firms should also think though other tax crystallization events relevant to their internal structure.
How can market participants help?
In order for this transition to operate as seamlessly as possible, it is incumbent upon product providers to ensure that the market is offered new products that relate to new RFRs in order to entrench liquid markets. In tandem, market participants should not wait to start transitioning reference rates – the sooner an alternative market is created, the more stable it becomes.
The IBOR transition is one of many initiatives stemming from the financial crisis that will have far reaching impact keeping project managers, risk professionals, legal teams, and product sponsors busy for some time. However, on this occasion, a big bang approach (e.g. transition all at once) may not sit well for many of these key players. Given how intertwined many businesses are with the age-old reference rates, it stands to reason that the transition may be a bit rockier than many expect. While work continues in each of the global working groups on RFRs, transition and fallback plans for firms need to keep pace. To quote the FCA: “inertia remains the biggest obstacle to a smooth transition.”