What’s in a name? From LIBOR to SONIA?
Arguably, one number matters more than any other in the world of finance. It is the basis for huge corporate loans and it underpins nearly $200 trillion of derivative contracts. However, it looks to be on its way out and The City isn’t quite sure how to replace it.
The number in question is LIBOR – the London Interbank Offered Rate – an array of interest rates set daily by a group of banks. They are never linked to actual transactions, instead providing indicative rates. Significantly reduced volumes of unsecured term borrowing between banks, which is the basis for LIBOR, has called into question its ability to continue playing a central role.
It was notoriously at the centre of rate-rigging scandals following the economic crisis in 2008, resulting in jail time for a number of traders and billions of dollars of fines for many financial . This lesson has prompted a change in the way rates are set, moving away from what was essentially a group of banks being asked a theoretical, somewhat irrational question: “What interest rate would you have to pay to borrow money from other banks?” to a more structured and governed approach.
What and who is impacted?
All market participants with products using LIBOR as the underlying reference rate for their pricing will be impacted by this change. This extends across each of the LIBOR currency regions: USD, GBP, EUR, CHF, and JPY. Front office products, operations policies, risk and finance pricing and product management are among the impacted areas of banks. Markets are all responding differently to the transition, due to significant reduction in liquidity within interbank funding markets preventing products being priced.
What are the alternatives?
A number of institutional working are considering methodologies for supporting various structures for alternative Risk Free Rates (RFRs), of which there are three broad options for consideration at this stage:
- A complete transition: Moving away from LIBOR could create considerable conduct, reputational and legal risk2. Where existing contracts with clients run into 2022, additional work will be required to review and amend documentation and confirm suitable replacements depending on the outcome of a market-led solution.
For new contracts agreed before 2022, consideration will need to be given to ensuring that appropriate clauses and fall-back provisions are included in documentation in the absence of specific replacement rates, adding to the administrative burden.
The UK’s potential replacement, SONIA (Sterling Overnight Index Average), has already come under scrutiny as it is backward-looking, whereas borrowers and lenders/investors require cash flow certainty that can only be provided via a forward-looking measure. This has driven a demand in the market for the creation of forward-looking, risk-free rates for terms that match typical interest periods under loans, providing certainty for borrowers and avoiding administrative burdens for lenders.
- LIBOR prevails: At no point has the BoE or FCA suggested LIBOR must be replaced. Although a transition is strongly encouraged, there is the possibility of LIBOR continuing in some fashion beyond 2021. This could come in various forms, including limiting the number of currencies included in the benchmark. However, even if LIBOR continues, market pressure to progress to new rates is increasing, especially for small or mid-sized financial products currently linked to . This is because the single most important qualification for the adoption of RFRs is liquidity. In that regard, a successful transition away from LIBOR would necessitate a sufficient level of liquidity for financial products, a potential issue for smaller, less liquid financial products.
- A middle ground: Part of the problem with LIBOR stemmed from the lack of actual transactions tied to the interest rate, as banks would estimate what it would cost them to borrow from one another. Tightening the controls and governance around this could be sufficient in regaining the confidence in LIBOR, provided there is collaboration between governments and the industry. Tokyo and Europe have adopted this hybrid approach through stipulating additional governance on requirements through the way in which rates are set, while also applying RFRs.
Regardless of the degree of transition, the move away from key reference rates to successor rates poses major challenges to financial institutions. The robust management of these challenges and the implementation of the future rates are closely linked to – and dependent upon – the set-up of a well-orchestrated change project. Such a project should look to include the :
- Business impact assessment – create an inventory of LIBOR impacted products to determine areas of prioritisation
- RFR modelling feasibility – review how a new modelling approach would impact business areas
- New model approach – define new operating model policies, procedures, models and methodologies
- New model adoption – define a transformation adoption roadmap, and manage transition across business operations, risk, finance, treasury, legal and technology
- Back book model adoption – define back book pricing methodology and transition, whilst managing migration to the new model
- Stress test against the new rate – banks will need to consider stress testing against the new rates; this will form a fundamental part of the transition
The extent of the impact on financial institutions of transition will depend on a range of factors such as the rate referenced, the adjustment defined by various industry working groups, the date by when the changes will take effect and the nature of the product or service. The benchmark is used throughout the entire financial system, therefore to put this transition into context, bankers have compared it to preparing computers for the new millennium, or the launch of the Euro. Not only does it determine borrowing costs and the prices of many derivatives, it is important in accounting and risk management; not to mention the logistical challenge.
Amidst these unknowns, what is certain is that the pace of change is picking up, largely driven by and industry working groups. As such, transitioning from LIBOR should be rapidly moving up the management agenda across the industry.
1 Andrew Bailey, Chief Executive, FCA
2 Changing the World’s Most Important Number, Oliver Wyman