4. Lagging liquidity
Market adoption and liquidity in ARR derivatives will be milestones for the transition plan. However, as the transition timing for cash products is likely to lag derivatives, the demand for ARR derivatives to hedge the potential interest rate risk embedded in loans and other cash products will also be delayed. Equally ARRs do not currently qualify as an eligible benchmark rate for hedge accounting, which may dampen the demand for ARR derivatives in the short term.
5. Renegotiation of existing contracts
For long-date contracts, firms may need to renegotiate contract language to transition from IBOR to ARR. Unlike derivatives, which will be addressed in bulk through updates to standard contract language (protocol), cash products for corporate and retail end-users have limited standardization, or protocol. In addition, firms will need to update the fallback language for all contracts to address the potential risk of IBOR discontinuation.
6. Dispute resolution
The transition to ARR may require renegotiating the spread due to the differences between LIBOR and ARR, such as credit and term premiums. If a bank comes up with its own approach for redefining the spread for its variable-rate instruments, the counterparties may find themselves on the losing end of the transition – which could lead to legal challenges and reputation damage.
7. Lack of global coordination
Instead of using a similar rate for both legs of an FX swap, as is the case with IBOR, different ARRs will be used for each leg of a transaction. That reality could result in a number of challenges in cross-currency swap markets. Further, the lack of harmonization in transition timing to ARR or in the timing of publication of daily ARRs across the major currencies will likely fuel additional challenges.
8. New accounting guidance
The Financial Accounting Standards Board (FASB) recently issued guidance on derivative and hedging transactions, and there are proposed amendments to ASC 815 that will add SOFR as a benchmark; similar guidance will be required in other jurisdictions. Banks will need to ensure that the ARR-linked instruments, contracts and derivatives poised to replace IBOR-linked contracts are recognized as eligible hedges under the accounting rules.
9. Lack of term rates
Most ARRs, initially, will solely be an overnight rate, which means that term rates will need to be calibrated based on transactions in the derivatives market. To facilitate the timely and smooth transition of cash products, the definition of term rates for ARR needs to be accelerated.
10. An unclear future
Some regulators, benchmark administrators, and market participants have hinted at the possibility of IBOR being available for selected currencies and tenors beyond 2021. The lack of clarity on the future of IBOR is a key hurdle in the rapid mobilization of transition activities and may also lead to fragmentation of liquidity in derivatives due to multiple reference rates.