INSIGHT: Financial institutions can prepare now for alternative reference rates
JOHANNESBURG – Financial institutions and corporates need to prepare now for the transition to new alternative interest reference rates. Assessing the potential impacts of the transition away from LIBOR will help to get ahead of challenges and realise the potential benefits.
The London interbank Offered Rate (LIBOR) is being replaced. Currently, LIBOR is the benchmark for over US$350 trillion in financial contracts all over the world. The impact of the transition from LIBOR will be far-reaching for financial services firms, businesses and customers alike. The transition is expected to be more far-reaching than that of Sarbanes-Oxley, MiFID II, and other major changes to the financial landscape.
After the financial crisis there were concerns around LIBOR, particularly in the wake of several traders that were accused of colluding to rig the rates. These concerns related mainly to the way in which LIBOR was set which is based on the professional judgement of contributing banks as opposed to actual transactional data. In 2017, the UK’s Financial Conduct Authority (FCA) announced that it would no longer compel panel banks to make LIBOR submissions after 2021.
Working groups from around the world have proposed alternative reference rates or are working to substantially strengthen existing rates. Five reference rates are emerging as an alternative to LIBOR. These alternative rates differ by region, currency, tenor, and basis. SOFR, overseen by the Federal Reserve Bank of New York, and SARON, administered by Zurich-based SIX Exchange, are secured rates, while SONIA (Bank of England), ESTER (European Central Bank) and TONAR (Bank of Japan) are unsecured.
How the LIBOR transition should take place
Regulators and central banks are not defining how the LIBOR transition should take place. Rather, they are engaging with the industry in plotting a way forward. Companies will need to determine which alternative benchmark they will use. With regulators issuing few if any hard mandates, financial firms will probably make different operational changes and follow different strategies and timelines.
The transition to these alternative rates will require significant efforts by financial institutions to address the impact on business and control processes as well as business systems, interactions with clients, risk management and financial performance.
In South Africa, the South African Reserve Bank (SARB) has made significant strides in its effort to reform the existing interest rate benchmarks. In 2018, the SARB issued a ‘Consultation paper on selected interest rates in South Africa’.
The paper proposed several reforms to key interest rate benchmarks as well as a host of new benchmarks that could be used as alternative reference interest rates. In May 2019, the SARB established the Market Practitioners Group (‘MPG’) to facilitate decisions on benchmark choices and operationalisation.
The SARB also published a recent report on stakeholder feedback highlighting the financial services’ preferences for the proposed alternative reform rate, as well as SARB’s recommendations. South African organisations can stand to learn from other jurisdictions when looking at a transition path to alternative reference rates.
Financial institutions should consider taking the following steps:
- Create a governance framework to execute, manage and monitor the transition.
- Identify the businesses, functions, products, contracts, models, processes and other business systems that use LIBOR and assess the impact of the transition on each.
- Identify all impacted business processes and systems and the lead time required for changes.
- Determine changes required to internal and external systems and processes, as well as dependencies.
- Determine what changes need to be made to infrastructure, cash products, derivative products, and trading and analytical systems, as well as risk and financial reporting systems.
- Assess potential accounting outcomes, for hedging portfolios.
- Inform and educate their employees and clients about the transition.
- Identify, enhance ad validate all models required to switch from LIBOR to new rates.
- Develop a framework for simulation uncertainty of new rates for capital and funding requirements.
- Identify all contracts with direct (LIBOR indexed) or indirect provisions.
- Identify and evaluate existing fall back and replacement language.
Companies will also need to keep track of changes in taxation and accounting rules.
Globally, financial institutions and other organisations will need to adapt to new financial market without LIBOR. The leading firms will be those who are taking steps now to prepare their systems and process for the alternative rates. These firms will be better abled than other firms to reshape the financial landscape by making fundamental improvements in collaboration and agility.
Stefan Beyers is a partner PwC Financial Services.