Treliant Industry Insights
June 21, 2018
Graham A.D. Broyd
Note: This is the second in a continuing series on the upcoming transition in LIBOR, one of the world’s most widely used interest rate benchmarks. Read Part I here.
We wrote in March about the fact that US Dollar LIBOR, the interest rate benchmark for $350 trillion of debt and derivatives contracts, is going to be replaced by a new benchmark—SOFR, starting as early as 2019. We have had a lot of dialogue since then with readers of that article.
Those who found the article helpful fall broadly into two categories. The first group now has these issues intellectually on its radar screen and has probing, but conceptual, questions about certain aspects of LIBOR’s removal from the marketplace and how it will impact bank businesses or functions. The second group will have some degree of direct responsibility for managing the impact of the replacement LIBOR benchmark and will be tasked with managing that change process. This article addresses some of the issues of the second group.
We would suggest two key starting blocks.
- Attempt to identify where you have contracts that have a link to USD LIBOR—an obvious starting point could be the International Swaps and Derivatives Association (ISDA) documentation representing your interest swap activity with clients, and
- Establish a schedule noting the many stages at which LIBOR will be replaced by SOFR, in chronological order, perhaps starting with the scheduled change in centrally cleared derivatives margin at the Chicago Mercantile Exchange (CME) in the first quarter of 2019.
We would add, from experience, that the time is coming to find an experienced project manager, who critically can understand or connect to all parts of the bank and its many varied businesses, functions, and jurisdictions. It would also be helpful if they could manage massive, multidimensional spreadsheets!
The global financial system’s move away from the London Interbank Offered Rate (LIBOR) to a new standard will have far-reaching impact—not just on short-term, interbank lending, which is LIBOR’s mainstay, but also affecting mortgage banks, credit card issuers, corporate lenders, traders in interest rate derivatives and futures, and others. Nearly all financial services companies have debt linked to LIBOR, which is embedded as a reference rate in trillions of dollars’ worth of outstanding contracts.
The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve and with representatives from the major participant banks, industry utilities, and client sectors, announced in June 2017 that LIBOR will be replaced by a broad Treasuries “repo” financing rate, the Secured Overnight Financing Rate (SOFR), reflecting the cost of banks borrowing cash secured against U.S. Treasuries.
Where are the Pain Points?
My experience on the ARRC, which initially included representatives of the most active interest rate trading banks in the market, was that every bank representative had a different series of priority issues and a different understanding of where their LIBOR transition pain points would be. Traders would worry about secured versus unsecured risk; operations representatives would be concerned about margin and collateral impact; lawyers would worry about clients’ documented agreements; sales managers would be concerned about explaining the changes to clients.
Discussions we have had in the broader marketplace have evidenced even wider feedback on what these changes will mean. Some people remember LIBOR only as an instrument that was allegedly manipulated by traders 10 years ago; others know it is as the reference rate for their student loans; some recognize the word as it impacts their credit card repayment rate; and many are aware that it is what their personal mortgage interest rate resets against every year.
It is all of the above, of course. Below is a table to understand where these contracts are, as defined by certain product and business types. This can be a great starting point for reviewing activities across your organization and starting to get a sense of how many pieces you will have to pull together.
For a project manager, one of the most difficult aspects of this work will be reaching out and coordinating across multiple and very distinct business divisions, to extract and confirm data, and to ensure coherent standards and practices when implementing the change program.
Where are the Surprises?
Three additional issues to consider when starting to build out a change program.
- Hidden Risk. The interest rate “reset” linked to LIBOR may be embedded in a product or in a term sheet, so this may not be immediately evident as LIBOR risk. Simple loan and swap contracts with LIBOR- based quarterly resets should be getting reported up to the bank’s treasury division and down to the desk that is currently handling money market or short-term interest rate risk on an ongoing basis. Some contracts will have a conditional or options-based trigger clause that will convert into a LIBOR-linked interest rate contract. These are not always easy to identify. Structured products are a key area for extra vigilance. There may be products that trigger into interest rate risk and interest rate resets under certain sets of conditions, such as equity price moves and commodity price moves—or a significant rise in short- term interest rates. These may not readily be identified as LIBOR risk.
- Overseas Exposure. There will be US Dollar LIBOR contracts outside of the U.S. Many international contracts will have reset risk against US Dollar interest rates, and some of them may not be documented or booked in the U.S. This is commonplace for loan activity in businesses in the Asia-Pacific region, and also in any activity linked to energy and natural resources businesses worldwide.
- LIBOR Holdovers. Some LIBOR contracts will remain in place for an extensive time period. A 30-year residential mortgage—entered into in the last two years and with annual interest rate adjustments tied to the LIBOR rate—is one example where it is quite possible that the change to SOFR may not be forced onto the client for many years. Such mortgages could remain linked to LIBOR or to the new “LIBOR plus” being rolled out by the Intercontinental Exchange (ICE), depending on a myriad of legal, client- facing, operational, and regulatory developments. Regulators have made it clear that LIBOR will go away, but some banks may have to retain the capability to manage some degree of LIBOR risk in parallel to SOFR risk for many years.
How Much to Budget?
The last requirement we will flag, in this part of our ongoing LIBOR series, is budgeting. Since the financial crisis, banks have been accustomed to having to fund “regulatory required” projects. These have been driven either by enforcement actions, in such areas as mortgage lending, anti-money laundering, foreign exchange, and sales practices. Or, they have been required by new regulations with scheduled delivery dates, such as Basel capital rules, the Dodd- Frank Act, the Volcker Rule, the Markets in Financial Instruments Directive (MiFID II), or Europe’s General Data Protection Regulation. These projects have been expensive and time- and resource-consuming.
This LIBOR change management project is neither the product of regulation nor enforcement, but it presents similar risks. Failing to get ahead of this issue could subject a bank to significant client confusion and backlash, as well as sudden and painful operational, legal, and risk management events caused by lack of preparation. We recognize there will be gasps of despair as banks plan for the costs of managing this multiyear transition. We would encourage everyone, however, to consider an early understanding and identification of the extent of the issue for your bank as a good starting point.
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