For years, the global financial industry has been grappling with what to do about benchmark integrates for financial instruments, and it's now time to start transitioning to alternative risk-free rates.
By Rajesh Sadhwani and Sylvain Collado, Banking and Capital Markets, DXC Technology
Game on. The Interbank Offered Rate (IBOR) replacement will have a major impact on financial services firms around the world, and the regulatory agencies are now putting on the pressure for institutions to begin their transitions to alternate or reformed benchmark rates ahead of a 2021 deadline.
But just what is IBOR? Let's start from the top: the IBOR transition was triggered largely because of the fraud and conspiracy scandals surrounding IBOR manipulations that go as far back as the early 1990s. The industry began considering risk-free reference rates (RFRs) and in 2017, the stage was set for a world-wide transition when the United Kingdom's Financial Conduct Authority (FCA) said that firms need to end their reliance
on and begin moving away from the London Interbank Offered Rate (LIBOR) before the end of 2021.
In a July 3rd, 2019 letter from the European Central Bank (ECB) to the CEOs of significant financial institutions regarding the ongoing transition to alternative risk-free rates, the ECB sets a sharp tone and puts barely disguised pressure on the financial industry to meet expectations. It insists on the fact that a clear understanding of the risks associated with global benchmark reform is a key milestone for a successful transition. The central bank is clearly concerned about the ability of financial institutions to meet all the regulatory requirements by the end of 2021.
Similarly, on July 12th, the U.S. Securities and Exchange Commission (SEC) issued a statement on the LIBOR transition, while the U.K.'s FCA LIBOR transition briefing to CEOs on July 15th added another layer to the warnings. Many onlookers were wondering, just what is LIBOR, and why transition away from LIBOR? Both statements highlight potential transition risks and provide helpful guidance on related disclosure obligations and risk management efforts related to the discontinuation of current interest rate benchmarks.
The IBOR transition genesis
The July announcements by the global financial regulators come after numerous warnings and announcements since 2016 - all of which were in response to the significant number of scandals relating to London Interbank Offered Rate manipulation by various banks. So, after over 40 years of being the reference rate used by the financial industry ($350 trillion worth of financial products are LIBOR-indexed) and being negatively associated with the word 'scandal', LIBOR and its equivalent global indexes are set to be replaced by alternative risk-free rates. However, this complex LIBOR transition will come with a vast amount of challenges for financial institutions that must comply with several deadlines determined by the regulators.
In terms of the new risk-free rates , it has been reported that by the fourth quarter of 2019, the daily publication for the Euro Short-Term Rate (ESTR) is expected, as is the transition to ESTR from the Euro OverNight Index Average (EONIA), which is the one-day interbank interest rate for the Euro zone. ESTR is an interbank interest rate calculated by the ECB on the basis of unsecured loans contracted overnight between financial institutions. By the third quarter the Sterling Overnight Index Average (SONIA) transition will begin and fall-back plans will be implemented, according to reports. SONIA is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions.
In the first half of 2020, the Federal Reserve Bank of New York will begin publishing
a series of backward-looking secured overnight financing rates (SOFR) and is expected to publish a forward-looking term SOFR rate, which is expected to begin publishing by the end of 2021. Now in the midst of the LIBOR-SOFR transition, SOFR is an influential interest rate that banks use to price U.S. dollar-denominated derivatives and loans. By the third quarter, LIBOR production will no longer be guaranteed by the FCA, and by Jan 1st
, 2022, EU BMR compliance will be required by all EU users and administrators of European and third-country benchmark rates.
Expect a cross-functional disruption
The transition to the Interbank Offered Rate represents a major cross-functional undertaking for all global financial institutions. Therefore, it is important for financial markets participants to not delay the completion of an IBOR transition impact assessment across their front-to-back value chain. DXC has compiled a high-level view of IBOR impacts across organizations in the table below, showing the global effect of the upcoming IBOR transition.
Contract remediation is part of a successful IBOR transition
Considering all the identified impact areas and following our analysis of this transition in a specific market context, contract remediation appears to be one of the biggest challenges. Due to the huge volume of documents (many of which are not in digital/machine-readable format) residing in various heterogeneous contract storage systems, contract reviews will represent not only significant operational workloads, but technological challenges as well. To ensure an efficient transition, financial institutions must make the remediation process efficient, compliant with local laws, and flexible, and above all, ensure that the process isn't disruptive to customers. The remediation process can be managed using a combination of business process changes and resource augmentation, whereas the smartest of players will partner with leading technology firms to leverage digital accelerator technologies such as optical character recognition (OCR), robotic process automation (RPA) and artificial intelligence (AI) to fast-track this process. While having a global effect, the IBOR transition can be improved with the right technology.
A fit-for-purpose program management effort is a prerequisite
Financial institutions should be mindful of handling too many impacts as part of their business-as-usual capabilities. While product development referencing the new indexes creation will form part of a firm's new product approval framework, this won't be the case for process remediation and technology enhancements. A strong and transversal change/program management function is therefore paramount to your IBOR transition roadmap. It must consist of the deployment of a multidisciplinary team that will be able to manage the IBOR transition from a business, operational, legal and IT perspective. Beyond global coordination, this team is to understand how the transition will impact the organization's operating model. In addition, the development of an independent risk-monitoring framework would be advisable to strengthen your overall IBOR transition program structure.
Drive success with a testing factory
A far-reaching change such as this requires a robust end-to-end testing strategy. From market data acquisition to pricing, margin call and risk monitoring processes, the objective of a test factory or center of excellence is to ensure all changes made across an institution's systems and processes are validated and verified prior to go-live. The testing process will have to be standardized, automated where relevant and fully documented for regulatory audit purposes, and helps you complete your IBOR transition roadmap. Independence and accountability are also in the spotlight, and the test approval process and related governance must be set up accordingly to make your IBOR transition program successful. The testing factory setup will need to mix business and function capabilities, as well as leverage technological accelerators.
Getting ready for the IBOR transition
Global regulators are taking this transition very seriously, following the change process closely through the various communications as well as the directives ordered - most recently the SEC's statement, the FCA's transition briefing, as well as the ECB's CEO letter, the latter which petitioned banks for the following information:
A board-approved summary of each institution's assessment of key risks relating to benchmark reform and a detailed action plan to:
Mitigate such risks;
Address pricing issues;
Implement process changes.
Contact points at management level to oversee the implementation of these action plans.
Significant institutions were asked to submit this by July 31st, 2019.
Despite the numerous uncertainties relating to the global IBOR transition, all institutions (no matter their size) should mobilize quickly to minimize the risks of not meeting the regulatory deadlines on time or staying aligned with their peers. The deadline may be two years out, but the time to start the gradual change is now.
DXC has an end-to-end Interbank Offered Rate transition offering that includes consulting, analytics and information governance, application services, platform implementation, contract remediation and testing services, leveraging digital tooling such as automation and AI to accelerate delivery of your transition programs. Contact us [add link] to earn how DXC can help you successfully transition to IBOR, and learn more DXC's Banking and Capital Markets services at www.dxc.technology/banking
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Client Partner - DXC Technology's Banking and Capital Markets practice - London Rajesh Sadhwani is a client partner within DXC Technology's Banking and Capital Markets practice in London. He has over 15 years consulting, program management and business development experience working with capital markets firms to structure and deliver global transformation programs to achieve post-merger integration, strategic cost reduction and respond to regulatory changes. Rajesh is passionate about helping capital markets clients navigate the strategic, technological and execution-related challenges and opportunities created by the digital revolution.