Libor transition Taking Action in an Uncertain Environment
- 1. Tel: Mail: Tel: Mail: Tel: Mail: LIBOR Transition Abul HASNAT Director – Risk, Regulatory and Finance (917) 859-3864 abul.hasnat@sia-partners.com Taking Action in an Uncertain Environment April 2019 Theo RABOUIN Senior Consultant (646) 496-0160 theo.rabouin@sia-partners.com Daniel H. CONNOR CEO US (862) 596-0649 daniel.connor@sia-partners.com
- 2. CONFIDENTIAL © Sia Partners 2 Impact of LIBOR’s Demise1 Alternate Rates Designated to Replace LIBOR2 Importance of Taking Action Now5 Key Steps in Preparing for the Transition4 • Identify Current LIBOR Exposure • Determine Alternate Replacement Rate or Rates • Modify Impacted Contracts to Reflect New Rates • System and Process Changes to Handle Transition Table of Contents Conclusions and Key Takeaways6 About Sia Partners7 Differences Between SOFR and LIBOR3
- 3. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 3 Impact of LIBOR’s Demise The London Interbank Offered Rate (LIBOR) has been the interest rate benchmark referenced by a wide array of derivatives, loans and securities products for many decades. Scandals related to the manipulation of LIBOR have diminished confidence in its reliability and prompted regulators and industry organizations to initiate efforts to find a suitable replacement. The Financial Conduct Authority (FCA), which has regulated LIBOR since 2013, announced in July 2017 that it will not compel or persuade banks to make LIBOR submissions after December 31, 2021. Anticipated complexity due to non-standardization Anticipatedcomplexityduetovolume OTC Derivatives Exchange Traded Derivatives Securitizations Bonds Business Loans USD LIBOR product spread and complexity of transition The impact of transitioning away from LIBOR cannot be overstated due to the massive footprint of products referencing LIBOR and the immense planning and effort needed in order to manage the transition. Global footprint of $370 trillion gross outstanding notional of instruments referencing LIBOR - USD LIBOR accounts for $200 trillion Many outstanding questions with regards to identifying a suitable replacement Organizations not operationally prepared to support such a transition Millions of legal contracts tied to LIBOR Not guaranteed to be available after 2021 Source: Federal Reserve Bank of New York Why it is a big deal Consumer Loans
- 4. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 4 Alternate Rates Designated to Replace LIBOR The Federal Reserve Bank of New York (NY FED) has established the Alternative Reference Rates Committee (ARRC) to help ensure a successful transition from USD LIBOR to a more robust reference rate. In July of 2017, ARRC announced that the Secured Overnight Financing Rate (SOFR) would be its recommended replacement for USD LIBOR. While we explore the transition from USD LIBOR to SOFR, it is important to note that other regions have initiated similar efforts to find replacements for LIBOR rates in other currencies. ARRC considered several criteria in determining its recommended replacement, including the following: 1. Benchmark Quality 2. Methodological Quality 3. Accountability 4. Governance 5. Ease of Implementation ARRC has published a “Paced Transition Plan” to facilitate and encourage the transition to SOFR SOFR: description and background Alternate rates from other regions TODAY 2012 July LIBOR manipulation exposed Calendar 2017 - June ARRC recommends SOFR as alternative to USD LIBOR 2018 - July ARRC unveils indicative SOFR term rate 2014 - November ARRC established to find alternative rate European Union ESTER - European Central Bank United Kingdom SONIA - Bank of England Switzerland SARON - SNB with SIX Swiss Exchange Japan TONAR - Bank of Japan 2019 Continue to build SOFR linked instruments 2019 – H1 Develop transition plan for move to SOFR and take action 2017 - July FCA plans to no longer compel submission of LIBOR past 2021 2021 – Q2 CCPs no longer accept new swap contracts for clearing with EFFR as PAI and discounting 2021 – EoY Create term-rate SOFR Complete transition to SOFR 2019 – EoY ISDA plans to amend definitions and offer a protocol
- 5. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 5 LIBOR SOFR Unsecured rate (includes a built-in credit component) Secured / Unsecured Secured rate Seven maturities (from overnight up to 12 months) Maturity Overnight $500 million in daily underlying transactions for 3-mo. LIBOR Volume $800 billion in daily underlying transactions Mean of panel bank submission rates (excluding several higher and lower rates) Calculation Volume weighted median (for combined repo datasets) 11:55am (GMT) Publication Time 8:30am (EST) ADVANTAGES DISADVANTAGES ADVANTAGES DISADVANTAGES Several different tenors available More consistency across regions using different variations of LIBOR Reduced confidence due to manipulation scandals As the rate is unsecured, additional risks are built- in to adjust accordingly Pros & Cons Calculated based on actual data, making it less vulnerable to manipulation Reflects fewer risks due to being secured, so rate is lower Only one maturity, term rates have to be created Adjustments are needed to make it more comparable to LIBOR Differences Between SOFR and LIBOR SOFR is intended to be a more reliable benchmark than LIBOR and while there are some clear advantages in transitioning to SOFR. The differences between the two pose a challenge in administering the change. VS
- 6. CONFIDENTIAL © Sia Partners 6 CEASE USE OF LIBOR Key Steps in Preparing for the Transition Systems and Processes Much of the details around how SOFR will work is still unclear, including whether adjustments will be needed and what are the other options if there is no forward term SOFR available. Systems and processes must be prepared for all possibilities as waiting for resolutions to all issues may not be an option. Identify LIBOR Exposure In order to be fully aware of the impact of such a transition, organizations must know their exposure to LIBOR connected instruments. The range and volume of this exposure will provide guidance for the planning and immediate next steps. Modify Legal Contracts Inventory of contracts referencing LIBOR need to be amended to incorporate fallback language in case of unavailability of LIBOR. ISDA will help facilitate some of the changes by proposing amendments but organizations will be responsible for implementing many of the changes. Determine Replacement Rate or Rates While it’s clear that SOFR is the designated replacement for USD LIBOR, the calculation of a forward looking term rate is still unclear. Much of this will be determined through industry consensus and ARRC recommendations which organizations must stay in tune with. LIBOR Transition Program The transition from LIBOR to SOFR will undoubtedly be a prolonged effort, making it critical to get a head start in not only planning, but also taking action where possible. Waiting for the uncertainties to be sorted out risks leaving the organization unprepared and incapable of making the switch within the timeframe communicated by regulators and industry organizations. Setting up a governance structure to execute and monitor the transition should be a top priority.
- 7. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 7 Identify Current LIBOR Exposure Sia Partners employs Data Analytics and Robotic Process Automation (RPA) technology to review documentation and identify link to LIBOR, essentially automating a key aspect of the identification process Sia Partners insights Identified risks Newly issued instruments linked to LIBOR will increase the exposure and the scope of the transition Manual processes are always more time-consuming and prone to errors such as omitting certain LIBOR-linked instruments in the identification process Stakeholders to involve Business heads Technology and systems Legal and contract management Key actions and considerations # 1 Review product inventory to determine current exposure to LIBOR The exposures identified helps narrow the contracts to be reviewed and amended # 2 Assess expiring contracts to determine those expiring before LIBOR cessation Focus should be on contracts not expiring until after 2021 and any new LIBOR linked contracts issued # 3 Review contracts for any linkage to LIBOR Automation can be leveraged to review and classify contracts, as well as for remediation # 4 Define plan for a gradual migration of all exposures Migrating all instruments at the same time will not be feasible so a phased transition will be needed #5 Identify businesses, functions, systems and processes impacted Early identification will ensure engagement from appropriate teams Actions Considerations Identifying the current exposure to USD LIBOR is the first step in planning for the transition
- 8. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 8 Determine Alternate Replacement Rate or Rates Identified risks Risk managers may be delayed in identifying impact of switch to LIBOR Delays in finalizing the methodologies for adjustments and term SOFR calculation can result in a risk of reduced time to enact the changes Stakeholders to involve Business leads Risk managers Key questions and answers # 1 As SOFR is a secured rate lower than LIBOR, will a spread adjustment be needed to compensate? ISDA is developing a Credit spread adjustment for derivatives and ARRC is doing so for cash products # 2 How will a forward looking SOFR term curve be developed? The Fed has published a methodology paper and ARRC has also published an indicative SOFR term curve # 3 What alternatives are available if an IOSCO compliant term SOFR is not available by the end of 2021? Alternatives being considered includes: a. SOFR compounded in advance b. SOFR compounded in arrears c. Simple daily SOFR in arrears SOFR Compounded in AdvanceOf the three alternative options, what would be the preferred second fallback rate option? 68% 16% selected up SOFR compounded in Arrears 16% selected Daily simple SOFR in Arrears SOFR is clearly the designated replacement for USD LIBOR, but many questions remain Questions Answers Source: Live poll of LSTA Operations Conference participants, April 9, 2019 (approximately 100 respondents) The decision on SOFR spread adjustments and forward looking term rate cannot be made in isolation. Industry consensus is critical, as is preparation for all possible outcomes Sia Partners insights
- 9. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 9 Modify Impacted Contracts to Reflect New Rates Identified risks Amending a large number of contracts once LIBOR ceases will not be practical Fallbacks should be thoroughly vetted to prevent unintended consequences Stakeholders to involve Legal Compliance Operations Key questions and answers # 1 What is fallback language? Fallback language governs what rate a loan would revert to if LIBOR was no longer available # 2 What considerations need to be taken in determining the fallback language? Fallbacks have to consider a trigger event, a replacement rate and adjustment # 3 What type of triggers can initiate the transition from LIBOR to SOFR? Mandatory triggers: 2 ISDA triggers and 3 “pre-cessation” triggers have been proposed Early Opt-in triggers: helps reduce LIBOR linked contracts prior to cessation # 4 Which contracts should be modified first? It’s not practical to handle all amendments at once so best to prioritize where possible # 5 Will adopting more robust contract language lead regulators to treat the amended contracts as new trades? This is currently being discussed in ARRC’s Regulatory Issues working group To amend existing contracts, clarity is needed on the new language to be used and the process for making changes Questions Answers Of estimated USD LIBOR contracts are maturing by 20211, leaving about 18% to be amended. This represents millions of documents across the industry and does not include newly issued contracts which do not mention an alternate rate. Source: Federal Reserve staff calculations, BIS, Bloomberg, CME, DTCC, Shared National Credit, and JPMorgan Chase. Data are gross notional exposures as of year-end 2016 Contract amendments should be phased to prioritize those with the highest combination of clarity of new language and volume Robotic Process Automation (RPA) technology can be used to scan documents and identify mentions of LIBOR and facilitate replacement Sia Partners insights 82%
- 10. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 10 System and Process Changes to Handle Transition Identified risks Delaying the initiation of system upgrades risks not having sufficient time to thoroughly vet and test the implemented solutions Stakeholders to involve IT Business leads Key questions and answers # 1 Where will SOFR be sourced from? Possibility of making the rates available on Bloomberg and Reuters screens is being explored Planning can be started on identifying systems that will need to source and disseminate the rate information # 2 What are vendor systems doing? Systems like LoanIQ will undoubtedly accomodate for the new rates and being aware of these changes can help to plan for integration and ensure consistency # 3 What changes can be made to systems before the intricacies of SOFR are decided? While there is no final decision on the spread and the term SOFR, it is clear that systems will need to handle add-ons to SOFR, possibly requiring additional fields within existing systems Enhancements to systems and processes can be time consuming, raising the urgency of getting a head start Questions Answers System enhancements can be initiated to account for all possible outcomes. New fields and ways to source data can be anticipated. Vendor system changes will require integration with internal systems Sia Partners insights
- 11. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 11 Importance of Taking Action Now For firms who are not yet aware, not yet engaged, and without plans to address their LIBOR-related dependencies, I warn you again of the risks. Andrew Bailey - CEO of the Financial Conduct Authority The industry is struggling to move forward with the transition given the many uncertainties still needing clarification. However, the benefits of taking action now and preparing for all possibilities will far outweigh the costs associated with losing valuable time waiting for outstanding issues to be resolved. Despite the warnings, firms are struggling to mobilize their transition efforts. Some firms may be relying on LIBOR to continue being published after 2021, while others may be taking a wait-and-see approach rather than taking a lead. Both approaches carry with them risks, as transitioning all exposure simultaneously at a latter date will prove to be impossible. Industry unprepared for transition to SOFR 65% Somewhat Knowledgeable Not prepared How knowledgeable do you feel you are on the LIBOR transition? How prepared is your bank for the transition away from LIBOR? 62% 24% were not knowledgeable at all 11% were very knowledgeable 25% were somewhat prepared 12% didn’t know 1% were very prepared Source: Live poll of LSTA Operations Conference participants, April 9, 2019 (approximately 100 respondents)
- 12. CONFIDENTIAL © Sia PartnersCONFIDENTIAL © Sia Partners 12 Conclusions and Key Takeaways 2. Stay Plugged-In 3. Gain the Advantage1. Mobilize the Organization One benefit of dealing with an industry- wide issue is that many aspects of the solution can also be developed at the broader level, reducing the risk of being an outlier in approach. In order to maintain consistency with the methodologies being utilized throughout the industry, it is critical to be aware of recommendations and other guidelines being published by organizations such as ARRCand ISDA. In addition to consuming the outputs of such groups, they also serve as a platform to raise any perceived issues. The transition from LIBOR to SOFRwill require prolonged engagement from many functions within the organization. Relevant stakeholders must be educated regarding the impacts of the change and be fully committed to seeing the transformation through. This endeavor can not be handled as a Business as Usual (BAU) matter, and will require appropriate project planning, resourcing, and decision-making in a timely fashion. The scope of the challenge that awaits demands that creative solutions are explored. Robotic Process Automation (RPA) will make the difference between being overwhelmed by the volume of documentation to be amended and having a relatively uneventful transition. Data analytics can provide a pivotal advantage in not only identifying the impacted contracts but also in facilitating the necessary changes.
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