News Analysis

‘LIBOR reform, one of the largest structural changes in the financial world’

Anand Kalyanaraman BL Research Bureau | Updated on May 11, 2020 Published on May 11, 2020

Rajosik Banerjee, Partner and Head, Financial Risk Management, KPMG

The use of LIBOR (London Interbank Offered Rate), currently the predominant global interest rate benchmark, is set to end in December 2021. Taking the LIBOR’s place will be other benchmarks such as SONIA, SOFR, ESTR and TONAR. Rajosik Banerjee, Partner and Head, Financial Risk Management, KPMG in India explains the implications of this major transition in an e-mail interaction with BusinessLine. Edited excerpts:

What is the scale of the expected transition from LIBOR to other benchmarks? How much progress has been made, and in which countries?

The benchmark reform is one of the largest structural changes to occur in the financial world in half a century, encompassing $ 350 trillion in notional value of financial contracts linked to LIBOR and its ilk. In addition to the volume impact, the change encompasses various aspects of a business such as risk management, accounting, tax and treasury functions and legal functions. The countries leading the transition — the US, the UK, Switzerland, Europe and Japan — are farthest with the transition.

For risk-free rates (RFRs) like SONIA and SOFR, calculators for computing term rates through compounding in arrears are already available with regulators. The process to calculate forward-looking term structure is still under discussion. Volumes in derivatives referencing the new RFRs, namely SOFR, SONIA, SARON, TONA and ESTER, are on the rise. This will be essential for forward-looking term structures.

The fallback language for existing contracts is being circulated by benchmark working groups and alternate term rates based on RFR are in the process of being published by administrators. Regulators are already encouraging creating new contracts exposed to these rates. Globally, the goal is clear, as we speed towards the end of LIBOR regime.

What are the challenges and costs involved in the transition?

Operational and regulatory challenges exist for all market participants. Financial institutions and corporations have manifold risks. Operational risks that institutions are exposed to are infrastructure changes to IT systems, business processes and legal challenges associated with transitioning a large volume of contracts. On the regulatory side, participants must keep a host of guidelines (related to accounting, risk management) in mind while making this change. One of the largest risks is conduct risk associated with transitioning financial contracts. Consumers and customers should be at the forefront of this transition.

Considering there will be different RFRs for various countries, and these may differ in their construct, it may add an additional complexity for global financial institutions. Active involvement from the regulators would help in easing out the transition and understanding complexity.

Costs are both direct and indirect. Direct costs can be thought of as the immediate hit taken on positions as contractual rates are changed. On either side of the contract, there will either be a winner or a loser when the eventual transition occurs. Indirect, but equally important, costs arise from changes that will be made to business processes, risk management models and associated IT infrastructure, and the legal costs for transitioning contracts.

The cost of loans for Indian market participants, be they institutions or individuals, will change depending on the funding mix of the bank or lender in question. The direction of the change and influence of new RFRs will vary from lender to lender. Under the MCLR regime, the lenders’ funding mix (deposits and borrowings), plays a part in determining the internal benchmark. Lenders with heavy exposures internationally, where IBORs come into play, will see changing floating rates for their products.

Which segments of the market will be the most impacted?

A segment is hard to pin down, as the ramifications of the transition are multi-dimensional, spanning institutions, products and business lines. The impact will spread across institutions, such as banks, asset managers, insurers, exchanges, CCPs, and corporates who have exposure in IBOR or IBOR-linked products. The exposure could range from derivatives contracts, loans, external commercial borrowings, foreign currency debts, structured products, bonds. Within institutions, the change affects multiple aspects of business such as risk management, accounting, tax and treasury functions and legal functions.

What are the implications of the change for Indian investors/borrowers/market players?

While the Indian benchmarks have not been published yet, Indian institutions and individuals are still not shielded from the change. Large institutions with foreign exposure, be it banks, NBFCs, mutual funds, insurance companies and pension funds, will obviously be affected by the change. Even corporates with oversees exposures will be affected. Contracts will have to be renegotiated to arrive at a replacement rate; related risk management models and processes, IT infrastructure and accounting practices will all have to be altered. This affect will trickle down to retail investors and borrowers from institutions. The MCLR regime is impacted by the funding mix of lenders. This impacts retail borrowers with floating rate contracts to the extent that their lender has foreign exposure via IBOR-linked contracts. Retail investors having exposure to larger funds will also be impacted.

Are Indian entities aware of and getting ready for the impending change?

At this stage, Indian banks, borrowers, corporates and investors, while aware, are not as ready as they should be for the transition. This could be because the Indian benchmarks themselves are not changing yet. Market participants with international exposure must begin assessing the impact of the transition as they will be affected, whether Indian regulators begin a transition of our own benchmark rates or not.

Is there possibility of an extension in the timeline beyond 2021 to help with the transition?

At a global level, there is awareness and significant work is being done to enable smooth transition. Countries such as the US, UK, Switzerland, Europe and Japan, who are leading the transition, have active regulators and independent bodies (such as ISDA, IASB) that are liaising with stakeholders and helping market participants through the transition. They have published consultation documents, term rate calculators and guidance for the transition.

Even though Indian benchmarks have not been made available yet, Indian market participants will be affected by the transition as the timeline is at a global scale. Anyone with foreign exposure must begin to think about the transition and the eventual change in Indian benchmarks to match the global wave.

Many benchmarks will be available from 2021 — for eg SONIA, TONAR, SOFR, ESTR. How should a borrower choose from among the options?

In the erstwhile regime of interbank offered rates, each country had its own benchmark rate for its currency. Each country is replacing its own benchmark rate, i.e. its own IBOR with new RFRs. For example, USD LIBOR will be replaced by SOFR, GBP LIBOR by SONIA, EURIBOR by ESTER and CHF LIBOR by SARON. In these cases, borrowers do not have much choice if they are transitioning contracts that they have entered in the erstwhile regime. Depending on the country or currency of exposure, the replacement rate is fixed.

The mapping of IBOR to RFR is not fixed, and here is where market participants have a choice or at the least some leeway for specific types of contracts, since the replacement is not one-to-one. Each new rate has markedly different risk characteristics than its IBOR counterpart. The crux will be choosing the right adjustment to make these new risk-free rates comparable to the rate they are replacing, both in terms of adjusting its tenor and adding spread to account for risk differences. (eg for secured RFR replacing an IBOR, risk premium will have to be added to the RFR as IBORs had risk premium added to them inherently).

Many contracts that expire beyond 2021 are still being priced on LIBOR. How will these be transitioned?

The jury is still out on the exact terms of the transition. In the short term, contracts that have fallback provisions (provisions for when the rate is not published for a short period of time) will have leeway to delay the transition.

In the long term, we must think about the best alternate rate and spread adjustments that capture the risk characteristics of the erstwhile IBOR rate. At a high level, the transition will involve converting the overnight RFR to a term rate (depending on the tenor used in the contract) and then adjusting this term rate with a spread that accounts for the risk differences between the specific RFR and IBOR. Each of these steps has a different method.

The other part of the problem depends on the type of contract that is being transitioned. If the contract is standardised, then the central counterparty (eg ISDA) must come up with the terms of the transition after consulting all stakeholders. This effort is already underway and ISDA has made a lot of headway. Contracts that are not standardised or traded OTC (over-the-counter) will be tougher to transition as the consent of both counterparties is required. These types of contracts will involve negotiation and discussion amongst counterparties to arrive at the best alternate rate.

Many customers seem reluctant to shift, not knowing their exact cost due to the lack (so far) of forward-looking SONIA term rates, unlike those in place for LIBOR. How will this be addressed?

Given low but increasing volumes of derivatives traded in the new RFRs (be it SONIA, SOFR, TONA, SONAR, ESTER) it is tough to get a forward-looking term rate that is implied by these transactions. ISDA is leading consultations for term rates based on new RFRs for derivatives (which may be carried onto cash products as the notional for derivatives is larger). Major economic participants are more inclined to this backward-looking rate for the transition since it limits volatility. The current best replacement is a backward-looking term rate with a static spread.

As with any choice, there are always trade-offs. The potential volatility of forward-looking rates is a major concern for those transitioning to the new regime, and the alternate is backward-looking rates. While backward-looking rates limit the volatility, they also lack any representation of the markets’ assessment of current conditions.

When it comes to analysing costs, we recommend market participants to begin their impact analysis/sensitivity analysis immediately. This would involve understanding how their positions are impacted under different transition scenarios and planning for the same. Reluctance is understandable, but market participants must also be as proactive and must seek out solutions to mitigate any potential fallout.

The MIFOR (Mumbai Interbank Forward Offer Rate) that is currently linked to LIBOR will also see a change. What are the implications of this for the Indian markets?

MIFOR is directly calculated from USD LIBOR. It is a major rupee interest rate used by institutions that have the underlying forex exposure in derivatives and lenders for floating rate products. Any banks, corporations and other institutions that use MIFOR to hedge forex and interest rate risk will be impacted.

As a start, regulators and benchmark administrators in India must think about how MIFOR will be altered or replaced by an entirely new rate. The most direct way to assess the impact would be to analyse the sensitivity of MIFOR-linked products to changing LIBOR rates. Financial institutions with exposure should begin to analyse the impact of using different rates in their existing contracts and gauge the most appropriate rate from the gamut of benchmarks used to hedge similar risks. New products may also be created for new benchmarks and may serve the same purpose as that served by MIFOR-linked products.

Published on May 11, 2020

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