LIBOR Replacement: Operational Considerations

Traders Magazine Online News, November 13, 2019

Joseph Giunta

What we know about LIBOR replacement today:

LIBOR is expected to be discontinued after 2021 as a result of regulators pushing participants to move away from what has been an industry benchmark for over 50 years. Today, LIBOR is thinly traded and calculated based on the contributing banks’ expert judgment as compared to alternative rates (such as SOFR in the U.S. and SONIA in the U.K.) that are representative of transactions in the marketplace. During the financial crisis, it was discovered that banks were falsely inflating or deflating LIBOR so as to boost profits on trades or to give the impression of a stronger credit standing.

Most financial institutions and many corporations are now faced with detailed contract reviews to determine the contractual fallback rate, as well as planning the operational transition away from LIBOR.

What is LIBOR exactly?

The London Interbank Offered Rate (LIBOR) is the daily rate that banks estimate it would cost to borrow from another bank. These estimates are submitted to ICE (Intercontinental Exchange), and then averaged to arrive at the LIBOR.

LIBOR is calculated in 5 different currencies: USD, GBP, EUR, CHF and JPY. It’s used as a benchmark for lending and derivative transactions across the globe. The British Bankers Association estimates that LIBOR appears on over one million trading screens around the globe, while the ICE Benchmark Administration states that LIBOR is referenced by an estimated US $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years. According to AARC, $200 trillion of these financial contracts reference USD LIBOR including debt obligations such as mortgage loans and corporate loans.

LIBOR Transition and Operational Considerations:

Financial institutions have a vast amount of work to do in adapting to the changing environment, considering factors like risk management, accounting, contracts, and operational processes. In some cases, organizations are approaching this solely as an exercise in repapering legal contracts. The transition to a LIBOR alternative rate will have significant operational implications on an organization’s infrastructure.

What this means to you:

Governance

Have you given thought as to how you will organize to manage the transition? What are the different workstreams? Is your team a cross-functional one? What’s the impact to people, processes and technology? Do you have a roadmap for replacement? Have you determined an alternative rate to LIBOR?

Legal

Do you have an inventory of contracts? How will you prioritize these contracts for the LIBOR transition? What type of fallback language will be used for new contracts? Has the firm agreed to standards around counterparty negotiations?

Risk Management

What’s the impact on risk and pricing models? How will operational processes and hedging strategies be affected?

Finance and Accounting

What type of impact will the transition to a new rate have on your processes? Do you need to update controls? What will the economic impact be on valuations, hedging, taxes? What type of disclosures will you need to make? What impact will the LIBOR replacement have on your capital, liquidity and funding costs?

Operations & Technology

LIBOR is deeply embedded across much of financial services. The transition to a new rate will result in a number of systems changes and operational processes across trading, clearance, settlement, internal and third-party pricing, accounting, reference data, and risk management models.

Have you given ample consideration to different characteristics of the replacement rate?  How will you acquire, maintain and distribute this information?  What database modifications will be required? Are your operations and technology processes capable of managing LIBOR, along with the new replacement rate and their related products concurrently?

Are there timing differences for rate acquisition? Have you sequenced its distribution across your infrastructure?  Once received, do you have a place to store the new data? How will you manage historical data? Do you have controls in place ensuring the accuracy and distribution of this information?

Communications

How will you communicate to internal and external stakeholders (customers, regulators, shareholders, debt holders)? What’s the mechanism for keeping employees informed as to standards, policies and parameters for contract negotiations?

The areas of focus mentioned in this article are indicative, but not all-inclusive. No two firms are alike, and depending on your business, some of these areas may require different levels of effort. Given the scale, complexity and resource requirements, inaction or inappropriate planning can be costly both from an economic and reputational perspective. Regulators are extremely focused on this transition. For example, Fed officials have stated that they intend to assess banks’ LIBOR transition as part of their examination process.

One thing is certain: 2021 is around the corner. If you haven’t started putting together your transition plan, or if you’re not making the necessary progress, it’s time to get moving.

Key Terms:

SOFR: (Secured Overnight Financing Rate) is a measure of the cost of borrowing USD overnight collateralized by Treasury securities. The benchmark is transaction-based. It’s published daily and administered by the Federal Reserve Bank of NY.

SONIA: (Sterling Overnight Index Average) is based on actual transactions, as it’s calculated by taking the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions. The rate is published daily and administered by the Bank of England

LIBOR: (London Interbank Offered Rate) is the average benchmark rate that some of the world’s leading banks charge each other for short-term loans. It also serves as the rate to calculate interest payments on various other loans throughout the world.

ARRC: (Alternative Reference Rate Committee) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate.

 

Joseph Giunta is a PArtner at New Bridge Consulting Group

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