By Vox FP Regulatory Consultants Megan Beukelman and Rosanna McAleese
The COVID-19 pandemic presents a challenging environment for the financial industry and its much-anticipated regulatory reforms, including the IBOR transition. Already a complex reform to navigate, the pandemic has introduced additional questions and uncertainties institutions are working overtime to address. Here, we explain how the IBOR transition came to be, how COVID-19 has impacted the planned shift and how institutions should be preparing.
The LIBOR Scandal
Once the gold standard for short-term interest rates, LIBOR came under fire in 2012 when investigators in the US, UK and European Union found banks had been manipulating LIBOR rates to generate profits all the way back to 2003. During the financial crisis, banks who set the LIBOR rate (known as “Panel Banks”) were found to have submitted “unrealistically optimistic” rates, artificially lowering the rate often 20 to 30 basis points below where it should have been. Ultimately, the LIBOR scandal cost the financial industry billions and created a PR firestorm for the offending financial institutions. (To learn more about the LIBOR scandal, see this piece by The Guardian).
Underlying Issues of LIBOR
Beyond the financial impact, the investigations brought to light many of LIBOR’s underlying issues.
The first was its lack of objective regulation. The Panel Banks who submitted their rates each day were the ones most directly impacted by them. While the British Bankers’ Association (BBA) calculated and published the daily rate, they had little disciplinary power over the Panel Banks. As Liam Vaughan and Gavin Finch explain in their book The Fix: How Bankers Lied, Cheated and Colluded to Rig the World’s Most Important Number (excerpted in the The Guardian), “The big flaw in LIBOR was that it relied on banks to tell the truth but encouraged them to lie.”
In response, the Financial Conduct Authority (FCA) shifted regulation of the index from the BBA to the Intercontinental Exchange Benchmark Administration (IBA).
Second, LIBOR relied on a stable and healthy unsecured interbank market. The 2012 Wheatley Review and 2014 Financial Stability Board (FSB) report found that as banks shifted away from bankrolling their operations through unsecured debt markets, the credibility of LIBOR was weakened. Without sufficient underlying transaction data, LIBOR submissions must rely on expert judgement which in turn can heighten the risk of benchmark manipulation.
This has meant Panel Banks are in the difficult position where they are “providing submissions based on judgement, with little actual borrowing activity against which to validate those judgements”, and as a result the FCA has had to spend a lot of time persuading Panel Banks to continue to submit to LIBOR.
The IBOR Transition
In 2017, the FCA first announced that banks would not be compelled to submit to LIBOR after 2021, at which point LIBOR may cease to exist—either from immediate cessation or reduced participation of Panel Banks making the rate unrepresentative. In a speech delivered by Andrew Bailey, Chief Executive of the FCA, he declared “While we have given our full support to encouraging panel banks to continue to contribute and maintaining LIBOR over recent years, we do not think markets can rely on LIBOR continuing to be available indefinitely. Work must therefore begin in earnest on planning transition to alternative reference rates that are based firmly on transactions. Panel bank support for current LIBOR until end-2021 will enable a transition that can be planned and can be executed smoothly. The planning and the transition must now begin.”
This statement led to the IBOR transition.
The IBOR transition is an enormous and complicated undertaking meant to create a more reliable and sustainable short-term interest rate and create consistency across the global economy. The process involves reforming certain benchmarks and replacing others, with various jurisdictions, working groups, products, and replacement rates all at very different stages of development, whilst attempting to prioritize alignment.
In the US and UK, IBORs may be phased out and replaced with risk free rates (RFRs), which are being developed on a currency-by-currency basis. These new rates are based on historical transaction data (vs. banks’ subjective views on their value) thereby conceptually making them more reliable and true to market value. However, the difference between how RFRs and IBORs are calculated creates an enormous operational challenge for institutions and markets around the world.
In the UK, a Bank of England working group selected Sterling Overnight Index Average (SONIA) and in the US, the Alternative Reference Rates Committee created the Secured Overnight Financing Rate (SOFR) as their respective RFR rates. In the UK, because SONIA was the existing GBP Overnight Index Swap benchmark there is already a larger volume of liquidity within these transactions, whereas in the US where their rate was created, building liquidity and take up has been a major focus for their transition.
The Impact of COVID-19
At the time of writing, there have been several announcements of delays to interim IBOR milestones, such as the six month extension for UK LIBOR loan end-date to March 2021 and the 5-week delay for the CCP transition to EuroSTR discounting. If we take the UK loan market as an example, the already identifiable reluctance towards increasing the pace of the LIBOR transition is only set to multiple given the competing priorities and increased uncertainty that COVID-19 is provoking.
On 25 March 2020, the FCA, Bank of England and Members of the Working on Sterling Risk-Free Rates released a joint statement reiterating that while some interim milestones may be impacted, the end timeline for LIBOR remains unchanged. They stated “the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet. The transition from LIBOR remains an essential task that will strengthen the global financial system. Many preparations for transition will be able to continue. There has, however, been an impact on the timing of some aspects of the transition programmes of many firms”.
Despite these announcements, there have been ongoing questions in the market about the likelihood of further delays, with some viewing these statements as an interim strategy used by regulators to keep the urgency. The prioritization of the LIBOR Transition is not only now competing with the more urgent priorities banks face, but we must also consider how this economic uncertainty is likely to impact the development of RFRs. Given key business areas required for the transition are now at the heart of the current crisis, only time will tell as to the true impact COVID-19 will have on the end transition timeline.
How Institutions Should Be Preparing for the IBOR Transition
While the recent announcements provide some short-term relief on IBOR milestones, it’s critical that institutions big and small continue to prioritize their response to the transition. Unless informed otherwise by regulatory bodies, market participants should continue internal preparations under the assumption that the existence of LIBOR cannot be relied upon after 2021.
Industry groups have suggested that impacted institutions may prepare for such a transition by establishing a clear IBOR transition plan — from quantification of exposure, product offering, documentation remediation, system and process changes, and consideration of the potential legal, tax, regulatory and related reporting implications associated with the transition.
With regard to document remediation, the approach institutions take may differ depending on the product and existing fallback language – in some circumstances a proactive transition to RFRs may be best achieved by replacing or amending the LIBOR contract with an RFR contract, whereas in others it could be best achieved through fallback regulatory initiatives. To this end, institutions should also be focused on building liquidity for new and existing RFR markets and monitoring the links and development between RFR and products.
Finally, institutions should be keeping up to date and, where possible, contributing to key industry consultations in relation to the benchmark transition and, in addition to understanding their own needs, anticipating the changing needs of their clients in order to effectively prepare them for the transition.
If you have any questions on how the IBOR transition will impact your business or are looking for an automated solution for bulk repapering and other IBOR-related document management needs, you can drop us a line here.