Benchmark reform: Financial services industry and clients need to prepare now
Paul Burgoyne, Head, Treasury & Money Markets, Standard Bank Group
With an overhaul of widely used interest rate benchmarks on the horizon, financial services firms and their clients need to assess what impact this will have on their businesses and take proactive measures to prepare for the transition.
Benchmarks including the London Inter-bank Offered Rate (LIBOR) are used to price financial contracts such as loans, derivatives and bonds worth more than $350 trillion, according to some estimates. Essentially, LIBOR is intended to reflect the rate at which major banks can obtain unsecured funding in a specific currency and for a specific term in the London interbank market.
But the LIBOR benchmark, which has been a dominant reference rate for most adjustable-rate financial products since it was introduced in 1986, is set to be retired by the end of 2021 as regulators take steps to bolster the stability of the financial system.
The United Kingdom’s Financial Conduct Authority has recently highlighted that, although the ongoing global COVID-19 pandemic may have understandably resulted in a shift in focus of financial firms and LIBOR end-users away from LIBOR transition, preparation towards their COVID-19 responses, firms must continue to work towards the central assumption that LIBOR will fall away at the end of 2021, and should target this date in their LIBOR transition planning.
Following the global financial crisis, concerns were raised around the integrity and reliability of inter-bank offered rates (IBORs) in general, given how fundamental they are to the global financial ecosystem.
A review found that IBORs were susceptible to manipulation and false reporting by banks, and also demonstrated that there had been a significant decline in the liquidity underpinning IBORs, meaning they may not represent the underlying markets.
The review concluded that the uncertainty around these rates represented a potentially serious source of vulnerability and systemic risk to the financial system, and made recommendations that IBORs should be strengthened and, if not possible, that alternative rates should be identified.
Since this review, numerous jurisdictions and authorities have announced that they would be reassessing the rates they administer. Where authorities have announced that these benchmarks will be discontinued – as is the case with LIBOR – there is a pressing need to plan ahead.
Some authorities have announced plans to shift to alternative risk-free, or near risk-free rates where possible.
The Sterling Overnight Index Average rate (SONIA) is to replace the pound-denominated LIBOR benchmark, while the US dollar-denominated LIBOR will be replaced by the Secured Overnight Financing Rate (SOFR). These new rates are fundamentally different from LIBOR in several respects, including that they reference overnight rather than term rates, and are backwards rather than forward looking.
All market participants with IBOR exposure should be preparing themselves for the transition, bearing in mind that exposure to numerous benchmark rates will add to the complexity since different IBORs are following different transition paths.
The Euro Overnight Index Average, which is also undergoing reform due to a lack of underlying transactions, will be discontinued in January 2022. Timelines around replacement of US dollar-denominated LIBOR remain uncertain.
In line with offshore developments, the South African Reserve Bank published a consultation paper in August 2018, in which it outlined proposals to reform key interest rate benchmarks and put forward proposals for new benchmarks that could act as alternative reference interest rates. In addition, various working groups have been formed to address the key decisions that need to be made around South African interest reference rates.
Standard Bank recommends that market participants consider the impact of IBOR discontinuation on their businesses, that they engage with industry working groups in local markets wherever possible – for example, by responding to public consultations on the proposed solutions – and that they raise awareness of the issues internally and review their products to understand where reference rates are used. Market participants should also take steps to understand the various interim transition timelines published to date, and the impact that the COVID-19 pandemic may have had on these timelines (whilst the ultimate LIBOR cessation date has not changed, some changes to interim dates have been announced).
In their planning, businesses can seek independent professional advice on the potential impact of interest rate reforms and can also look to other markets for guidance.
The United States Securities and Exchange Commission (SEC) says organisations should assess whether they or their clients are exposed to contracts extending past 2021 that reference LIBOR, for example. The discontinuation of LIBOR will likely affect the operation of these contracts.
In these cases, proactive renegotiations with counterparties may be needed to address contractual uncertainties.
Further, where alternative reference rates are expected to replace LIBOR in existing contracts, adjustments may be required to maintain the anticipated economic terms of such contracts.
Meanwhile, the SEC notes that where derivative contracts referencing LIBOR are used to hedge floating-rate investments or obligations, the discontinuation of LIBOR may impact the effectiveness of the company’s hedging strategy.
By being proactive, informed and prepared, financial services organisations and their clients will be well placed to manage the requirements of this transition.