Since our previous blogs late last year, regulators, central banks and industry bodies have all been busy, updating the market around key developments, challenges and requirements, and even providing a handy implementation checklist for the IBOR – RFR transition. There’s no excuse for market participants to delay.
Why the urgency? Let’s start with what we know right now:
- Although certain IBOR currencies will stay for the foreseeable future, if not longer (such as EONIA/Euribor), the move away from IBOR is happening and all market participants must start planning now, or risk missing the 2021 deadline and facing additional costs.
- Many major IBOR currencies have chosen their new RFR, with many also creating new contracts referencing the new RFR benchmark (SONIA and SOFR being perfect examples).
- Although industry bodies are working together, the cash and derivatives markets are not yet synchronized, with some key differences around cessations triggers and backward versus forward looking calculations. That increases the potential for unwanted issues such as basis risk.
- Contracts in IBOR continue to be created in larger notionals than in the new RFRs, due to a lack of liquidity and term structure across newly created RFRs.
- Fall-back language and calculation methodologies have been drafted, with industry input. Indeed some products already have final recommended contractual fall back language, including ARRC for USD FRNs and syndicated loans, with business loans and securitisations following quickly. The finalisation of fall-back language across products and supporting calculations (such as compounding methodologies) looks imminent. But although the fallback ISDA language introduces an obligation to switch out of IBOR, as soon as IBOR is not permissible, no such obligation exists for instruments which derivatives are supposed to hedge, such as bonds or loans. Left untreated these could create serious headaches.
- CEO letters have been drafted by supervisors to all large and significant financial institutions of leading countries transitioning to a new RFR (including the UK, US and Europe), along with checklists and requests for transition plan progress updates. Senior managers responsible for implementing the transition programme have been nominated, thereby making them accountable.
This continuous release of information and preparing for early transition should give firms more control over their future in a new post-IBOR environment. Every financial institution should now have a starting point to from which to kick-start their IBOR transition programme. Although each will face different levels of complexity, the development of a plan highlighting the key areas impacted across the institution and the sequencing of these tasks should have already begun.
Many financial institutions are no doubt starting to analyse their exposure to IBOR by product, currency and tenor (for trading). But they need to go further. It’s vital they understand their full exposure, not just on derivatives, but across all products carried in the bank’s book and across all processes: risk, finance, operations, legal and technology.
Take loans for example. Although less complex than derivatives, loans face significant infrastructure and client impact issues. Why?
- Cash management systems do not benefit from the constant investment in transformation which benefit more exciting derivatives business. As a result infrastructure tends to be more outdated, creating challenges around adjoining systems, workflows and people.
- Then you have the added dimension of dealing with less sophisticated investors, who may not understand the changes caused by the IBOR transition.
- These two aspects alone will take time, money and effort to address.
Even for derivatives, the technology teams which support sales and trading platforms need to brace for reconfiguration and re-tooling requirements on a broad portfolio of inter-dependent and inter-connected systems, given that front-to-back trade flows these days mean that these transition requirements will extend well beyond pricing and deal capture functionality.
And even if financial institutions are well advanced in their planning, we would still strongly encourage them to engage with their systems providers and the infrastructures they rely on (including utility providers). Many changes will have multiple dependencies, firm-wide: it’s vital to understand exactly what is changing and when.
Banks in particular should also focus on their clients’ needs and their obligations towards those clients. Their pivotal position in financial markets meant that banks were the first companies targeted. It makes sense that they should now take the lead: they have a major role to play in helping customers get to grips with the impact that transition will have on their business.
Lastly, for other market participants, the biggest burden may inevitably fall on the smaller accounts and large community of wealth and asset managers who lack the bandwidth and expertise to make the switch, and the experience to deliver such a complex programme as IBOR transition. This will undoubtedly require a continuous level of communication, collaboration and education from consultants, technology vendors and the banks themselves.
What does all this mean? In a nutshell, the bulk of the preparatory work should be happening now.
While the unknowns may provide a case for holding back on preparations, there are more than enough knowns for financial institutions to act now. Anyone holding out in the hope of a term rate and the finalisation of fall-back languages, risks falling behind on vital planning and execution.
If that wasn’t enough incentive, good liquidity in IBOR markets today means that participants can reduce their dealing cost of closing out, if the liquidity in alternative RFRs allows a straight transition out of IBOR exposures. Firms which are considering waiting until the last minute, are potentially increasing the risk that any liquidity in IBOR may not be sustained, which will ultimately lead to additional costs for late movers. Timing is critical to manage the switch.
Catch up with Davies’s previous articles here:
