Specialists from Bloomberg, Standard Chartered Bank, ING Bank and Clifford Chance discuss IBOR transition challenges and how to address them.
The FCA (Financial Conduct Authority) announcement on LIBOR cessation timelines in early March has provided much needed clarity to the market, according to panellists at a virtual event jointly hosted by Bloomberg and Regulation Asia.
The clarity has resulted in a stronger impetus to drive forward IBOR transition programmes at financial institutions. While most sell-side firms already had their transition programmes relatively well organised, the clarity was particularly needed on the buy-side, which has so far lagged in transition progress.
“It’s been helpful for the buy-side to have the spread adjustment pinned down. Those holding out or just taking their time on the [ISDA] protocol – there has been a lot more engagement from those players,” said Paul Landless, Partner at Clifford Chance. “It was definitely a useful and much needed moment in terms of breaking some of the inertia that’s been seen in the last few months.”
According to Landless, however, the buy-side in APAC still needs more formal guidance from regulators (e.g. ‘Dear CEO’ letters). To date, Australia has been one of the few APAC jurisdictions where regulators have reached out to buy-side firms. Landless expects other regulators in the region to follow suit and start to increase focus on buy-side operational readiness.
“One issue that’s still missing compared to what we’re seeing in London or New York is discussion on tough legacy,” Landless said, referring to LIBOR contracts that cannot be converted to a non-LIBOR rate or amended to add fallbacks. The expectation – or hope, for some market participants – is that APAC jurisdictions will start to come forward with more guidance around tough legacy, he said.
Henry Vu, Asia IBOR Transition Program Lead at ING Bank, highlighted the different pace at which various jurisdictions are moving in APAC, particularly as some markets like Hong Kong and Japan are adopting a multi-rate regime. “There is generally a lack of an alignment in terms of harmonisation of milestones and guidance across various jurisdictions.”
The panellists noted that Hong Kong’s deferral of the deadline to cease issuance of new LIBOR linked contracts from end-June to end-December was seen as much-needed relief, allowing banks more time to design new RFR products, get compliance sign-off, and ensure readiness of internal systems.
According to Bloomberg specialists, discussions with banks have highlighted that there is a severe lack of awareness and understanding of new RFR products from end customers that needs to be addressed. With the deferral, banks will have additional time to explain the RFR products and features to their customers.
A prudent approach to change
Across jurisdictions, one of the key challenges for banks is ensuring readiness of technology and infrastructure, particularly given the significant number of RFR product variants and market conventions. Each bank will need to plan and prioritise system development based on the business case for each benchmark.
The first step to this is to understand your bank’s exposures, the panellists said, advocating a holistic approach that takes into account product classification, maturity distribution, currency exposures and other factors. Then from an infrastructure planning perspective, it is important to voice out your requirements and secure the necessary resources as soon as possible.
Bloomberg specialists advise: “Don’t be afraid to fight for resources internally to make sure you have the correct level of attention for your product development requirements in Asia.”
The panellists highlighted potential constraints in terms of time, resources, budget, and human resources which may hinder development progress. In some cases, banks may have the resources available to cater for only a small number of contingencies in their system development, they said.
It is also important to make sure those systems will be able to cater for minor changes, such as adjustments related to – for example – how lockup periods and time lags are calculated, and how spread adjustments might be applied. Ensuring flexibility in the design of system infrastructure means that firms will also be able to adapt to new market conventions and trends that may develop over time or gain acceptance in the market.
Vu reiterated the importance of understanding the bank’s exposures in order to build a business case not only for planning and prioritising system development, but also for onboarding new benchmarks. Besides the new RFRs, he anticipates that over time credit sensitive rates such as BSBY (Bloomberg Short Term Bank Yield Index) and the ICE Bank Yield Index will be adopted.
“People still prefer to have a rate that looks, smells and tastes like LIBOR with respect to the term structure as well as credit sensitive element,” Vu said. “The key question is how robust those credit sensitive rates are. Once certain benchmarks have obtained IOSCO compliance and EU or UK BMR compliance, we can expect to see a lot of adoption.”
The key message from the panel was “Don’t wait”. Firms should start active transition as soon as possible.
“We already have a lot of announcements, best practices, toolkits, guidance, documentation, fallback language – all these things actually give a lot of certainty to market participants,” Vu said. “The focus now should be on execution and operationalising the transition, and reaching out to your clients to educate them.”
Getting your hands dirty
The virtual event also featured a second panel focused on the risk management challenges associated with the transition to RFRs. According to Bloomberg specialists, the most affected risk types are going to be valuation and market risk.
The transition to RFR is going to impact the valuation of instruments, including valuation adjustments to account for counterparty credit risk. On the market risk front, firms will be exposed to basis risks with potential effects on market volatility and liquidity. This is going to extend to models related to market risk including the capital charge calculations. In APAC, managing basis risk is seen as more challenging given that local IBORs will coexist with RFRs.
Institutions will need to make sure that RFR indices, curves and volatilities are included as risk factors in all of their market risk metrics. Bloomberg specialists noted that banks adopting the internal models approach will need to figure out the appropriate risk factor time series for the new RFR curves going all the way back to 2007/2008, when these markets did not even exist.
Mathieu Lepinay, Managing Director and Global Head of Macro Structuring at Standard Chartered Bank, pointed to market risk challenges even with interest rate swaps – which are considered the least problematic instruments to manage within the IBOR transition. Specifically, the transition for cross currency swaps – which are widely used in APAC – will be a challenge as there will be two legs being transitioned to new benchmarks.
Lepinay also highlighted challenges with interest rate caps, floors and swaptions, which he said will see their valuation completely change. “These contracts are probably not the best to just leave alone to be transitioned automatically and might require a more proactive approach.”
He also pointed to basis risk as one of the more challenging risk types in the transition. This refers to potential mismatches between the cash instrument (e.g. loan) and the derivative being used to hedge the market risk of the cash instrument.
“One potentially simple solution that is readily available is to look at the type of indices the Fed, for example, has made available for SOFR,” Lepinay said, referring to the compounded averages of SOFR over rolling 30-, 90-, and 180-calendar day periods (SOFR Averages). Using the index on both the loan and the swap is a simple way to minimise basis risk, he says.
“The clock is ticking, so it’s very important to be proactive. By being proactive, you’re reducing the risk of having negative surprises,” Lepinay said as a parting message. “We still find new things almost on a daily basis as we look at different types of trades, settlements, connectivity between different systems, etc. So it’s important to start getting your hands dirty.”
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