The LIBOR transition and the great reset for Financial Markets

Banks, regulators, insurers and financial market participants across the board are preparing for the phase-out of LIBOR (London interbank offered rate) by end-2021. LIBOR has been the most commonly used and popular benchmark rate for short-term funding for 40+ years. Its cessation in slightly over a year’s time is being compared to the Y2K moment for global financial markets, requiring massive adjustments while also presenting enormous challenges. Morgan Stanley uses the analogy of world salt supply running out, thereby requiring chefs to recalibrate countless recipes using the new replacement with different usage while still continuing to run their restaurants, to describe the impending LIBOR transition. With current estimates pointing to $200 Tn - $300 Tn in financial contracts referenced to LIBOR, the analogy aptly brings the gravity of the situation to the fore.

Why the sunset?

LIBOR rate setting uses primitive methodology drawing on daily submission of funding rates by a group of panel banks, after which they are averaged, adjusted and released. Secondly, the sample size of panel banks has declined significantly following the 2008 financial crisis. Currently between 11 and 16, this isn’t big enough to make a representative sample for financial markets that have grown both in size and complexity over the past decade. Third and perhaps the most important catalyst was provided by LIBOR manipulation by the colluding banks during 2008 crisis that resulted in complete loss of market confidence alongside hefty fines being slapped on 10+ global financial institutions.

What are the replacements?

The efforts to find suitable replacement for LIBOR has been underway for the past few years, however there isn’t a single uniform global reference rate that has been worked out yet. The determination of alternative reference rate (ARR) is going to be a country-level exercise with individual countries introducing local currency denominated rates. For USD-denominated loans and securities, the Federal Reserve has recommended Secured Overnight Funding Rate (SOFR) which is based on US treasury transactions data. UK’s proposed new risk-free rate is Sterling Overnight Interbank Average Rate (SONIA), Japan’s will be Tokyo Overnight Average (TONA), Switzerland’s Swiss Average Overnight (SARON) among others. SOFR however is expected to supplant USD LIBOR as the dominant global benchmark rate.

Why the migration presents a challenge?

The ARRs are structurally different from LIBOR, making it the crux of the challenge in transition. The key differences arise on five counts:

1. LIBOR is based partially on transaction data and partially on expert judgement, making it subjective. Whereas SOFR (or other ARRs) relies entirely on actual transaction data

2. LIBOR underpins unsecured and uncollateralized debt as against SOFR which is secured with treasuries as collateral

3. LIBOR is bank-to-bank commercial lending rate and includes credit risk; SOFR is a risk-free rate as it is based on Treasury

4. LIBOR has a term structure of interest rates with seven different maturities ranging from overnight to one year. SOFR in contrast is purely a daily/overnight rate

5. LIBOR reflects bank’s expected cost of capital and is forward-looking; SOFR is historical rate based on observable transactions only

What are the challenges?

The transition to risk-free rates and the ensuing resets demands significant transformational efforts requiring massive adjustments to technology platforms, business processes and workflows, financial and risk models among others. The challenges presented are manifold described as under:

1. Operational: At an operational level, legacy contracts and new long-dated contracts (especially derivatives) with maturity beyond 2021 continue to reference LIBOR. These would require renegotiation to approve changes in reference rate and/or incorporating fallback provisions, in the event of continued use of LIBOR beyond its cessation. Secondly, as ARRs represent daily rates, defining term structure becomes difficult and ambiguous, which might increase borrower risks by potentially converting a floating rate loan tied to LIBOR into a fixed-rate one. Third, financial and risk models will need to be recalibrated to assess appropriate spreads to be applied to ARRs, which might consequently result in significant changes in risk profiles and valuation of contracts.

2. Technological: Technology platforms, business applications, contract management and loan pricing systems – both in-house and external, will all have to be revamped and overhauled to reflect the new methodology, workflow and model associated with ARRs.

3. Legal: Despite best efforts to renegotiate on free & fair basis, if counterparties find themselves on the losing end, it could lead to lawsuits and long-drawn court proceedings requiring banks to expend additional time, effort and costs on dispute resolution.

4. Financial: Above all, the costs for adapting systems and educating/training functional teams and business units on the merits of ARRs over LIBOR appear substantial. As per Oliver Wyman estimates, 14 of the top global banks expect to spend over $1.2 Bn on LIBOR transition. Given that number, it isn’t hard to imagine that costs for the entire financial services industry could be several multiples of that sum.

Can AI/ML help?

That said, not everything looks gloomy. A number of emerging technology solutions leveraging AI and automation promise to simplify some of the transition challenges and speed up the re-adjustment process. Applica, a data science startup, for example offers AI-enabled text comprehension platform that contextually interprets and classifies reference rate provisions and fallback clause content with minimal human interaction. Enterprise software firm Volody’s LIBOR transition solution systematically reads all contracts, determines clauses requiring changes and auto-creates addendum, thereby speeding up contract discovery, amendment and execution while Synechron’s solution enables banks to identify and quantify LIBOR exposure both at a contract level and in aggregate, while speeding up the review process 30X.

The final onus, however rests on all market participants to ensure an orderly and smooth transition. With financial markets just in early stage of recovery following the turmoil caused by the global pandemic outbreak, the LIBOR transition is going to place further stress on resources and efforts. More so as the transition period seems to be lining up with the pandemic time frame, and will likely test the industry resilience and preparedness for a post-LIBOR landscape.