IBOR Reform: A Well-rested Goliath

May 30, 2019

by Michael Gorman, Global Head, Regulatory & Compliance Practice

Making preparations for 2019 – 2020

1.  A Sleeping Giant no more

IBOR reform is not new. It has been on most firms’ radar for the past few years. And, although some market participants have well-established programmes in place, others are just starting to organise themselves and realise that 658 days is not ample time to undertake the complex and broad changes the reform will require. IBOR reform is a sleeping giant—one that is starting to stir, stretch its arms, and yawn to a waking readiness. Pretty soon, most firms will find themselves facing a wide-awake, well-rested Goliath clad in armour.

How big? For perspective, consider this infographic that JP Morgan included in a January 2019 white paper; the graphic illustrates Goliath’s size ($200 trillion, or roughly 20 times the US GDP) and reach (retail to bonds to cash markets to derivatives to, well, practically everything with interest element):

The problem with LIBOR

As you well know, size is only part of the challenge. Diversity of and linkage among financial products with embedded IBORs presents eye-watering difficulty.

Hedging is one example. Take certain cash products linked with derivatives used to hedge FX or interest rate exposure under them. Because cash products and derivatives, as product classes, are transitioning away from IBORs at different paces, it is entirely possible that a cash product and a related derivative transition to Risk Free Rates (RFRs) at different times, creating basis risk that could cast doubt on using hedge accounting, which could impact P&L volatility. The FCA has acknowledged as much. And, the IASB has issued proposed amendments to the IFRS standards to allow hedge accounting to continue during any transition.

2.  A Call to Preparation

Scaremongering is not the point. Awareness and a spur to action are. The FCA’s chief executive, Andrew Bailey, noted that the ‘biggest obstacle to a smooth transition is inertia – a hope that LIBOR will continue, or that work on transition can be delayed or ignored.’[1] For their part, global regulators have attempted to nudge preparations along.

The joint PRA-FCA ‘Dear CEO’ letter (September 2018) requested ‘a board-approved summary of [ ] firms’ assessment of key risks relating to LIBOR discontinuation and details of actions [they] plan to take to mitigate those risks.’ FINMA, the Swiss regulator, issued a self-assessment questionnaire (February 2019) that asked basic questions related to: governance, impact assessment, new products & financial instruments, and education, client outreach & communication. The Hong Kong Monetary Authority’s letter (March 2019) requested its regulated entities begin similar preparations. Early in May 2019, ASIC, the Australian regulator, joined its brethren in issuing a short, pointed letter to its regulated, requesting similar preparation.

Whatever the form or length of outreach, the regulatory fraternity seems clear in its message: IBORs will lose their dominance so how are you, the regulated, going to transition away from them? In other words, how are you going to beat Goliath? For certain, the industry will require more than a stone and a slingshot…

3.  Heeding the Call and Facing the challenge

Despite inherent differences, all firms can approach the IBOR transition from a common framework, using broad themes to triage areas of highest impact and coordinate an appropriate response to face the challenge. That framework is not mystical or proprietary. It is an intuitive, common-sense set of guidelines that allows one to delve into operational and commercial complexity sensibly and responsibly.

The themes are:

  • Programme governance;
  • IBOR exposure by product (initial and rolling);
  • IBOR impact by function;
  • New products; and,
  • Client outreach and communication.

A few words about each below.

3.1   Programme Governance

The past five years of market structural reform has given the industry two important governance lessons:

  • First, regulatory reform projects rarely come in on, or under, the estimated budget. The increased spend isn’t because of under-estimation. It is more often linked to a mad dash towards a project’s finish when a firm needs additional external resources with a corresponding premium on price. (Remember the insanity of December 2017?) Plan accordingly and identify external partners that can flex up and down as needed to support the programme.
  • Second, targeted collaboration with external providers works better than a wholesale delegation of programme responsibilities. Firms are relying more and more on their internal SMEs and staff (business and operations), whom external consultants then support. External vendor deployments are smaller and more strategic, aimed at accelerating execution rather than leading it. It comes down to the high intrinsic value of knowledge in a firm’s own staff to implement a regulatory change and to be accountable for it in the future.

It bears thinking of these both when planning IBOR transition programmes at the start of and during execution.

3.2   IBOR Exposure by Product

While most firms have done an initial exposure analysis, many are confronting the more important challenge: measuring exposure on a rolling basis. Collating multiple products across multiple divisions is not easy. As we all know, most firms have as many core banking systems as they have products. These systems are siloed and likely incompatible, making timely updates to an initial exposure analysis more challenging and more manual. There’s no uniform solution here, only a fair warning to develop a process so that executive sponsors, programme management and the business can understand how exposure is changing over the next two years.

3.3   IBOR Impact by Function

There’s nothing revolutionary here. As with past market structural reforms (like Dodd-Frank, MiFID II, Margin Reform, etc.), firms are well-placed to inventory the functions across the business lifecycle that would be implicated. For IBOR reform, it is practically all, which makes cross-functional communication and responsibility so important. That impact, as we know, will be both operational (processes and workflow) and technical (IT systems), triaged based on the initial (and rolling) exposure analysis.

3.4   New Products

A smooth transition will be the product of intricate, connected parts moving harmoniously. Fresh debt instruments using the new RFRs needs to be issued; swaps and futures markets need to grow; and, new, robust contractual language for new and legacy transactions needs drafting. Many commentators have discussed the markets for new products utilising RFRs, the underlying challenges in calculating the new rates and associated elements of issuance. They are imminently more qualified to comment on these matters and contribute to the market’s evolution from IBORs to RFRs. I could only add that it should be an interesting landscape to witness as new products across all asset classes are issued (as they have been in some assets classes).

3.5   Client Outreach and Communication

To date, firms have been able to rely on a piece of legislation or an agency rule as the basis for contacting a client (a sensitive undertaking) and requesting a change in that customer’s relationship to the firm. The IBOR transition is different because no legal mandate exists. IBORs are supposed to suffer a passive death in that the FCA will no longer compel banks’ submission post-2021. It may seem like an academic point, but it will become more practical when drafting a ‘IBOR Disclosure’ to your commercial clients, or an initial form letter for mortgage holders, or the host of other communication to clients of all levels of sophistication and product use.

To understand the difficulty here, consider how each type of client would respond to the following statements of fact:

  • Certain interest rate benchmarks are subject to ongoing international and other regulatory guidance and proposals for reform.
  • It is not yet certain how any alternative benchmark will be calculated or applied to financial products. However, it may be necessary to determine or agree a successor reference rate or risk-free rate.
  • Please note that compiling bodies, sponsors and administrators of IBORs, contributing banks on the relevant IBOR panel, reference banks providing IBOR quotations pursuant to interest rate setting or fallback provisions or otherwise, and developers of alternative reference rates (including their participants) have no obligation to consider your interests in calculating, adjusting, converting, revising, discontinuing or developing any IBOR, alternative reference rates or fallbacks or in any of their submissions or quotations.

One foresees multiple drafts of multiple forms for these sorts of disclosures to align the require messaging across all levels of sophistication and across all divisions within a firm. It is no easy task and should be discussed this year. I would note that some firms are starting to issue notice publicly to their clients.

4.  Final Thoughts…

As challenging as the IBORs transition will be in size and scope, the framework to face it is familiar given the years of regulatory reform in the industry. So, unlike for David, Goliath’s is not the industry’s first giant. Careful planning, the right tools and the right partners to support execution and acceleration will best this giant.

[1] Andrew Bailey, “Interest rate benchmark reform: transition to a world without LIBOR”, Speech (Bloomberg London, 12 July 2018), available at www.fca.org.uk (last visited 28 May 2019).