How will you respond to IBOR transition?

Transcription

1 How will you respond to IBOR transition? July 2018Q4 201

2 Fall back language is an essential safety net a seatbelt in case of a crash when LIBOR reaches the end of the road. But fall backs are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt. Andrew Bailey Chief Executive of the Financial Conduct Authority, 12 July How will you respond to IBOR transition?

3 Background Interbank offered rates (IBORs) play a critical role in global financial markets, acting as reference rates for cash products and derivative contracts held by a wide array of market participants and worth hundreds of trillions of dollars in notional value across currencies. Australian firms, buy-side and sell-side alike, have strong ties to these global benchmarks via offshore funding. Equally, derivative contracts referencing these global benchmarks play a critical role in the hedging strategy for a significant number of Australian corporates. There are a number of factors that have necessitated a fundamental review of the reliability and robustness of IBORs since the global financial crisis. Liquidity has significantly reduced within interbank unsecured funding markets, driven by the introduction of short-term wholesale funding rules, money market reforms, as well as Basel liquidity rules requiring banks to be longer funded. IBOR panel banks are increasingly reluctant to submit quotes based on judgement rather than underlying transactions. Charges of IBOR manipulation have further stoked concerns around systemic risks related to the maintenance of these key financial benchmarks. Led by the Financial Stability Board (FSB) Official Sector Steering Group (OSSG), regulators and industry bodies have accordingly undertaken a series of initiatives to restore confidence in major interest rate benchmarks. This has resulted in a drive to select alternate nearly risk-free reference rates (ARRs) conforming to the benchmark principles put forward by the International Organization of Securities Commissions (IOSCO). 1 These efforts and concerns about the ongoing viability of IBORs were justified in July 2017, when the UK s Financial Conduct Authority (FCA) announced that it would no longer persuade or compel banks to make London Interbank Offered Rate (LIBOR) submissions from the end of Global regulators have since highlighted the urgency of financial markets transitioning to ARRs, and have signaled their intention to supervise this process by ensuring that market participants understand their IBOR exposures and have made commensurate efforts to address the associated risks. Firms will need to be able to demonstrate to FCA supervisors and their PRA counterparts that they have plans in place to mitigate the risks, and to reduce dependencies on LIBOR. Andrew Bailey Chief Executive of the Financial Conduct Authority 12 July 2018 At its core, the problem we face today is that the financial system has built a tremendously large edifice on a structurally impaired foundation. William C. Dudley President of the Federal Reserve Bank of New York, 24 May Principles for Financial Benchmarks, July 2013, International Organization of Securities Commissions (IOSCO) How will you respond to IBOR transition? 3

4 Current state of play To respond to the IBOR transition challenge, industry working groups have been established in all key IBOR jurisdictions. These working groups have decided upon ARRs for the major IBOR currencies, 2 with the exception of the euro. A decision on the European ARR is expected to be announced by the Working Group on Euro Risk-Free Rates in September All of the ARRs put forward for these currencies are overnight rates, in contrast to their current IBOR incumbents, which are presently set for a variety of tenors. It is generally thought that term ARRs will be introduced in due course, once liquidity in the overnight market improves. Building liquidity in ARR markets, however, remains a serious challenge. The ARRs are also a mix of secured (i.e., repo rates) and unsecured rates, whereas the major IBORs are all presently unsecured. A number of other industry bodies and market infrastructure providers are also now actively engaged in facilitating the transition to these ARRs. The International Swaps and Derivatives Association (ISDA) has begun to publish definitions for ARRs to allow trading in cleared and non-cleared ARR-linked derivatives. ISDA has also recently published its consultation regarding amending the fallbacks related to IBOR-related derivatives in its 2006 ISDA Definitions. LCH and CME Group are starting to clear derivatives referencing the new benchmarks, and futures contracts are being launched referencing some of these ARRs by the likes of CME and the Intercontinental Exchange (ICE). Finally, individual working groups are developing transition plans to move to their respective ARRs, in line with the FSB OSSG recommendation in its Reforming Major Interest Rate Benchmarks. 3 To date, only the UK and US working groups have published transition plans. A summary of these developments is presented in Figure US dollar (USD), UK pound sterling (GBP), euro (EUR), Swiss franc (CHF) and Japanese yen (JPY) 3. See Reforming Interest Rate Benchmarks, October 2014, Financial Stability Board 4 How will you respond to IBOR transition?

5 Figure 1: Overview of existing key IBORs and their alternative ARRs Jurisdiction UK US EU Switzerland Japan Benchmark GBP LIBOR USD LIBOR EURO LIBOR EURIBOR CHF LIBOR JPY LIBOR JPY TIBOR, EUROYEN TIBOR Administrator Intercontinental Exchange (ICE) Intercontinental Exchange (ICE) Intercontinental Exchange (ICE) European Money Markets Institute (EMMI) Intercontinental Exchange (ICE) Intercontinental Exchange (ICE) Japan Bankers Association TIBOR Administration (JBATA) Current Term/overnight Term Term Term Term Term Term Term Secured/ unsecured Submission/ transaction based Expected to continue alongside ARR ARR Administrator Term/overnight Unsecured Unsecured Unsecured Unsecured Unsecured Unsecured Unsecured Reformed sterling overnight index average (SONIA) Bank of England Secured overnight financing rate (SOFR) Federal Reserve Bank of New York To be determined Announcement expected Sep 2018 To be determined Announcement expected Sep 2018 Swiss average rate overnight (SARON) TBD TBD SIX Swiss Exchange Tokyo overnight average rate (TONA) Bank of Japan Tokyo overnight average rate (TONA) Bank of Japan Overnight Overnight TBD TBD Overnight Overnight Overnight Proposed Secured/ unsecured Submission/ transaction based Working group Transition plan published Unsecured Secured TBD TBD Secured Unsecured Unsecured Working Group on Sterling Risk-Free Reference Rates Timeline with Milestones Alternative Reference Rates Committee (ARRC) The Paced Transition Plan TBD Working Group on Euro Risk- Free Rates TBD Working Group on Euro Risk- Free Rates The National Working Group on Swiss franc Reference Rate Study Group on Risk-Free Reference Rates Submissionbased Submissionbased Submissionbased Submissionbased Submissionbased Submissionbased Submissionbased Transactionbased Transactionbased Transactionbased Transactionbased Transactionbased Study Group on Risk-Free Reference Rates How will you respond to IBOR transition? 5

6 Australian benchmark reform The systemic risks associated with relying upon submissions-based IBORs have been acknowledged by regulators and market participants in Australia. Critically, the Australian Bank Bill Swap Rate (BBSW) has undergone significant reform since IOSCO published its Principles for Financial Benchmarks in 2013: The administration of this key term unsecured Australian benchmark was transferred from the Australian Financial Markets Association (AFMA) to the Australian Securities Exchange (ASX) in On 21 May 2018, the ASX implemented a more transaction-focused rate-setting methodology, involving a 3-stage waterfall process whereby: 1. A VWAP calculation is the primary method used to determine a BBSW rate for all tenors. This calculation is performed over all eligible transactions observed within the rate set window. 2. The previously-used national best bid and offer (NBBO) calculation method is employed where a BBSW rate cannot be formed under the abovementioned VWAP method for a given tenor. 3. A further fall-back waterfall calculation method is used to populate BBSW tenors in the event that both the VWAP and NBBO calculation methods fail. In Australia, in contrast to other markets, the changes to enhance the longevity of BBSW are well advanced, and it has been possible to anchor the benchmark to a greater number of transactions There is still a place for robust creditbased benchmarks in the financial infrastructure, and we expect that BBSW and the cash rate will be able to coexist as the key benchmarks for the Australian dollar. Guy Debelle, Deputy Governor of the Reserve Bank of Australia 15 May How will you respond to IBOR transition?

7 Australian regulators have to date signalled that they believe that the implementation of this alternate calculation methodology will allow BBSW to persist as the key Australian benchmark, along with the RBA cash rate. The critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day to calculate a robust benchmark. Guy Debelle, Deputy Governor of the Reserve Bank of Australia, 15 May 2018 The healthy basis swap market between BBSW and the cash rate is also seen to provide a key foundation to allowing market participants to smoothly exchange cash flows under these benchmarks. Our view While the support of the existing Australian benchmark by the RBA is an encouraging sign for market participants using products referencing BBSW, this is an area that should be closely monitored as other IBORs are transitioned onto their respective ARRs. The introduction of new products and improved liquidity in ARRs may have unforeseen impacts on BBSW. Local market behaviour may also shift over time. For example, users of products currently referencing 1-month BBSW may wish to consider referencing the 3- or 6-month tenors in the future, given that liquidity in the 1-month tenor has recently significantly diminished due to new liquidity standards disincentivising banks to issue short-term paper. Market participants using products referencing BBSW should also consider the potential impact of a dramatic sustained reduction in underlying liquidity that could threaten the benchmark s validity under the IOSCO benchmark principles. How will you respond to IBOR transition? 7

8 The time to act is now While BBSW appears unlikely to change as the key Australian benchmark during the short term, Australian firms with exposure to foreign markets or funding should begin to assess the impact of broader IBOR reform on their operations as soon as possible. On pages 10-11, we have outlined some of the key operational and financial challenges that transitioning to ARRs will present for sell-side and buy-side institutions, corporates, as well as for market infrastructure providers. These impacts will be felt across a number of functions within each organisation, including treasury, sales/trading, market risk, credit risk, legal, finance and tax. As detailed on page 13, establishing a broad-based IBOR transition project team early on will key to success in addressing these challenges. Doing nothing is not an option For firms exposed to global markets or foreign funding, not preparing for transition to new benchmarks is simply not an option. The discontinuation of LIBOR is not a possibility. It is a certainty. We must anticipate it, we must accommodate it and we must adapt to it. J. Christopher Giancarlo Chairman of the US Commodity Futures Trading Commission 12 July How will you respond to IBOR transition?

9 New positions Liquidity is likely to dry up in existing IBOR markets (particularly LIBOR markets after 2021), making it more difficult to transact in derivative or cash products referencing current global benchmarks. Market participants must therefore plan to trade new products referencing ARRs in the future. They may wish to consider adopting positions in these new products gradually, by letting shorter-term IBOR exposures roll off and replacing them over time with products referencing the new benchmarks. Market participants should also ensure that they understand the implications of trading these new instruments. For example, the absence of forward-term fixing for overnight ARRs may introduce additional market risk and budgeting complexity for organisations looking to lock in floating rates via such instruments as floating-rate notes (FRNs) in the future. Interest payments for floatingrate instruments may only be fixed in arrears for overnight ARRs, as opposed to in advance for term IBORs at present. Longer-dated positions Ignoring IBOR-linked positions that are due to mature beyond 2021 may also result in a number of unfavourable consequences. Should an IBOR cease to exist permanently, the outcome for financial contracts linked to the IBOR will be contingent upon the fallback language that the contract contains. There is presently enormous variation in the clarity and contents of these fallbacks between contracts for both cash and derivative products. Some of the potential outcomes of these differences are presented in Figure 2. Figure 2 Existing fallbacks are: Clear Unclear Contractual counterparties may encounter: Increased borrowing or lending costs for commercial loans, where the fallback differs significantly from the IBOR Hedge dislocation, where cash products and their hedging derivatives fallbacks differ Floating rates referencing IBORs effectively being converted to fixed rates (where the last available IBOR rate is stipulated to be used), resulting in: Forced sales of fixed-rate notes, bonds or securitised products Dislocation between the rate paid on collateralised loan obligations (CLOs) and their underlying securities, leading to disrupted cash flows and potential downgrades Operational and financial considerations for IBOR transition To avoid adverse scenarios, market participants should consider either: 1. Actively re-trading their IBOR positions maturing beyond 2021 and replacing them with ARR equivalents; or 2. Amending existing contractual terms to clarify what should happen in the event that the reference IBOR permanently ceases to exist. Both of these options introduce a number of operational and financial challenges. Some of these challenges are well understood, while others are being debated and resolved via the various ARR working groups. Significant costs are likely to be incurred in addressing the operational challenges. How will you respond to IBOR transition? 9

10 Key operational challenges 1 2 Determining IBOR exposures Creating a detailed inventory of products and financial contracts linked to the IBORs will be challenging for many organisations with exposure to these benchmarks. Given that a lot of existing financial contracts are not digitised, affected organisations will need to find efficient ways of extracting and categorising key contract terms, including fallback terms, so that legal and financial risks are identified and a strategy can be determined. Establishing a process to monitor and manage IBORrelated inventory throughout the transition to ARRs will be key. Renegotiation of contract terms Firms looking to renegotiate contract terms may find some counterparties unwilling to agree on amendments due to potential negative revaluations or contractual triggers coming into play, such as requirements to pledge additional collateral. With respect to derivative contracts, protocols to be provided by ISDA will likely facilitate multilateral contract amendments between counterparties, although the large number of contracts to be amended will still present a significant logistical task. Bilateral contractual amendments will be required too, including in scenarios where counterparties have chosen not to adhere to multilateral protocols. Contractual renegotiation for cash products is likely to be significantly more cumbersome. This is because cash contracts are not typically standardised and thus do not lend themselves to protocol-driven amendments. Bilateral negotiation will therefore be required, as well as multilateral renegotiation for instruments such as bonds, syndicated loans and securitised products. To complicate matters, unanimous stakeholder consent may be required for some of these multilateral negotiations. This will be a particular challenge in the case of securitised products, where identifying noteholders is often difficult due to anonymisation Governance and controls Establishing robust controls and approval processes around the renegotiation and transitioning of legacy contracts will be paramount. Inappropriate governance over the contract transition process may expose organisations to a wide array of financial, legal, operational and conduct risks. Litigation and valuation disputes If amending reference rates for legacy positions while the relevant IBORs still exist, counterparties (and particularly retail investors or borrowers covered by consumer protection laws) may try to sue if they can see that the newly-negotiated terms have resulted in worse outcomes than had they remained on their original terms. Defending against these claims may be costly for financial institutions, and should be accounted for accordingly in firms planning efforts. Technology and infrastructure Organisations with large IBOR footprints will likely need to implement changes to a wide range of proprietary and third-party platforms. Robust historical data sets for ARRs will need to be sourced and integrated into valuation, trading and risk management systems. Middleware and reference data management will be impacted, as will collateral management platforms, accounting and commercial banking systems. Models and risk management In line with the abovementioned changes to risk management infrastructure, new interest rate derivative models will be required to bootstrap discount and projection curves to price derivative positions correctly. The impact on non-interest rate derivative risk models and business models that rely on interest rate feeder models will also be notable. This will include funds transfer pricing (FTP) models managed by Treasury. 10 How will you respond to IBOR transition?

11 Key financial challenges Fair value adjustments Amending the reference rate for existing contracts will have an immediate impact on position valuations, both directly (via the interest rate variable), and indirectly for instruments with embedded volatility (which also depend on interest rate volatility as a price input). These fair value changes may also impact the amount of taxes to be paid, or result in the crystallisation of profit or loss for counterparties using accrual accounting under the International Financial Reporting Standards (IFRS). Accounting and hedging Transitioning to IBORs is likely to have significant impacts on hedge accounting for affected firms. Upfront assessments of the economic relationship between hedged items and their hedging instruments will become more challenging should significant structural basis exist. Critically, finance teams will need to determine whether changes in benchmark rates represent a substantial modification of the terms of hedged items. They will have to determine whether a new ARR should be considered a permitted hedgeable risk, and whether a change in hedged risk should trigger a de-designation or redesignation. Hedged items and their hedging derivatives may need to be booked separately at fair value, resulting in potential net income volatility. There also remains an open question on whether highly probable transactions referencing existing benchmark rates are still expected to occur if the exposure matures beyond Timing basis Firms with IBOR-linked hedges may be exposed to basis risk due to timing differences in negotiating amendments to the contractual ARRs for derivatives versus the underlying assets or liabilities they were intended to hedge Similarly, market participants with cross-currency swaps referencing IBORs may encounter negative valuation impacts from different currency legs being transitioned on different timelines (for example, as per the phased approaches being adopted by the various ARR working groups). Basis may also arise in the event that the different currency legs reference secured and unsecured rates respectively. Term basis Basis risks may also arise in the event that cash products are established referencing new term versions of the ARRs, but their hedging derivatives only reference the overnight ARRs. Note that greatly improved liquidity in new derivative and cash products referencing ARRs will be required for term reference rates to be made available and for ARR term curves to be constructed. Market participants and industry bodies continue to debate the appropriateness of derivatives referencing such term ARRs in the event these term versions materialise. Regulatory costs Renegotiating financial contracts may have downstream effects on regulatory capture, including direct financial impacts via regulatory capital or liquidity requirements. ARR working groups and various global bodies are currently working to clarify these regulatory implications. Similarly, amendments to derivative contract terms may lead to capture under current margining or clearing rules for non-centrally cleared derivatives across jurisdictions. As well as potentially significant operational impacts, this will affect organisational cash flow, particularly for corporates with no margining operations currently in place. Accelerated taxation on gains Terminating or amending cash or derivative contracts may entail that tax be recognised immediately. This, in turn, may entail that tax payments on realised gains be brought forward. How will you respond to IBOR transition? 11

12 Next steps While the work conducted by the various ARR working groups and the likes of ISDA will continue to drive much of the IBOR transition timeline, there are a number of steps that organisations with IBOR exposures can and should be taking now to prepare. These steps should be explored by all affected market participants, from banks, insurers and asset managers, through to corporates and market infrastructure providers. Most notably, organisations must establish IBOR transition programs and conduct impact assessments to understand the extent to which they, as well as their clients and trading counterparties, are currently exposed to the various IBORs. This is a necessary foundation on which organisations can plan their transition strategy and implementation programs. The transition away from LIBOR represents a significant risk event for firms of all sizes, and they should actively manage this transition through their existing frameworks for identification, management, and mitigation of risk. William C. Dudley President of the Federal Reserve Bank of New York 24 May How will you respond to IBOR transition?

13 Establishing your IBOR transition program 1 2 Appoint a broad-based IBOR transition team Mobilise a formal IBOR transition program with a strong governance framework and senior leadership appointed to oversee and report progress to relevant executive committees and the board. This program should be global and cross-functional in nature, with business leaders represented from inception. We believe it is important to include representation from capital markets and treasury functions, as well as other business areas where IBOR exposure may be less visible and more difficult to manage (such as retail banking and commercial lending functions). Conduct an impact assessment It will be important to consider both direct and fallback IBOR exposures when conducting an impact assessment and developing an approach to inventory management. 1. Product assessment: Categorise and quantify financial IBOR exposures by various parameters, including maturity, optionality, counterparty, client segment, business and jurisdiction. While existing technology and trading platforms may be leveraged for some of this analysis, other aspects will require manual review. 2. Legal contract assessment: Extract and analyse for sufficiency the information contained in cash product and derivative product contract fallback provisions. Priority should be paid to those positions due to mature beyond Contractual clauses related to terms such as break fees and the calculation of penalty interest should also be assessed. 3. Risk assessment: Analyse the potential impacts of transitioning to ARRs on the risk profile and financial resources of your organisation. Factors such as basis risk and operational risk, as well as company earnings, capital, funding and liquidity should be considered Operational assessment: Identify areas of operational impact, including systems, models and processes that are linked to current IBORs. Both internal and external dependencies will need to be determined, including reliance upon third-party data and infrastructure providers. 5. Inventory management: Establish and maintain an inventory of cash product and derivative contracts linked to the IBORs across jurisdictions, as well as those products that reference BBSW. This should include a mechanism to report these exposures on an ongoing net and gross basis. IBOR exposure during transition should be forecast based on known business needs as well as wider business assumptions regarding future economic and industry conditions. Develop a transition roadmap Develop a comprehensive implementation roadmap for prioritised initiatives, including key workstreams, projects, milestones and ownership. A strategy for educating and communicating with both internal and external stakeholders should also be addressed, including clients, technology vendors, regulators, industry bodies and ratings agencies. Note that engaging with other market participants and industry working groups will be key in helping shape transition timing and approach, as well as in designing new products referencing ARRs and redefining fallback provisions. Launch a formal IBOR program Publish a multi-year enterprise-wide project management office toolkit, including a program charter, a stakeholder map and resourcing requirements. Workstreams should have objectives, milestones and work products clearly defined, with criteria for success articulated from the outset. How will you respond to IBOR transition? 13

14 Conclusion The impact of IBOR reform will be felt across the globe. Financial services organisations and corporates alike will soon need to reference new benchmarks for their cash and derivative exposures. They may also need to explore new risk management strategies and hedging products. These changes will have broad and crossfunctional effects throughout organisations, including on treasury, risk, legal, finance and tax. Many Australian firms will not be immune to these impacts. While BBSW presently has the support of regulators and Australian market participants, this may change over time. Australian firms with exposure to foreign funding or hedging requirements will also be impacted by the broader global IBOR reforms that are currently underway. This will be especially the case for Australian banks, which frequently utilise offshore wholesale funding. Given the scale and complexity of this inevitable transition, we strongly recommend that market participants initiate steps to prepare now. The operational challenges associated with preparing for IBOR transitions are daunting. Simply assessing the impact of the changes will require considerable time and resources for many market participants. In particular, efforts around legal contract repapering and risk management throughout the IBOR transition will be sizeable for many firms and financial institutions. However, the cost of inaction will be significantly greater. 14 How will you respond to IBOR transition?

15 Our cross-functional IBOR team Australia Tim Dring Oceania Banking & Capital Markets Leader tim.dring@au.ey.com Damien Jones Partner, Capital Markets Advisory damien.jones@au.ey.com Michelle Segaert Partner, Financial Services Law michelle.segaert@au.ey.com Steven Nagle Partner, Actuarial Services steve.nagle@au.ey.com Douglas Nixon Partner, Financial Services Risk Management douglas.nixon@au.ey.com Danielle Donovan Partner, Financial Services Transfer Pricing danielle.donovan@au.ey.com Simon Jenner Partner, Financial Services Tax simon.jenner@au.ey.com Andrew Bangura Senior Manager, Capital Markets Advisory andrew.bangura@au.ey.com Asia-Pacific Gary Mellody Partner, Financial Services Risk Management gary.mellody@sg.ey.com Amit Sharma Director, Financial Services Risk Management amit-a.sharma@sg.ey.com Patricia Tay Partner, Financial Services Assurance patricia.tay@hk.ey.com Sky So Partner, Financial Services Risk Management sky.so@hk.ey.com Americas Roy Choudhury Partner, Financial Services Risk Management roy.choudhury@ey.com Daniel Scrafford Partner, Financial Services Risk Management daniel.scrafford@ey.com Janina Polo Senior Manager, Financial Services Advisory janina.polo@ey.com John Boyle Senior Manager, Capital Markets Advisory john.boyle1@ey.com Europe Shankar Mukherjee Partner, Financial Services Risk Management smukherjee@uk.ey.com Mduduzi Mswabuki Partner, Financial Services mmswabuki@uk.ey.com How will you respond to IBOR transition? 15

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