Against a growing chorus of warnings, banks need to begin planning in earnest for the transition to new risk-free reference rates.
A few weeks ago FCA Chief Executive, Andrew Bailey, cautioned on the dangers for firms of continuing to rely on LIBOR as a reference rate both for existing financial contracts as well as when writing new business. Despite firms being put on notice that they will need to transition to new risk-free reference rates, he stated that there was a continued ‘inertia’ and ‘misplaced confidence’ that LIBOR would continue in some form, putting both individual firms and wider financial stability at risk.
He is right to be concerned, it is a big issue which requires concerted attention from industry and regulators alike. Interbank offered rates or ‘IBORs’ – of which LIBOR (London InterBank offered rate) is the most well-known – are used as reference rates for financial contracts such as bonds, securitisations and derivatives worth in the order of €100tns globally.
The days of IBORS such as Sterling LIBOR, USD LIBOR and EURIBOR have been numbered since 2012 and reforms proposed in the aftermath of the so-called LIBOR rigging scandals. LIBOR is primarily a measure of the cost of borrowing between the world’s largest banks, and is calculated based on submissions from a panel of such firms.
Reforms were introduced off the back of that scandal in order to make the IBORs more robust, including that the data that banks submit should be based on real transactions, as much as possible. But with volumes of unsecured lending between banks far below their peak, there is no longer enough data to sustain a rate based on these markets.
Work has been taking place to identify alternative reference rates since 2014. But arguably the final death knell came last year when Andrew Bailey announced that by the end of 2021 the FCA would no longer compel panel banks to submit the data necessary to calculate LIBOR. Thus signposting regulatory expectations that by 2021 firms should be ready to shift to new risk-free reference rates (RFRs) instead. SONIA has been identified by The Bank of England as the new, unsecured overnight risk-free rate.
AFME, along with many of its members and other bodies, has been engaged in those efforts, but much more needs to be done to ensure the industry is ready.
For instance, a recent report we published along with ISDA, ICMA and our sister organisation, SIFMA, suggests that while there is widespread awareness that transition planning is needed, many firms, issuers and investors are yet to begin serious preparations
The IBOR Global Benchmark Transition Report surveyed 150 capital markets participants including banks, corporates and law firms. It found that while 87% of market participants are concerned about their exposure to IBORs and are familiar with the matter, only 11% have allocated budget to resolving the issue and just 12% have developed a preliminary project plan.
The survey also found that part of the reticence for taking action comes from industry lacking ‘a clear sense of direction’ from regulators and RFR working groups about both the desired end state as well as how firms should approach key issues such as tackling legacy transactions, which are linked to an IBOR.
In this context, it is welcome that ISDA has released its consultation on technical issues related to the introduction of fallback arrangements for derivatives contracts, which reference certain IBORs. The continued work of the various RFR working groups on refining plans for the new RFRs will also provide additional clarity over time.
But while it goes without saying that until many more details are finalised it won’t be possible for firms to put concrete arrangements in place, waiting for every i to be dotted before taking action isn’t really an option.
The issue in June by the EIB of a £1 billion floating rate note linked to SONIA was also a major step forward, which showed that a bond linked to the new RFR could be successful.
Immediate action from market participants to identify the specific risks and challenges for their own organisation will ensure they are prepared and can avoid any nasty surprises further down the line. Questions firms should start to ask themselves include ‘what is our level of exposure to IBORs?’ and ‘how would a permanent cessation of IBORs affect us and our clients’?. The IBOR Global Benchmark Transition Report includes a fuller checklist which firms can use for IBOR transition planning. Making these preparations now will ensure firms are ready to react as more details are finalised, and help to avoid a disorderly, and potentially costly, transition.