As in the case of MiFID II, all will not be known when LIBOR migration is really going to be due. But lessons should have been learnt by now that the earlier the banks set this in motion, the lower the execution risk, and therefore the cost, over the longer run.
Since just waiting is not an option, central banks and lobbying groups have started moving ahead with contingency plans and early assessment of collateral damages, should the market not move fast enough. Central banks in Asia are seeking alternatives to ensure a smooth transition from the current IBOR benchmarking model tainted by manipulation scandals to new home-based indicators.
As an initial gap from IBOR, most Asian benchmarks are directly managed by local central banks, thus not subject to the BMR (European Benchmark Rules), and are more likely to update their existing benchmarks independently; like Japan with its upcoming unsecured overnight rate TONAR (Tokyo Overnight Average Rate), or Australia’s revamping of the BBSW (Bank Bill Swap) reference rate. Meanwhile the USA, the UK and Switzerland announced a decisive stop to associating their Benchmarks with LIBOR and its current participant-based rate-setting process.
On the other hand, as highlighted by Risk magazine recently, three popular Asian foreign exchange rates (Korean KTFC18, Philippines’ Bappeso and Taiwan’s TAIFX1) are administrated by local unregulated entities or brokers, likely to fall under the BMR, which prohibits EU-supervised firms from using non-authorised indexes and benchmarks after 1 January, 2020. Options are therefore to seek EU approval or transfer the benchmarking to an authorised administrator by 2020.
As for the impact intensity, and by looking at the highest points of correlation with US LIBOR for example, Asian emerging markets will likely get hit the hardest, as they depend heavily on the most liquid currency’s rates eco-system.
Following an earlier ISDA (International Swaps and Derivatives Association) survey, the creation of new benchmarks clearly highlights the need for market participants to expect a long transition time. This article gives background elements on the announced end of LIBOR, the local benchmarking effort in Asia, and highlights the main topics banks should have on their roadmap, starting now.
Key LIBOR facts
- The average rate at which banks can get unsecured funding in the London Interbank market is the LIBOR; though several IBOR benchmarks exist, with a focus on 5 currencies (USD, GBP, EUR, CHF, JPY) and 7 maturities (O/N, 1w, 1m, 2m, 3m, 6m, 12m), used to infer reference rates for longer maturities.
- The administrator of LIBOR is ICE, still used as the main benchmark rate for USD/GBP/CHF/JPY derivatives contracts. 80% of the total LIBOR-referenced contracts exposure (by gross outstanding notional) is in fact based on USD LIBOR and EURIBOR, meaning USD 370 trillion out of USD 460 trillion.
- 80% of LIBOR-referenced contracts are OTC derivatives and ETDs; a total of USD 300 trillion, as per ISDA:
- USD 165 trillion in US derivatives
- USD 135 trillion equivalent in EUR derivatives
- As per ISDA, in Japan the volumes covered by JPY LIBOR and TIBOR are respectively:
- USD 30 trillion for JPY LIBOR-based derivatives and bonds / loans
- USD 5 trillion in TIBOR-based derivatives and bonds / loans (Japanese Yen, Euroyen)
- As a matter of fact, the main activities impacted span across the entire financial industry and their clients, with a major impact on banking activities (commercial, investment, private, retail), with specificities by asset classes, and across departments (Front Office, Treasury, Accounting, Legal, Marketing, etc)
Transitioning away from LIBOR – Alternatives and basis spreads
Asia has developed a series of local benchmarks to better control their local and regional liquidity. However, these are still dwarfed by the presence of LIBOR, limiting the interest of market participants, and therefore their legitimacy, in such benchmarks.
- The significant reduction in unsecured borrowing in the interbank market, one of the main activities around LIBOR (market consensus provides LIBOR fixings), following the financial crisis and rate-fixing scandals means that there is a lack of transaction data to calculate LIBOR. This potentially puts into question the use of LIBOR as a benchmark rate from 2018-2019 onward.
- Prohibitive prudential rules for interbank borrowings (initiated by Basel III recommendations) and the move towards more liquidity and risk-friendly sources of funding (repos, bonds, deposits) have accelerated this ongoing trend, not only in Europe and the US but also in Japan, Australia and Hong Kong. China’s SHIBOR is also to be followed closely.
- The LIBOR fixing manipulations have compromised the credibility of LIBOR as a representative measure of interbank funding cost.
- The UK FCA (Financial Conduct Authority) announced that from the end of 2021, it will no longer require banks to submit rates into LIBOR, making LIBOR even more unreliable and creating a risk (though unlikely) that it won’t be published anymore
- After reviewing the major interest rate benchmarks, the FSB (Financial Stability Board) found that near risk-free reference rates are more suitable than reference rates such as LIBOR which include a term credit risk component. Asian Central Banks are following suit.
In this context, authorities and regulators have supported the idea of moving away from LIBOR and towards near RFR (Risk-Free Rate) benchmarks. Many initiatives and working groups have been launched by local central banks, market association and exchanges to find the most suitable alternative benchmarks, such as SOFR (US Fed’s Secured Overnight Financing Rate), SONIA (Sterling Overnight Index Average), SARON (Swiss Average Rate Overnight) and TONAR.
The BOJ (Bank of Japan) recently prepared its own response to risk-free reference rates with the new Overnight Rate TONAR, following studies with group of Japanese and international banks. However, the transition to TONAR requires further market support momentum.
In Europe, banks have until late 2020 to sort out the replacement for the euro version of the LIBOR benchmark rate, according to ESMA (the European Securities and Markets Authority).
The question is: which area will grow first with the local benchmarks? Hedging and asset swaps / liability swaps may be a genuine start, though basis spreads with existing loans, bonds and derivatives LIBOR base may be material at the beginning, due to liquidity constraints.
Main differences with alternative rates
The new rates are very likely to differ from LIBOR, EURIBOR and TIBOR, especially in times of financial stress, with lower levels than the IBOR rates, implying a higher ‘add-on’ to compensate. Consider stress-testing periods, interbank markets, basis risks and term-structure shake-up.
- New reference rates are overnight rates based on actual transactions while IBOR is a forward looking term rate (i.e. based on estimates). Overnight rates provide less visibility to investors and issuers alike, as payments are not known in advance.
- LIBOR tenors correspond to popular maturities for short term borrowing (especially 1 month and 3 month), while O/N financing is more unusual outside the interbank market.
- Instead of being unsecured, such as LIBOR, new rates have the option of being secured, which means there is no credit spread related to a bank’s credit risk.
- Using alternative rates to LIBOR means moving away from a relative “one size fits all” consistency of fixing methodology and term structure dynamics (especially the bootstrapping method) to multiple reference rates and methodologies, each representative of market and currency specificities.
Market uncertainty and the need for fall-back provisions
- In the loan market, and across Asia, Europe and the Americas, drawings in different LIBOR currencies under the same facility are currently priced at the same margin. However, different margins per currency may be required if different benchmarks (e.g. secured and unsecured) are used for different currencies, with the associated risk of basis spreads.
- Uncertainty over how FRNs (Floating Rate Notes) can be traded if the rate is not fixed at the beginning of the period (e.g. floater, reverse floater, etc.)
- Continuity of contracts for instruments referencing LIBOR by specifying fall-back plans. Fall-backs are common across mature financial markets, including Asia, and are usually triggered in response to temporary situations. However, a discontinuity of LIBOR could be permanent, leading to a commercially non-viable situation. On the derivatives market, fall-backs should cover both new derivatives contracts and existing derivatives contracts referencing LIBOR.
- Unlike the derivatives market, the loan and bond markets do not have any protocol system for amendments:
- Loan market: contracts referencing LIBOR may need to be renegotiated and amended when changing to an alternative rate. Loan provisions could be included to mitigate the risk associated with a renegotiation.
- Bond market: contracts may also need to be renegotiated and amended with the added complexity that not all owners of bonds are easily identifiable (unlike loan arrangements).
- The derivative markets benefit from an established term structure and pricing framework based on LIBOR. Rebuilding valuation infrastructure with new benchmarks will raise many technical issues and take time to implement – along with the need to validate new risk approaches at the group-level, limiting the speed of change.
What banks should do
Given the remaining uncertainties, all the required work cannot be front run. However, banks need to start engaging in the process of change and concrete actions have to be launched now to ensure a smooth transition in the future. And this includes assessing the depth and complexity of exposure, the directs and indirect impacts to the P&L and risk measurement, and work ahead of the curve to be seen as a champion and a reference in the market.
In that respect, Asia is no different from the rest of the world and can make a difference by preparing ahead of time, using its developing secured and unsecured overnight rates organisations. Financial market participants in Asia need, however, to pay attention not only to their markets and reference rates, but also to the correlations and ripple effects from US and EU markets.
One of the issues in Asia will be the double-speed approach, with international clients looking for rapid change to where the global liquidity is, versus a portion of local and regional clients likely to require a more gradual approach, with an increased trend towards local benchmarks, as was the case for local currencies following the 2008 credit crisis.
Steps to take
- Establishment of a specific task force to investigate several areas:
- Mandate all business lines to assess economic, client, risk, legal, system impacts, and define a high-level action plan and a centralised project structure
- For international banks in Asia, dependency on head-office approaches may limit the speed of change in local markets, often seen as secondary in size and priority.
- Conduct risk impact assessment using modelling methodologies and high level impact estimates, and including client relation and reputational risk, with regard to legal positioning for underwriting of new contracts.
- Assess infrastructure impact, such as in areas of trading, clearing, accounting, tax, data management and migration A global or regional approach is required to avoid change programme dislocations.
- Impacts in areas such as accounting, tax and ALM (Asset Liability Management) will require Quantitative Impact Studies (QIS)
- Identify Legal repapering requirements with regard to areas such as client negotiation and communication, etc.
- The multi-country challenge of Asia may see local benchmarks competing for liquidity, leaving legal repapering and negotiations a real challenge.
- Assess business and operational impacts in relation to new products, trading strategy, Middle Office, Back Office, n a growth market, strategy on benchmark selection will require clear convictions about trends. Operations, often outsourced, may require a plan-ahead.
- Assess economic impacts based on changes in contract values and cash flows, and additionally determine balance sheet impacts.
- Assess technical impacts based on pricing models, risk frameworks and how rates are embedded in them.
- A challenge for participants relying on pricing tools provided by vendors is that the transition will be dependent on vendors’ readiness.
- Analysis of inventory: if not already accessible via databases or datalakes, this may require automated processing of legal documentation, i.e. OCR projects to digitalise inventory of OTC contracts and scan for existing fall-back provisions.
- Impact assessment:
- A quick dynamic tool to assess exposure to LIBOR contracts by counterparties should be built to engage early into remediation with priority counterparts (taking into account MtM, margin requirements, etc.) Scenarios on the regulatory and internal performance metrics should be run to assess the real impacts on monitoring data. A clear governance should be set on the benchmarks to apply based on the activities, geographies and suitability of the market players and their counterparts.
- Prospective analysis: investigate and rank scenarios according to “what-if” impacts, potential for materialisation and start building on common denominator actions
- Definition of strategy with regards to street working groups: a group-wide governance strategy in needed to define the high-level game plan. To keep building LIBOR positions without fully understanding the potential consequences is a risky strategy. Players who know their exposure, risk and strategy early can greatly influence the formation of market consensus and have the potential to become an early player in the newly defined reference rate. For example, providing liquidity in potential new benchmarks would help to secure new business. Like in any fundamental market change, it is best to be neither a lone pioneer nor lagging behind other market players.
- Define a solid and realistic timeline: define internal deadlines in line with industry-agreed milestones to work against, in order to allow sufficient time for impact analysis and change management.
The workload for this required effort is certainly not to be underestimated. And Asia should not wait for Europe or the US to kick start the effort.There are still a lot of unknowns which could drive banks to adopt a wait-and-see approach. We believe a proactive management of this major market change will allow the bank to get in motion faster. Actively monitoring the developments could help identify business opportunities instead of facing the bottlenecks the rest of the market will have to deal with.
Matthieu is director at Chappuis Halder based in Hong Kong, in charge of regulatory and front office streams. Olivier is the firm’s managing director based in London and focusing on global capital markets.