How the transition will change global finance
Trillions of dollars of debt and derivatives products are likely to continue referencing IBOR after 2021, but IBORs and ARRs are different.
The transition from IBORs to ARRs will impact the global financial system in two critical ways:
- There’s the challenge of legacy contracts. While firms are pivoting away from IBORs, trillions of dollars of debt and derivatives products will continue to reference the index after the 2021 deadline.
- ARRs and IBORs are distinctly different. No ARR will be equivalent to the related IBOR because of structural differences between the two. IBOR underpins unsecured and uncollateralized debt and continues to rely on a good deal of expert judgment. ARRs are based on actual overnight transactions and secured by collateral.
This variation between IBORs and ARRs means that the risk profile and valuation of trillions of dollars of financial contracts will likely change once they’re benchmarked by ARRs. To mitigate the uncertainty, firms will need to determine the appropriate spreads to be applied to ARRs ahead of the transition, requiring the recalibration of a wide range of financial and risk models.
This transition will demand a significant transformational effort from both financial services firms and market participants with extensive exposure, bringing a number of challenges along the way.
Understanding the challenges of IBOR transition
Much remains uncertain, but stakeholder inaction risks aggravating the issues facing firms as they move to ARRs.
A lack of preparation could trigger market volatility. EY has mapped out the 10 most critical issues likely faced by firms transitioning to ARRs:
1. Regulatory uncertainty
Regulators see the transition to ARR as a voluntary, industry-led initiative. The lack of definitive regulatory guidance on the IBOR transition may slow down progress as banks deem “wait and watch” to be the most prudent strategy. This inaction may further aggravate the situation due to a build-up of more legacy contracts inventory for future transition.
2. Operations and technology upgrades
IBOR is extensively embedded in business and operational processes, pricing and risk models, data models, and applications. For example, Funds Transfer Pricing processes at banks commonly use LIBOR as the base rate. Firms will need to identify references to an IBOR across the entire organization, including identification and assessment of transition impact on processes, models and applications.
3. Recalibration of models
IBORs are used as a proxy for general interest rate risk and discount factor in valuation, financial modelling and risk modeling. As such, a wide range of models will need to be redeveloped, recalibrated and revalidated as a result of transition to ARR. The lack of a historical sequence and asymmetry in the timing of transition across products and linked contracts may result in additional risk for firms.
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.
Making sure you’re ready for the transition
While many firms are concerned about IBOR exposure, few have begun planning for 2021.
The extensive use of IBORs in financial markets will make the transition to ARR a significant enterprise-wide transformation. And, while 2021 may seem far away, banks need to mobilize their transition efforts now, elevating this topic to the board and executive management.
So far, all indications show that impacted stakeholders remain unprepared and the upfront planning that such a complex transition requires has yet to happen.
In a global survey conducted in June 2018 by the International Swaps and Derivatives Association (pdf) (ISDA), 87% of respondents said they were concerned about their institutions’ IBOR exposure. But just 11% confirmed they had actually started allocating budgets to the transition, and only 12% had begun developing a preliminary project plan.
This wait-and-see approach carries huge risk – because how well firms navigate this milestone will have a lot to do with their level of upfront preparation.
To help you prepare for the new post-IBOR world, we have identified several steps that can smooth the IBOR transition.
IBOR is being phased out by the end of 2021 in favor of alternate reference rates (ARR). Many stakeholders remain unprepared for the change and need to mobilize their transition efforts now.