Two key structural differences distinguish ARRs from IBORs. First is the nearly risk-free nature of ARRs, for example the US dollar-denominated Secured Overnight Financing Rate (SOFR) or the Swiss franc-denominated Swiss Average Overnight Rate (SARON), whereas IBORS are based on unsecured lending - they include bank credit spread premiums that are not included in ARRs. Second, IBORs are quoted for multiple defined tenors, while the proposed ARRs currently are quoted primarily for overnight tenors. These key structural differences will drive ARR-IBOR basis risk, which firms will need to measure and manage. For ARRs based on secured rates, differences in market liquidity and the supply-and-demand dynamics for underlying collateral in the repurchase agreement market may also contribute to ARR-IBOR basis risk.
These differences may cause market value to be transferred if IBOR rates are discontinued and firms transition existing IBOR transactions simply by selecting an ARR in its current form as a new reference or “fallback” rate.
To manage this risk, firms will need to gauge the appropriate spreads to apply to ARRs to mitigate significant potential value transfer, and the associated legal and reputational risks. While determining appropriate spreads to ARRs remains a work in progress, the launch of some ARR-based underlying futures and the evolution of the ARR swaps market will help market participants with pricing through market-implied basis spreads between ARRs and IBORs.
Firms preparing to trade new cash and derivatives products referencing ARRs should act immediately to implement front-to-back processes to capture and confirm trades, perform margin calculations and settlements, as well as curve construction and pricing. To manage ARR risk and its basis to IBORs, firms also will need to determine historical market data proxies in the absence of full empirical information. Such market data may be used for several risk models, including those for value-at-risk, counterparty exposure measurements (such as potential future exposures or valuation adjustments), risk-based margins, asset-liability management (ALM), and stress testing.
Desk mandates should be reviewed and updated, calibrating position limits appropriately to reflect the market depth of new reference rate products. New practices may need to be implemented to monitor the overall interest rate derivatives’ market liquidity risk associated with longer-dated exposures where market depth may shift across benchmarks. As ARR markets evolve, they will be used by central counterparties to calculate interest paid on posted variation margin and to discount swap cash-flows. This will require firms to update their corresponding discount factor curves.
The potential exists for IBORs to be discontinued and derivatives’ liquidity to move to other benchmarks. As a result, firms will need to reassess their ALM hedging strategies and limits to manage the possible increased basis risk arising from asymmetry in bank credit spreads or tenor resets in asset, liability and hedge products. Similarly, if IBORs are discontinued, firms may have to monitor potential contingent asset-liability basis risk when the fallback language in certain legacy cash products differs from that in derivatives hedging instruments.
Even if IBORs are not discontinued, firms will have to manage valuation risk by actively monitoring the liquidity of longer-dated legacy positions linked to IBORs. They also will need to consider whether valuation adjustments appropriately reflect bid-ask spreads and the extent to which firms are able to exit such positions.
To fully understand the broad implications for valuation and risk management infrastructures, it will be crucial for firms to assess their model inventory for all IBORs across the enterprise. This will make it easier to understand how the relevant IBORs are used not only for interest rate derivative products but other areas such as commercial lending, mortgages, ALM, and funds transfer pricing. Having as much lead time as possible will enable firms to plan for the significant amount of work required to modify, develop or validate models in the new ARR environment. Implementation must be completed before the end of 2021, when panel banks will no longer be compelled to make IBOR submissions.
This article was originally published in Risk.Net.