(L)ibor reform: How will it affect bank treasury functions?

Firms must demonstrate executive ownership, readiness to address the implications, and understanding of the risks involved. By Dr Jan Rosam, partner, financial services advisory, Ibor lead Germany, EY, and Gernot Schmidt, product manager for regulatory solutions, SimCorp

25 October 2019

Regulators are increasingly interested in industry progress and bank treasury readiness for the (L)ibor reform. In this  article, EY and SimCorp experts explain why it’s crucial that bank treasurers can demonstrate a tangible action plan for addressing the (L)ibor reform’s implications for specific functions.

Is your firm ready?

Most financial firms will be facing significant consequences from the end of 2021, when the majority of Interbank Offered Rates (IBORs) will be phased out by regulators and replaced by new alternative reference rates (ARR). With many consequences only just emerging, understanding the impact for each firm and taking the right actions will require that firms address some essential questions during a structured and cross-organisational analysis and change process under appropriate executive ownership. With a special focus on bank treasury functions, this article takes a closer look at the changes, implications, and recommended actions for firms impacted.

For more than 40 years, Interbank Offered Rates, especially the London Interbank Offered Rate (Libor) as well as the Euro InterBank Offered Rate (Euribor), have set the benchmark rate for lending on an unsecured basis, underpinning the worldwide trade in financial products from bonds and loans to derivatives and mortgage-backed securities.

However, a series of scandals has sealed the fate of the once dominant IBOR benchmark, including a group of banks being accused of manipulating their IBOR submissions during the financial crisis. To address the shortcomings of Ibors, the International Organisation of Securities Commissions (Iosco) published the Principles for Financial Benchmarks in July 2013 to address conflicts of interest, etc. In September 2013, G20 leaders endorsed these principles as global standard.

Multiple regulatory-driven actions have followed, for instance the European Benchmark regulation, which recognises major interest rate benchmarks (such as Libor, Euribor, Eonia (Euro OverNight Index Average)) as critical benchmarks and requires these to be robust, reliable, resilient, and always possible to calculate, without compromising their integrity.

Integrity especially has become important, illustrated by the three-month US dollar Libor, the most heavily referenced Ibor benchmark. It is supported by less than $1bn in transactions per day and has seen a sharp decrease in number of participants within the Ibor panels, diluting Ibor’s relevance and resilience.

Given these facts, regulators and market participants agree that financial products need to transition to new alternative/risk free (RFR) reference rates based upon real transactions. Working groups have been set up globally to determine these new rates and guide the market on the transition path (see Appendix 1).

Geographical differences in the transition

Both the UK and the US plan to phase out Libor and transition to a new benchmark by the end of 2021. In the EU, the situation has evolved differently. Originally, the European regulators had an aggressive plan for the transition, but they have recently allowed all critical benchmarks two more years to become compliant. The “safety net” for Euribor has been set up due to uncertainty as to whether the new hybrid methodology would be sufficiently robust and ready in time.

Since then, on July 3, 2019, Euribor’s new methodology has been accepted as Benchmark Regulation (BMR) compliant and, in theory, can continue to be used alongside the new €STR (Euro short-term rate). However, it remains to be seen if future Euribor fixings will really depend less on indicative quotes and if its robustness will significantly improve. It is very likely that liquidity will shift to €STR regardless, leading to a diminishing importance of Euribor despite its reformation.

What does the reform mean for bank treasuries?

As the reform affects all processes and instruments that reference Libors, the market impact will be substantial. Directly impacted instruments are those that refer directly to one of the affected interest rate benchmarks and will need to change in terms but also in respect of their contractual foundation (eg derivatives, floating rate notes, and loans). Indirectly impacted instruments are those using interest rate benchmarks for FX forward calculations, discounting, or collateral margin calculations.

Treasuries will not only be affected through issuing and trading these instruments in their books, but also operationally in their run-the-bank processes. The impact can be classified into five main areas.

1.  Business strategy for new floating rate business

Given the fact that Libor will be discontinued by the end of 2021, treasurers need to think about when to start using the new ARR indices for their own business, when to start offering new ARR products to clients, when to start the transition of bank positions away from Libors, and how to deal with new Libor business prior to the end of 2021.

Generally, every new Libor trade increases the transition risk and efforts required and should be reviewed critically, specifically as long as no robust fallbacks are included within the legal documentation. In more evolved markets, some investors already avoid Libors, but in most markets, there is a continued demand from investors, corporates and retail clients for floating rate funding, mortgages, and loans based upon Libors. It is even more important that treasurers understand the risk and make a decision regarding appropriate pricing of specifically these trades that might increase risk premia, limit maturities, and remove multi-currency switch optionalities.

Additionally, treasurers should start reviewing the effects on each of the balance sheet positions to be able to understand the impacts and to be able to develop a strategy for the transition. Specifically, institutions with no access to foreign liquidity might have very price sensitive cross-currency positions where small changes can lead to significant profit and loss (P/L) swings and should therefore do a careful review.

Recommended actions:

  • Decide which (L)ibor instruments should still be allowed to be traded prior to cessation.
  • Decide which new RFR products you want to offer to clients.
  • Review existing fair value and cash flow hedges and their documentation.
  • Review balance sheet positions to understand the impact and sensitivity towards any change in reference rate.

2. Pricing, valuation, and liquidity management

Changing the reference rates on existing and new issuances will significantly alter the funding profile of a bank. It cannot be assumed that all issuances can be switched at the same time and banks will run the risk of introducing funding premia. Cash flow models and liquidity risk management frameworks need to be updated to include ARR-based products.

Also, changing the discounting curve or the reference rate within can change the net present value (NPV) of floating rate note (FRN) or derivatives. Appropriate compensation payments have to be agreed or the terms have to be adjusted in a “fair” manner. The NPV change, when the International Swaps and Derivatives Association (Isda) fallback is triggered, can be significant. So, there “will be winners and losers” as stated by Isda CEO Scott O’Malia. In order to avoid negative value transfer when transitioning Ibor-linked cash products, banks need to be able to calculate fair value adjustments and justify those in the relevant conversations with their counterparties. Otherwise, they will face significant litigation and conduct risk if counterparties feel disadvantaged, specifically when retail clients are involved.

Large impact should be expected for derivatives where the Isda fallback is triggered. In such cases, an Ibor reference rate is replaced with an ARR, adjusted with a benchmark spread calculated from historical Ibor vs ARR spread. As an example, for a fix/float GBP-Libor swap with 20Y maturity, a deviation of three basis points (bps) between the historical and the actual GBP-Libor versus Sterling Over Night Index Average (Sonia) spread will yield an immediate value transfer of 50bps of notional.

Another related complexity will arise from the usage of Libor rates for margining of cleared trades. Clearing houses are expected to move to ARRs margining and discounting during 2020. It is yet unclear if all major houses will agree on a “big bang” migration date. But regardless of timing, banks need to update their internal collateral models and be prepared to explain any differences to counterparties that might use different models. LCH Clearnet and CME have outlined different compensation mechanisms to neutralise value transfers from the switch. Firms need to understand if these mechanisms are compatible with internal processes and systems.

Lastly, existing fair value and cash flow hedges will be massively affected by the change. Hedge effectiveness might diminish because of discrepancy in fallback rates for hedging and hedged items or credit spread differentials. Timing differences in the ARR adoption for different markets or the renegotiation of cash and hedging products will also impact hedge effectiveness. This is a complex area and it will require collaboration across departments to mitigate the risks and develop a robust action plan.

Recommended actions:

  • Analyse your books to identify (L)ibor-linked positions maturing after 2021.
  • Calculate potential value transfer for these positions.
  • Understand timelines and changes to margining and discounting by clearing houses.
  • Take a decision within investment teams or risk departments which (L)ibor instruments should still be allowed to be traded prior to cessation.
  • Review existing fair value and cash flow hedges and their documentation.

3. Legal documentation

Impacted legal documents can be grouped into four classes:

  1. Documentation such as product prospectus or marketing documentation for issuances which might need regulatory approval.
  2. Contract documentation such as derivative master agreements, confirmations or collateral and clearing agreements which govern the different instruments or determine the rate that is used for calculating interest on collateral.
  3. Loan and mortgage contracts with incorporated floating rate interest rate payments.
  4. Documentation regarding cash and saving accounts or overdraft facilities.

Changes to these legal documents / contracts might follow a market standardised process such as the Isda-agreements where Isda might provide a protocol solution. Other documents might need a client consensus, regulatory approval or bi-lateral negotiations. At many firms, the number of documents that need to be reviewed, categorised, updated, and reviewed can easily be in the thousands or even ten thousands. To make this exercise more manageable and operationally efficient, firms should consider new technologies like Artificial Intelligence (AI) and Natural Language Processing (NLP) to support them. The gigantic re-papering exercises under Mifid II have shown that these tools can add significant value.

To avoid legal risks, firms need to develop a strategy specifically for Libor/Euribor transactions in the next two years, where both benchmarks will still be available, and need to make sure that appropriate fallbacks are defined, as for example recently published by the Alternative Reference Rates Committee (ARRC) working group (WG) or Isda for different (L)ibors.

The process for implementing new fallbacks in any of the mentioned contracts will most likely follow a two-step approach. At first, the mechanism needs to be implemented, which gives one or both sides or an agent the right to change the floating rate, once the reference rate is permanently ceased, based upon a trigger event. In a second step, both sides need to agree on the concrete fallback depending on the linked reference rate, which will be developed in the months to come and might be implemented centrally (eg by Isda), but which needs to be done bilaterally for loan / mortgage contracts. Various working groups have set out principles and recommendations with regards to the process as well as on the construction of legal wording around fallbacks (eg European Central Bank (ECB) Working Group, ARRC WG).

Recommended actions:

  • Analyse contracts such as prospectus, derivative agreements, or loan/mortgage contracts to understand (L)ibor impact arising from benchmarks, valuation specific clauses, or optionalities leading to a floating rate contract.
  • Create an inventory of your trading/derivative/repo agreements.
  • Take a decision on adherence to Isda benchmark supplements and potential protocols to come.

4. Communication

Many parties and stakeholders need to be considered: it is not only clients and counterparties but all participants within their wider network, i.e. their clients, their counterparties, solution providers, IT providers, regulators, associations, as well as their internal and external stakeholders. This requires a good communication strategy and training of everyone who has touchpoints with the participants in the wider network of the organisation.

Gaining interest by regulators is now seen across every market and lately also from ECB in the EU. For more information on regulatory requests outside the EU and timelines, see Appendix 2.

Recommended actions:

  • Set up an enterprise-wide “Ibor transition office” to centralise internal and external communication and to coordinate activities across different business teams including risk and operations.
  • Train all client-facing staff in order to prepare the client outreach and feedback cycle.
  • Ensure active participation within industry working groups and consultations.
  • Reach out to your vendors as well as partners to align time plan.

5. Operations and technology

The impact on operations and IT infrastructure will depend on individual firms’ current setup, eg the degree of outsourcing and automation, but significant changes should certainly be anticipated. These relate to T+1 settlement of ARRs, new instruments, and migration of legacy contracts.

  1. Change of fixing time to T+1   

Overnight rates from ARRs are available one day later than currently. The operational platform needs to be adapted in order to embrace the T+1 settlement of the rates and subsequent calculation of interest payments. The data flow will change, thus impacting fixing cycles of contracts and collaterals as well as payment and report generation.

Recommended actions:

  • Analyse impact on operations due to changes in fixing date and time of new ARRs such as €STR compared to Eonia.
  • A holistic change management approach including business process impact assessment related to eg risk and portfolio management.
  • Special attention should be given to classical failure points such as handovers between parallel or co-existing systems, where customised flows may need adjustments.
  1. New instruments based on ARR

Operational challenges may arise from the introduction of new ARR instruments such as Sofr/€STR swaps and futures or Sofr & €STR FRN’s. The term rates needed in these instruments are typically constructed by compounding of the relevant ARR, and fixing-in-arrears will be more common across all products. In addition, a suspension period will be a common feature in the coupon calculation of FRNs.

Individual yield curve constructors, such as eg swaps, deposits, and futures will need to be adapted to include the new structures and the calibration algorithms needed to accommodate these. Specific examples are futures on ARR terms as well as swaps with fixing-in-arrears. The operational platform must be sufficiently flexible to include these anticipated changes and be prepared to include the instruments and market standards that will emerge within the next two years.

Recommended actions:

  • Sell-side firms must validate that their platform is sufficiently flexible to manage the trades, securities, and derivatives structures that are emerging as market standards, including new calculation methods for accrued interest and adjusted valuation and risk models.
  • Engage with platform vendors and internal teams to understand required changes and limitations in existing platforms.
  1. Exchange of compensation payments for legacy contracts

(L)ibor contracts with long-dated maturities will need to be converted into ARR contracts. The first FRN has been converted from Libor to Sonia, but the process seem challenging for FRNs in general since all bond partners need to accept the new terms. Seen from that perspective, the process is simpler for OTC contracts, since these are inherently bilateral during Q4/2019 and ISDA is expected to issue guidance on the protocol for contract migration. The over-the-counter (OTC) contracts can be migrated into an ARR by addition of an adjustment spread with the purpose of minimising the value impact. The adjustment spread is to be published daily by an independent organisation.  

The change of terms for existing legacy instruments will lead to the exchange of compensation payments and will follow a negotiation process or market actions, such as triggered by clearing houses. These changes need to be anticipated, compensation amounts need to be pre-calculated, settled and booked correctly to avoid impacts on accounting and valuation as well as risk measures.

It is pertinent that the operational platform supports the complex conversion of a legacy position into the new position structure. Equally important, this technical conversion needs to be done without impacting income by realising P/L, while also allowing for a one-off payment that compensates for the value transfer.

See Appendix 3 for examples of new market standard instruments and the expected migration process.

Recommended actions:

  • Analyse impact on operations front-to-back when introducing new RFR products and when re-structuring existing portfolio of instruments incl. change of valuation, risk, operations, confirmations, accounting, tax, and legal.
  • Follow the new product approval process for the new RFR products to make sure that all departments are aware of the characteristics of the new RFR products.

Open questions and expected developments
By now market participants have more clarity on the timing of the expected cessation for different (L)ibor rates, the successor ARR rates (see Appendix 1), and expected fallback mechanism on derivative agreements and accounting standards.

However, some key questions are not fully answered and need to be carefully considered, both at firm  and at industry level, for example:

  • How will term structures be developed and how quickly will markets gain liquidity in the new ARR rates to start the transition?
  • The transitioning of derivative contracts to ARR will require exchange of adjustment payments amounting to millions of €. How can banks ensure that they provide sufficient transparency to their counterparties to mitigate litigation risk?
  • Many legal documents, eg product agreements, instrument term sheets, or collateral agreements among others refer to Ibors and need to be updated. How can this process be structured and executed cost-efficiently and with minimal legal risk?
  • New derivative instruments are emerging that reference ARRs, rather than Ibors. What changes to product guidelines and risk governance are required so that they can be traded?
  • At the same time, these new instruments and the transitioning of existing contracts have tremendous impact across most operational systems. Is this change reflected appropriately in the project backlog for operational teams? Have sufficient resources been allocated?

Regulators across the world are getting more and more interested in understanding industry progress as well as the firms’ readiness for the (L)ibor reform. It is crucial that firms can demonstrate executive ownership and a tangible action plan to address the firm-specific implications of the reform as well as  understand the risks involved in the transition.

Appendix 1: Ibor working groups

Appendix 2: Communication - regulatory requests and timelines

 

Appendix 3: Examples of new market standard instruments and the expected migration process

The table below provides a few examples of expected new market standard instruments and the expected migration process.

 

Market change

Migration of long-maturity contracts

Legacy instrument

Reference rate

Target instrument

Expected process

Interest rate swap on Euribor

Unchanged, as Euribor continues

Same

No migration required

Interest rate swap on EUR-Libor

€STR compounded

Interest rate swap with fixing in arrears and third party spread

Migrate without P/L impact

Interest rate swap on USD-Libor

Sofr compounded

Interest rate swap with fixing in arrears and third party spread

Migrate without P/L impact

Overnight index swap denoted in EUR

€STR replaces Eonia

Overnight index swap on €STR

Migrate without P/L impact

Total return swap; funding leg refers to USD-Libor

Funding leg refers to Sofr compounded

Funding leg has fixing in arrears and third party spread

Migrate without P/L impact

Swaption on CHF-Libor

Underlying swap refers to Swiss Average Over Night (Saron) compounded

Underlying swap has fixing in arrears and third party spread

Migrate without P/L impact

Sterling future

Sonia future

None

Close position

Cap/floor

Unclear

None

Close position

Forward Rate Agreement (FRA)

Unclear

None

Close position

Floating rate note

Reference to ARR

Unclear

Unclear

Loans

Reference to ARR

Unclear

Unclear

Alternative investments

Reference to ARR

Unclear

Unclear

 

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