LIBOR Transition

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Are you ready for the LIBOR transition?

LIBOR is considered one of the most widely used and important interest rates in finance, upon which trillions of dollars rest. Its expected phaseout after 2021 could result in massive business and market disruptions for companies, auditors and other market participants, unless mitigating action is taken.

  • The London Interbank Offered Rate (Libor) has survived since 1986. It is widely used as a reference rate for financial contracts and as a benchmark to gauge funding costs and investment returns for a broad range of financial products, including loans, mortgages, credit cards, and interest rate derivatives. In addition, variations in the “spread” between LIBOR and other benchmarks indirectly act as a key indicator of changing investor sentiment in global financial markets.
  • However, after courting controversy during the 2008 financial crisis, Libor is set to be phased out and replaced by alternative reference rates (ARRs) from the end 2021.
  • Libor’s much-discussed end will lead to significant impacts for banks, corporate clients and governments as products referencing it become less available. The move to ARRs is fast becoming one of the hottest financial services topics.

News of LIBOR’s downfall came several years after the LIBOR scandal—an event peaking in 2008 in which a number of financial institutions were accused of fixing LIBOR rates. Banks were found to have reported artificially low or high interest rates for profit. Naturally, this suggested to the banking industry that LIBOR was neither reliable nor sustainable. As a result, regulators around the world ramped up their supervision of benchmarks and decided to replace LIBOR with alternative reference rates that are more representative of the market and are harder to manipulate

Navigating the LIBOR transition

  • If you haven’t done so already, you should begin identifying existing contracts that extend beyond 2021, such as financial instruments, credit agreements, and customer, vendor and employee agreements, so that you can evaluate their exposure to LIBOR. Some legacy contracts will likely contain contingency language that’s triggered if LIBOR becomes unavailable. However, unavailability and complete withdrawal aren’t the same, and in many cases, legacy contracts contain interest rate provisions tied to LIBOR that, when drafted, didn’t envision its permanent phaseout, leading to potential uncertainty in contract interpretation. And then there are circumstances where the contract interpretation is clear, but the adjustment may not be in line with parties’ expectations, like in the case of a variable-rate loan changing to a benchmark rate that is considerably higher or the language allowing for a change in reference rate but not a change in the spread over the reference rate. Resolving these types of issues can be very time-consuming, which is why you can’t afford to be passive.
  • What follows are some of the concerns that you ought to consider as you try to grasp and ease the risks related to the LIBOR transition:
  • Whether you have, or are exposed to, any contracts referencing LIBOR that extend beyond 2021 and if so, the effect of the discontinuation of LIBOR on your operations for each of those contracts.
  • Whether actions need to be taken to mitigate risks in the case of contracts with no fallback language for when LIBOR is unavailable or in the case of contracts with fallback language that doesn’t contemplate the expected phaseout of LIBOR, such as renegotiating with counterparties to address contractual uncertainty.
  • The alternative reference rate that might replace LIBOR in existing contracts; whether there are fundamental differences between that alternative reference rate and LIBOR that could impact profitability or costs; and whether the alternative reference rate needs to be adjusted to maintain the expected economic terms of existing contracts.
  • The effect of the discontinuation of LIBOR on a company’s hedging strategy in the case of derivative contracts referencing LIBOR that are used to hedge floating-rate investments or obligations.
  • Whether use of an alternative reference rate introduces new risks and if so, the actions to be taken to mitigate those risks.

Five key risks and mitigating actions

Following the FCA’s call that market participants should treat the withdrawal of Libor as definite, Deloitte’s Steve Farrell, Mark Cankett and Ed Moorby outline five of the key risks that firms are facing and some actions that might mitigate them.

Risk One Global Divergence Risk

  • The RFRs for the five Libor-based currencies (USD, GBP, CHF, EUR and JPY) have been agreed and live (with the exception of the EUR rate) for some time. However, their suitability and use for new ‘front book’ financial products, along with the replacement of historic ‘back book’ financial products, is still not clear. There is debate about development of a term structure, how fallback calculations for derivative products may impact and the legal and regulatory practicalities of transitioning Libor-linked products held by retail customers. Some market participants are therefore considering ‘alternatives to the alternatives’ (ie, alternative rates to the RFRs, which may address some of these issues). This could give rise to increased market segmentation and a wider range of benchmarks coming into use across the financial system. Divergence creates an additional layer of complexity for firms. Firms will have to contend with assessing risk, developing scenarios and planning for change, across a multitude of differing rates, which may vary by geography, customer type and product.

Action

  • Firms should participate in the debate across all key working groups, track divergence and create strategic solutions to identified risks. Firms should also ensure their progress in the issuance or take-up of RFR-linked products does not stall because of the ongoing debate.

Risk Two New Product Development

  • Regulators are keen on market adoption of the RFRs. The transition away from Libor therefore requires the adoption of appropriate fallbacks in legacy contracts, as well as the issuance of new contracts that refer to RFRs. As above, market participants have started to issue RFR-linked products for both cash and derivatives, but the picture is varied depending on currency and geography.

Action

  • Firms should continue to educate and build awareness across the market around the transition. Look at commercial opportunities, the design of new products, as well as the operational elements to support them.

Risk Three Conduct and Legal Risk

  • The conduct and legal risk in respect of Libor transition is significant. This links to a fundamental point that Libor continues to be used in both existing and new contracts despite clear messages that it will be discontinued. Moreover, many market participants acknowledge that a ‘PV neutral’ transition, while perhaps theoretically possible, will be difficult to achieve in practice.

Action

  • Firms should establish governance that captures consideration of these risks and promotes accountability. They should focus on awareness building for: 
  • client-facing teams. 
  • support staff to ensure that everyone has an understanding of the transition and is aware of how the firm wishes to engage its customers.
  • legal teams so that the fallback language in contracts, as well as the documentation of new products and decision-making around their development and sale is appropriate. 
  • Externally, the focus will be on raising awareness with customers and being clear on the messages that firms can give today.

Risk Four Programme Risk

  • Firms in the UK have been asked to provide a comprehensive assessment of the risks arising from transition. But there is the risk that the increased awareness of senior executives is not necessarily translating into the speed and level of activity needed to prepare firms to launch new RFR products and be ready to transition their back books.

Action

  • Programme leads continuously need to educate staff, raise the significant risks that arise from not acting now and challenge the board to make key decisions, such as agreeing dates for ceasing to issue Libor products. Effective governance should help ensure the central team responds to the needs of regional teams where local challenges may be different. Firms should ensure the responsibility and accountability are clearly assigned to senior managers.

Risk Five Impact of Existing Regulatory Requirement

  • There are many risks associated with the end-to-end operating model of firms. Some of the key areas in which existing regulatory requirements may affect transition and create challenges include:
  • Customer communications and outreach: regulatory requirements regarding pre-sale product disclosures (for example, under MiFID II) require careful consideration in the context of transition. In addition, firms should also consider best execution requirements.
  • Model risk management: regulatory requirements supporting change management (eg, material changes), testing and model validation require consideration and will drive a significant body of work for firms.
  • Capital and liquidity reporting: an area of recent scrutiny in the market, it will be important for firms to establish the knock on impact of risk measurement on the as yet unaudited capital reporting requirements.
  • Financial reporting: while hedge accounting considerations are the primary concern, broader financial reporting requirements, including risk disclosures, financial instrument measurement and recognition/ derecognition, are still key.