Our new report on the LIBOR transition argues that while banks with large LIBOR-based exposures have used the time since the FCA’s announcement in 2017 to assess their exposure, develop transition plans, and begin moving certain new transactions to Risk Free Rates (RFRs), additional risks and complexities have emerged.
Progress has been held back by uncertainties around where and whether term RFRs or alternative credit sensitive benchmarks will be available. Smaller banks with less exposure appear to be planning to rely predominantly on the existing fallback clauses in contracts to bring about the transition away from LIBOR – an approach which regulators have explicitly advised against.
Activity now needs to shift from fallbacks to new product development and transition, and the speed of change needs to accelerate sharply to meet the 2021 deadline. This requires action by both market participants and regulators to avoid a major market disruption.
Actions that need to take place to accelerate the LIBOR transition
Regulators should remove disincentives for market participants to switch from LIBOR-based to RFR-based Derivatives, including increased initial margin requirements for entering new RFR-based trades (particularly if existing trades were grandfathered), tax liabilities from realising gains, and potentially adverse accounting effects.
They should also clarify whether or not credit sensitive benchmarks are a realistic alternative to LIBOR and RFRs – banks would understandably prefer to use a credit sensitive rate for lending and the hope that this will be possible is holding back development of products based on RFRs.
Banks should develop loan products based on RFRs. In the near-term, backward looking RFRs are the only available option and adjustments to interest observation periods may be required to give advance visibility on cashflows and mitigate systems. If and when term RFRs – or even credit sensitive rates – are established, products using these rates could be added to allow customers (and banks) to choose. But banks cannot afford to wait due to the lead time to transition legacy contracts.
Preparations for transition of legacy transactions should also begin. Different impacts across different products within a single customer relationship will require integrated data and analytics and a consistent playbook for re-negotiation, which will take time to develop due to the complexity of bank systems and organisations.
Central Counterparty Clearing Houses (CCPs)
CCPs should accelerate the shift to SOFR discounting and PAI on cleared derivatives to reduce dependency on Fed Funds and increase demand for – and liquidity of – SOFR swaps.
Benchmark administrators should accelerate development and publication of term RFRs, coordinating trading platforms and liquidity providers to secure access to the required derivatives or futures input data.
In addition, the risk of wasted effort and investment, particularly by banks in developing RFR-based loans, needs to be seen in the context of the bigger operational and financial risks of LIBOR being discontinued before the industry has transitioned.
The above actions will have to happen in parallel if the mammoth task of transitioning away from LIBOR is to be completed by the end of 2021. Further delays raise the risk of a market-wide dislocation, as well as economic, conduct and operational impacts for individual market participants.
The Emerging Risks Of Replacing LIBOR
While there is uncertainty, and progress has been slow, banks and industry groups are continuing to work to prepare for a transition from LIBOR. As these efforts progress, there are a series of new emerging risks which have not been sufficiently addressed to date which will need to be urgently looked at.
LIBOR Risk 1: Over-Reliance On Fallback Clauses
Some market participants are planning to rely on updated fallback clauses to transition from LIBOR when it becomes unavailable. This creates major operational risk, from needing to process new and different fallback formulae, to needing to calculate new interest payments, valuations, margin and collateral requirements for tens or hundreds of thousands of contracts on a single day.
LIBOR Risk 2: Inconsistency In Fallback Terms And Triggers Threatens Risk Management Integrity
While current fallback language in contracts is inadequate because it may result in unintended consequences (e.g. floating rate notes fallback to the last LIBOR fixing and thus effectively become fixed rate notes), it is at least reasonably consistent in terms of the fallback trigger (i.e. the non-publication of LIBOR) and the actual fallback rate itself within each asset class.
While new fallback language being developed by ISDA and other industry bodies is a positive step forward, differences in fallback language for sub-sets of transactions could result in increased basis risk.
LIBOR Risk 3: Conduct Risk And Data Complexity In The Repapering Process
Negotiations to “re-paper” existing transactions will be challenging. Banks require a complete view of their exposures to each customer/counterparty and the estimated economic impact of transition across products and currencies, including the differences in fallback terms. This is particularly challenging when products are booked across different businesses and will require significant lead time.
To mitigate the conduct risks of transition, banks will need to develop standardised treatments, decision trees and playbooks with appropriate governance to ensure a defensible position when selecting replacement rates. A fragmented approach could negatively impact customer relationship and lead to reputational damage, economic loss, conduct fines or legal action.
LIBOR Risk 4: Impact On Earnings Of Using A Risk-Free Rate For Lending
With so many variables still unknown, most banks have not yet begun to formally and quantitatively analyse the economic, balance sheet, and P&L impact of various transition scenarios, nor analyse the potential impact of future stress scenarios once the industry has transitioned to RFR-based products.
More information on LIBOR transition
For more information on replacing LIBOR download the full report or contact a member of our LIBOR transition team.