Scroll

Insights and News /

10 June 2019

LIBOR Transition… SONIA yet SOFR to go!

Lexi Whomersley

Lexi Whomersley
Consultant | Capital markets | London

Lucine Tatulian

Lucine Tatulian
Partner | Financial services | London

Background

The rate often described as the “world’s most important number” is set to disappear post 2021. In 2017 the FCA announced that banks would no longer be compelled to submit LIBOR data, effectively announcing its demise. LIBOR, the average rate at which large banks lend to each other, is currently referenced in ~$400trn contracts and has been the standard benchmark in highly complex financial instruments, to student loans, for decades. LIBOR’s fall has been a long time coming, as the rate is not derived from actual transactions, which leaves it open to manipulation - as witnessed by the much publicised rigging scandal.

Approach

When structuring a programme, the number of workstreams required is dependent on the organisation’s size, scale and geographic footprint. In general we see a varying degree of programme maturity, with three broad themes:

  1. Hybridised Programmes – strong central team to guide strategy, with execution federated to business functions
  2. Central accountable executive - usually CFO, Treasurer, CRO or COO with strong support from Front Office teams
  3. Financial uncertainty – on total cost for transition and impact on the balance sheet.

Given the 2021 deadline and several industry unknowns, it is tempting to kick the issue into the long grass, however, given the complexity of the transition, and increasing liquidity in products referencing alternative reference rates prior to 2021, this would be unwise. A high level exposure assessment should have been completed and an in depth analysis and transition planning should now be underway.

Impacts

The impact is likely to be multi-faceted and firms must be flexible in response to market developments. The transition goes beyond being an administrative change, as proposed alternative rates are structurally different. Currently, alternative rates are overnight so do not have the term structure found in LIBOR. Moreover, credit spreads are either non-existent or not comparable to that in LIBOR.  The switch is, therefore, unlikely to be an easy one-for-one, potentially creating “winners” and “losers”, and leading to conduct issues. This also gives rise to operational challenges of updating IT systems, differences in calculating coupon payments and is restricting liquidity in certain products (e.g. Loans). As the method of calculation is different, product valuation changes are likely to impact key Risk and Finance metrics, controls and data requirements. Given these holistic changes, firms will face increased regulatory scrutiny and potential PnL volatility.

Legal and Compliance Teams will play a key role. A large number of contracts that reference LIBOR extend beyond 2021. Renegotiation is likely to be costly and resource intensive, and more importantly may create financial gain for one party, leading to conduct risk and future litigation. Compounding this issue is that fact that fallback provisions in contracts are mostly inadequate, and do not often envisage a situation where LIBOR is permanently discontinued.

Firms face a number of risks in the transition and we recommend taking a proactive approach in tackling them. An increasingly common theme is looking at technology to help mitigate these challenges.                            

Recommendations

We recommend setting up a hybrid programme with strong central leadership, which allows business divisions to take responsibility for the transition. Monitoring industry developments is important to ensure latest thinking is reflected in transition planning. Firms should start with the no regret activities, and make sure the problem is not getting bigger (i.e. conduct risk mitigation and improved fallback on new trades). The impact of the transition cannot be underestimated – firms must start planning now for life beyond LIBOR.

Click on the below link to download our placemat overview: