Financial institutions should be treating the LIBOR transition as an opportunity to strengthen client relationships and win market share, says Matthieu Sachot at Chappuis Halder & Co.
Late May, Randall Quarles, Chairman of the Finance Committee at the US Federal Reserve, gave his views on the serious and pressing matter of preparing for the transition away from LIBOR. UK Financial Conduct Authority (FCA) officials Andrew Bailey and David Ramsden provided more optimism, assessing progress to being line with their expectations. One week later, however, FCA Director of Markets and Wholesale Policy Edwin Schooling Latter warned market participants that slow efforts to switch to new reference rates would be regrettable, and punishable.
While additional alternative rates keep sprouting, the fallback language for legal contracts currently referencing LIBOR are still undergoing a process of fine-tuning, with the support of ISDA (the International Swaps and Derivatives Association) as well as risk-free rate (RFR) working groups (notably the ARRC and Sterling groups). Operational teams at financial institutions are meanwhile scrambling to assess processes, systems and financial reporting risks and efforts, for both their firms and their clients.
The Financial Accounting Standards Board (FASB) recently announced a ’continuation of contract’ proposal to avoid accounting treatment and reporting mayhem. Besides this welcomed effort, ISDA is pressuring the International Accounting Standards Board (IASB) to provide clarity on international treatments under IFRS.
In the background, preparation is marching forward in the risk departments at financial institutions, considered the 2nd lines of defence after client and market-facing departments. Treasury Risk and Liquidity Risk are holding key roles, beside the usual suspects, i.e. Market Risk and Credit Risk Management departments. At stake: funding and funds transfer pricing (FTP) transitions, hedge adjustments, investing / divesting strategies, and dynamic collateral management.
Foremost, all these preparation efforts are ultimately aimed at strengthening relations with existing clients and ongoing prospects – to gain market share – or at preparing for clients that could be willing to renegotiate their contracts ahead of the scheduled transition.
The May 30th ISDA/Bloomberg Benchmark Regulation and Migration Conference in Hong Kong highlighted a limited focus on clients in LIBOR transition programmes, showing a lack of anticipation and recognition of the opportunities they present.
Is there a time for keeping your distance?
Regular updates on cash and derivatives volumes and fallback language are an essential factor for market participants to take new RFRs seriously, as well as perform scenario and speed of transition assessments. US banks, insurers and asset managers, and some proactive financial players in the EU and Asia, have made progress, weighing scenarios and preparing transition programmes based on their best business and legal judgments.
Others have preferred a status quo or a quieter approach until now. The main reasons for this “wait and see” approach has been that some financial institutions have wanted to make sure legal terms as well as liquidity in RFR markets are sufficiently developed before moving ahead. But any delays hinder other efforts to manage transition impacts, and may ultimately jeapardise market position.
Those with a more forward-looking approach have communicated with clients to warn them of the impacts of the transition, also preparing for the changes in war-room like meetings involving Treasury, Legal and various business lines, along with 2nd-line-of-defence departments, namely Treasury Risk, Liquidity Risk and Scarce Resources Management.
Considerations for treasury and liquidity risk management
The cashability of assets, and the novation or unwind capacity of hedges, are at the heart of the transition away from LIBOR, as bi-curve pricing becomes a challenge, and once-perfect hedges break into gain/loss recognition and require adjustments. Firms will need to be able to project the impact of these changes on their balance sheets and overall liquidity.
However, while this may rely on certainty regarding specific accounting treatments – which are yet to be confirmed – projections and stress-testing will be key to determining funding sources, volumes and maturities, as well as hedging, investment and collateral optimisation strategies.
The ability to identify the upcoming fragility of specific trusted counterparties, a potential lack of volume for specific maturities or other liquidation difficulties, is essential to not only manage the risks ahead, but also to respond to early enquiries or trade requests from specific clients, if the market is not running havoc in the meantime.
FTP impacts on funding arrangements
A financial institution’s funding arrangements have large and direct repercussions on business lines and client funding costs, via FTP structures as well as securities lending, prime financing and repo / reverse repo activities. This spiralling conundrum requires Treasury Risk to step in and organise potential market actions as well as shock-absorbing FTP add-ons.
Most of the market participants have not tested the main FTP impacts, citing a lack of clarity on the RFR markets, with many waiting to move closer to the deadline. The development of €STR (the Euro short-term rate) is also cited as one of the major challenges, as it is currently only known as EONIA + 8.5bp, with no price publication expected before 2 October 2019, and no debt issuance as of yet.
Beyond the FTP challenge, the management of funding risk is a challenge which requires daily reviews of trusted networks across the globe in case of major market dislocations, whether due to crisis or transition-related disruptions. This work is currently largely limited to a “Rolodex approach”, whereby firms select their better-known Treasury and Scarce Resources Management partners to review scenarios on a daily basis. However, the lessons of the decade-ago global crisis have made way for a ‘Network-at-Risk’ approach, as firms look to avoid last-minute surprises and trapped liquidity at defaulting counterparties.
Significant growth in SOFR, SONIA issuances
As of August 2nd 2019, over USD 185 billion of bonds have been issued in SOFR, the new USD secured RFR. Several US and supranational market players (Fannie Mae, Freddie Mac, IBRD, etc) moved to SOFR early, anticipating the change to be significant amid expectations of large scale roll-overs of mortgages and other loans, and with assurances of indirect support from the Federal Reserve via reverse-repo programmes (and the potential now for a repo programme as well).
While SOFR’s momentum was initially intended to serve the US market, the increased liquidity also triggered attention across other regions. But, due to SOFR’s reliance on the repo market and its quarter-end volatility, some regional banks have started to instead favour AMERIBOR, the unsecured-equivalent rate to SOFR.
On the other side of the channel, SONIA has already had a long life as a reference rate, and as a result it has become as a natural LIBOR replacement for new issuances in the UK and in fallback language. Elsewhere, the RFRs of Japan, Hong Kong, Australia, Singapore, and emerging markets have seen some traction, though new issuances have so far been relatively limited.
Volume of SOFR issuances: As of August 2nd 2019, 29 institutions had issued over USD 185 billion notional in floating rate securities tied to SOFR, including over USD 68 billion between June and July.
Volume of SOFR notionals: Outstanding SOFR-linked notional across all products has grown significantly, especially in derivatives, from less USD 100 billion in May 2018 to over USD 9 trillion as of April 2019, a gain of 9,000%. (Source: SIFMA SOFR Primer)
Interbank funding shifts in favour of deposits
While new issuances and derivatives use have grown materially in the new rates, interbank funding transactions have made regular reductions, as financial institutions, especially retail, gradually switch to deposits in response to Basel III liquidity metrics – LCR and NSFR.
The preference for deposits has affected balance sheet risk weights, among other accounting impacts, but with respect to the new rates, there have still been limited interbank loans issued in either SOFR or SONIA so far.
Unfortunately, since December 2017, the Federal Reserve no longer publishes interbank lending data, so it is unclear how reliable the current view of net interbank transactions is.
Cross-border access to intra-group funding
Within banking groups, cash and securities passed on to legal entities in specific countries are another challenge the LIBOR transition presents, given that these transactions may impair banks in terms of local liquidity ratios, such as LMR or LMA, and may require them to plan ahead and communicate with local regulators.
In addition, limited cash and derivatives volumes may not only cause liquidity to dry up, but they may also trigger “trapped liquidity”, in cases where certain countries look to limit cash outflows or risk pile-ups. The case of trapped liquidity in China is a good example, where specific laws can allow cash to flow into and out of Chinese entities, while also allowing for a sudden freeze or reversal of those legal agreements.
With respect to intra-group funding, firms that have collateral or securities lending arrangements in place with their legal entities in other jurisdictions need to check their capacity to adjust RFRs and regain access to their funding and securities. The question remains open as to whether liquidity issues associated with the LIBOR transition can trigger a scenario that opens the door for resolution and recovery plans to be activated.
Dislocation of funding and lending in a low rate environment
A recent change in tone at the US Federal Reserve and the ECB (European Central Bank) has clearly signalled that interest rates will be low or negative for a prolonged period of time. While both the approach and the expected impacts can be debated, SOFR rates can leverage on this, being already lower than LIBOR due to its repo-based structure.
Lending rates, on the other hand, pose a challenge in such an environment, wherein the financial sector has historically tended towards taking on more risk for the extra margin. This dislocation requires a change in banks’ risk appetite frameworks and additional scenario stress-testing.
This is especially the case when junk credits exists, in which case thresholds and early-warning indicators should be closely monitored to assess issues. Examples of such scenarios include the June 2019 liquidity crisis at H2O Asset Management (Natixis) and the valuation difficulties experienced by BNP Paribas in the summer of 2017.
How illiquid are you?
Firms that are presently unable to assess the cashability of their assets and off-balance sheet facilities in detail, or to unwind hedges or swap positions in an efficient way with minimal impacts, will scramble trying to do so when LIBOR’s demise knocks at the door.
Liquidity risk management entails the ability of a firm to not only understand its capacity to sell assets – and estimate the expected cost through LVaR (Liquidity-adjusted Value at Risk) for example – but also to anticipate timings and market depth for on- and off-balance sheet exposures. Firms also need to know how to manage currently underrated issues associated with collateral management.
If a firm’s liquidity buffer portfolio is under passive management, it should be made semi- or fully active, to avoid being unexpectedly locked when the LIBOR transition is underway, whether at the firm or sector level.
Clients argue that only limited number of banks have communicated the potential impacts to help them prepare the wave ahead – especially in Asia. But, all of the above efforts should be aimed first and foremost at clients. Then the firm level. And finally, the overall financial sector.
The ability to anticipate funding and liquidity risks is not just necessary to ensure firms remain risk-averse and can limit potential problems; it also presents an opportunity to strengthen relationships with existing clients and ongoing prospects.
Firms that do not plan on doing this should be aware that other banks – both large and small – are already treating this as an opportunity to build greater market share.
The firms that are doing the most to prepare their clients will find themselves ahead of the post-LIBOR pack.
Matthieu Sachot is director at Chappuis Halder & Co., Asia-Pacific, in charge of the regulatory and front office streams. He also provides technical training on managing LIBOR transition programmes.