Libor, the interest rate that reflects the general cost of unsecured borrowings by large banks, is the world’s most widely used benchmark rate. It is used in millions of contracts with an estimated gross notional of $370trn and is referenced by a wide range of financial products, from exotic derivatives to retail loans by all participants in financial services including investment banks, asset managers, commercial banks, and exchanges.
However, the use of Libor has been on a decline due to a variety of reasons including sharply reduced interbank short-term borrowing and preference for rates that are directly observed in the market and based on borrowings secured by collateral. Regulators in all major financial centers, with the exception of Europe, have already started publishing alternate reference rates, such as SOFR in the US, Sonia in the UK, Saron in Switzerland and Tonar in Japan. Finally, UK’s Financial Conduct Authority (FCA) announced, in the summer of 2017, that it will no longer require banks in Libor panel to submit rates required to calculate Libor after 2021. These developments have cast serious doubts on the ability of Libor to continue to be the reference rate of choice and financial institutions are setting up task forces to deal with the impending loss of this benchmark in the financial services industry.
Implications for financial institutions
As the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing Libor. Further, while Libor provides a benchmark for unsecured term structure, proposed alternative reference rates are overnight with some based on secured borrowings and others on unsecured loans. Differences in credit risk and term structure will change the economics and therefore impact financial institution’s market risk profile. Thus, the transition from Libor to alternative reference rates will require changes to risk models, valuation tools, product design, and hedging strategies, including accounting for the related hedges.
Contracts referencing Libor and not due to expire soon will leave firms at risk of substantial exposure. Most contracts have fallback provisions – covenants reflecting unavailability of Libor. If the period of unavailability is brief, as envisaged when the contracts were drafted, the resulting losses and gains are manageable. If fallback terms are used for the remaining life of the contract, the financial impact is likely to be significant, with winners and losers on either side of the contracts.
There are other challenges that Libor transition will bring for financial institutions. There is uncertainty about the timing of migration as most likely different transition timelines in different geographies will mean firms will need to build capabilities to support Libor and ARRs in parallel, further complicating an already complex problem. Lastly, the process of contract renegotiation and product redesign will be different for different asset classes and currencies. For certain asset classes, industry protocols (as in ISDA) may emerge quicker than highly bespoke commercial loans. Reliable alternative reference rates for different currencies are expected to be available at different times. This would require migration approaches and timing will vary by a combination of asset class and currency, making the overall process complex and expose firms to significant risk.
A four step roadmap for transition
To solve any problem one must fully understand it. As simple as this may sound, this seems to be an issue with many business managers. While they know that unavailability of Libor will have a wide impact, many do not know where to start. We believe they should start by estimating its impact. That will include, firstly, an assessment of their exposure to Libor. This assessment should ideally be done by products, by geography and, by business lines. Secondly, institutions need to re-evaluate the effectiveness of hedges and their accounting treatment under an ARR regime. And lastly, they need to review their contract where fall back provisions do not provide adequate protection, and calculate associated gains or losses.
Contracts referencing US dollar Libor that are expected to remain active beyond 2021 are estimated to have a notional value of over $30trn. Contracts referencing non-USD Libor will be an additional similar amount if not more. Hence repapering of a massive number of contracts is a given. This will be a good opportunity for the institutions to move away from emails to a digital platform in order to fast-track the contract negotiation process. Advances in natural language processing allow extraction of key terms with limited human involvement. While outsourcing is an obvious option, AI can help reduce cost and improve capacity which will be critical as demand for repapering picks up.
Every contract referencing Libor will need to be reviewed to assess how its economics change under ARR, followed by assessing financial impact and then defining new terms to achieve an equivalent economic impact. The difficult part would be communicating the changes to the client. Lack of regulatory protocols, such changed in contracts may lead to protracted and expensive negotiations.
Lastly, there will be a front to back impact on an institution's technology infrastructure. This will include building new reference data feeds and distribution mechanism, an update of valuation models, review and remediation of controls, set up program management to manage this transition, to name a few.
Essentially, Libor is unlikely to continue to remain the reference rate of choice, leading financial institutions to migrate to alternative reference rates. Migration from Libor to ARRs is going to be, long, complex and expensive. Institutions need to start early, beginning with an assessment of the impact, reviewing their contracts and plan for repapering where necessary; redesign products, update valuation models, review controls and lastly setup appropriate change programs to execute the transition.