Have we made enough headway in preparing to abandon IBORS?

 New IBORS after 40 years?

Do you know that for more than 40 years interbank offered rates (including the better known as LIBOR, the London one) have been a fact of daily life of the whole financial services industry? They have been the benchmark for the lending on an unsecured basis, from bonds and loans to derivatives or mortgage-backed securities. Unfortunately, because of some scandals and rate manipulations, these IBORS are now upending. The bank scandals in 2012 have sealed the future of IBOR benchmark. In UK, the supervision has been shifted to IBA (i.e. Intercontinental Exchange Benchmark Administration). IBA has tried to strengthen the indices in a slowdown lending market (e.g. 3-month LIBOR USD the “reference index” is supported by less than a billion transactions a day). As consequence, it has been decided to move to an alternate reference rate (i.e. ARR IBOR benchmark) by end of 2021. Lots of countries will follow UK and USA, including EU and Switzerland). But it is tomorrow. No one seems to be ready. It is always good to correct and solve problems. But the solutions must be relevant.

It is clear to all treasurers that the up-coming phase-out of the Interbank Lending Rate (IBOR) means big changes to financial services. Nevertheless, we have the impression, maybe wrong, that just few firms are well prepared.

The underlying market LIBOR measures is no longer liquid. This index was often used to hedge the general level of interest rates, for which it is inefficient given it includes a term bank credit component. The LIBOR submission won’t be guaranteed after 2021. The problem resides in the fact that LIBOR is embedded in many operating models. This could impact many contracts dealt. Therefore, we need to understand the exposures and risks, to assess benefits of this migration, consider ways to mitigate risks and address regulation changes, to put in place contingency arrangements and futureproof documentation and, eventually, to contemplate strategy for after transition period and for new deals.

Transition that will change the whole finance

With such transitions, we have the legacy problem of old contracts. Lots of contracts may still refer to IBORS after 2021. The ARR’s and IBOR’s are structurally different. The old one is referring to unsecured and uncollateralized transactions fixed by expert judgement when the new one is based on actual transactions and secured by collateral. The firms will have to recalibrate a range of deals and risk models behind in determining spreads to be applied. It a huge challenge for both parties.

There are several potential issues including for example a certain regulatory uncertainty and lack of guidance on the IBOR transition which may slow down progress. Transitions are often complicate and may take more time than initially thought. Once inventories are done, it also may result in a system issue. The systems, whatever, must be updated to another reference rate. IBOR’s are also used for general interest rate risk and discount factor in valuation, financial and risk modelling. As such a large range of models will need to be revisited and recalibrated because of the transition to ARR. Potentially they may lack historical sequence and asymmetry in timing of transition across products. Will we have a lack or a lag in derivatives products to hedge potential interest rate risks embedded in loans or other cash products? Maybe… ARR’s aren’t not yet eligible benchmark rate for hedge accounting purposes. We hope they will be eligible soon. The FASB has issued guidance on derivative hedging transactions. Other standard boards will have to amend rules to make ARR’s referenced instruments eligible. For long-date contracts, firms may need to renegotiate contract language for the transition. Conversely to derivatives, it should be addressed contract by contract. The possible risk of IBOR discontinuation (sooner or later) obliges companies to review all contracts. It depends obviously of the number of contracts concerned. Do we have a risk of disputes to be resolved? It is possible although we can imagine that it is in the best interest of both parties to find a common ground. The redefinition of sprads may of course cause problems. In my opinion, people exaggerate (especially lawyers) this risk. The lack of global coordination in the transition may cause issues in the different currencies. We could face discrepancies in IBOR’s and ARR’s, in case transitions are not coordinated between currencies. Initially, solely the overnight rate will be available. The term rates will have to be recalibrated too based on transactions in the derivatives market. As the future of IBOR’s remain unclear (after 2021), some regulators and participants expect they will remain available beyond the deadline. It is not clear. On the other hand, without final “final” deadline, there are always players keen to keep the former reference rates. Extended deadlines only complexify the situations, in my view. Better to decide a final stage and to refuse extensions, as for SEPA, for example.

End of IBOR, not a new issue

The announced end of IBORS is not a new issue a treasurer could claim not being aware of. We still have time to prepare. Of course, it is another problem on top of many others. But in this case, I believe it remains “manageable”. Five new reference rates (i.e. SONIA, SOFR, SARON, TONAR & ESTER) will appear soon, with different attributes. They intend to be the response to widespread allegations of LIBOR manipulations and numerous fines on international banks. The idea imposed by regulators to refer to transaction data makes sense. The objective was to closely align benchmark rates to IOSCO principles. These new rates aim at strengthening existing IBORS by anchoring them in real transactions. This could be a pain point. They should be more robust and better suit for use in many applications. The new rates are backward-looking overnight rates when LIBOR’s were forward-looking tern rates for 7 tenors including a premium paid on longer-dated funds. It is therefore a rather different approach and publication timings. These differences raise some obvious concerns, as all new regulations would say the wise man. They will have specific implications for syndicated loans, for bonds, for floating rate notes or for derivatives.

The market participants will have to gradually replace EONIA in Europe for example, with ESTER as a reference rate for all products and contracts and make all necessary adjustments for using the ESTER as their reference benchmark, including making the appropriate changes to their IT systems to enable a T+1 publication, i.e. taking into account that ESTER will be available by 09:00 CET based on individual transactions conducted on the previous trading day, while currently EONIA is published by 19:00 CET based on the same-day transactions. These are the types of technical challenges to be addressed.

It is fair to remind reader that the corporate treasury associations (i.e. EACT) and local ones in several countries have played an active role in defending treasurers’ best interest in the definition of a new risk-free rate.

EONIA prolonged for 2 years

The European Commission has agreed to prolong for two years the existing rate indices and the EONIA, which still one day will be replaced by ESTER. Some treasurers, like in France, were worried about the risk of a too short transition period with the preliminary deadline of 1/1/2020. We should as much as possible use benchmark rates based on real and effective transactions. However, in case of default of real transactions, we need a robust method to supply the absence of references. In future, supervisors will control rate indices administrators.

ESTER (i.e. Euro Short Term Rate) the new index for free risk rate, should reflect the cost of borrowing over night from a financial counterparty. The ECB will start publishing this rate as of October 2019. It has been suggested to EMMI (European Money Markets Institute) to change the method to calculate during a transition period a synthetic EONIA from ESTER + 9 basis points. After a while systems and organizations will have to be ready for onboarding ESTER.

ECB has encouraged to a smooth transition to ESTER. It is needed to minimize disruption to markets and consumers and to safeguard the continuity of contracts to the greatest extent possible, including contracts that currently reference a term rate rather than an overnight rate.

What does it mean for banks?

For banks it is just another regulatory issue to implement and to manage. It won’t be that simple. It will represent a lot of work without real added value. I wonder whether IBOR changes is not another reform (although fully justified and necessary), which could “kill” banks. After numerous reforms (e.g. B3 & 4, Midif2, PSD2,…), economic downturn, negative interest rates, AML quests from States, will banks survive? Some of them are in difficult shape and another layer of mergers can be foreseen. Treasurers will certainly blame banks for all the scandals: money laundering, FX, LIBORS, etc… However, an economic system without solid banks won’t be viable in the mid-run. I remain dubitative in front of all these changes and constraints. Aren’t we going too far with bankers? Maybe. Nevertheless, recent AML scandals tend to convince the most conciliatory treasurers that eventually all these reg’s are simply correcting excesses and cannot be criticized at all. I like to compare to doping, a never-ending story in sports. However, I remain optimistic and I do expect to see, one day, the end of the tunnel and to stop discovering in newspapers another financial scandal.  

To the question whether these new reference rates will bring the expected comfort, it is not easy to answer at this stage. In my view of Treasurer, it makes sense and former scandals proved the system must be reviewed. As I use to say the best is sometimes the enemy of the good. As always with new regulations, I am tempted to believe they will bring us a better and more secured financial working environment.

Fran?ois Masquelier, Chairman of ATEL  - April 2019 - Luxembourg