BY MICHAEL ROBERTSON
This article was first published in Global Risk Regulator, December 2018.

Despite the issues around Brexit and the demands of ongoing compliance with regulations such as MiFID II, there is increasing evidence that financial market institutions are ramping up their planning for life after LIBOR.

During a speech delivered to Bloomberg last year, Andrew Bailey, chief executive of the FCA reiterated that the discontinuation of LIBOR was inevitable and that organisations must be prepared for the orderly transition to alternative interest rate benchmarks.
Following that, banks under the supervision of the FCA and the Prudential Regulation Authority received a letter designed to ascertain the extent to which senior management are cognisant of the implications of the discontinuation of LIBOR.
These banks were asked to provide  – by end of last year – an overview of how the transition to the new risk-free rates would impact their operations and the steps they were planning to take to mitigate these risks.

How far have preparations gone?

One of the factors behind the FCA/PRA intervention is that there remains an apparent lack of education and awareness around interest rate reform. Firms need to be in ‘planning’ mode to ensure they fully understand the impact of reform across their business – be it data systems, documentation, models, process flows and/or operating procedures.
This inventory-like assessment is necessary to answer questions such as ‘how big is this for me’ and ‘what resources (financial and human) do I need to address the issue’.

Whilst progress has been made in publishing a reformed SONIA alternative rate, there remains a feeling that the immediacy of the issue is still not fully understood. IBOR exposure continues to increase across the market and much is still required in order to ensure adoption across user type (banks, buy-side, pension, insurance or non-financial firms) and markets (derivatives and cash markets).

What are the challenges?

With a significant amount of work still ahead, it is difficult to summarise a full list of challenges at this time. We do know, however, that LIBOR reform will potentially impact across all key functions, from sales, trading and risk management to treasury, legal, operations, compliance and IT. A number of consistent pain points are emerging during our conversations with clients.

The first of these relate to legal issues and documentation, specifically the obvious challenge of contracts with maturities beyond 2022 referencing LIBOR. This is likely to be addressed by shifting to the replacement rate or amending based on fall-back language. The ISDA consultation on fall-backs represents a significant step forward  but firms still need to understand the inventory of documentation impacts (legal master agreements, collateral service agreements) to fully quantify the extent to which any repapering, renegotiation or rewriting of legacy contracts is required. Firms should be planning communication with impacted clients on a case by case basis.

Then there is the infrastructure challenge, where reform could require accounting, risk management and third party pricing models/systems to be planned and implemented internally. Technology changes and infrastructure impact will need to be budgeted and resourced accordingly.

Fragmentation is also an issue. Previously, all rates were published by a single authority (ICE) but the proposed reform will see the introduction of more domestic regimes, predominantly administered by central banks and likely staggered over a period of time. Harmonisation and consistency of approach will be challenging given the scale of change across market participants, regulatory bodies and governing trade associations.

Some market participants believe LIBOR reform is impacting other market/regulatory initiatives such as FRTB. There is a real risk that some of these risk free rate (RFR) contracts are treated as non-modellable under current FRTB rules or that – depending on adoption timelines – IBOR contracts end up being treated as non-modellable. Either way, this would lead to a capital charge add-on or use of the standardised approach under FRTB, which in turn leads to more capital requirements for banks.

Then there is the issue of liquidity – regulators will want to get RFR products up and running so as to create sufficient liquidity in the market. At the outset, central banks will only be publishing a reference overnight rate and there is uncertainty around the term structures or yield curves in these new quoted rates. Bank risk management and valuation engines rely on the term structure to build curves.

The new rates will be calculated differently from LIBOR and are truly riskless (in contrast to LIBOR, which carries an inherent credit risk to the quoting bank). As such there is a small basis difference between the two rates and so the risk profile and VAR of portfolios will change on repapering.

The absence of historic rates or correlation data for the new RFRs throws up a number of questions which are yet to be answered regarding how to price options or calculate VAR in these products. In addition, there is a question over RFRs as part of standard initial margin model calculations, which also requires historic data for calculating initial margin on uncleared OTC positions.

So where do we go from here?

The majority of firms will have established central LIBOR reform programmes. Where applicable, jurisdictional business and function owners must be plugged into these internal change groups to ensure they have the requisite visibility and awareness of the topic. Business units should be undertaking their own system and model impact assessments to understand the full functional and economic implications of reform.

Industry RFR working groups will continue to play a pivotal role in achieving the objective of a market led transition to SONIA by the end of 2021. Working groups – and any technical sub forums – will provide the requisite transparency, direction and decision making on this initiative.

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