The transition from LIBOR to Alternative Reference Rates (ARRs) promises to be the biggest shake-up in financial markets in recent history. There is still much industry speculation, with no definitive view on how long LIBOR will continue to be published or indeed how long it will be permitted for use in new financial contracts beyond the end of 2021.
A variety of transition scenarios are possible, but as Edwin Schooling-Latter, Director of Markets and Wholesale Policy at the FCA, made clear in a recent speech, the FCA will “assess the capability of a critical benchmark to be representative of an underlying market and economic reality” and that the regulator will invoke its power as the LIBOR Benchmark supervisor “each time a supervised contributor – i.e. a panel bank – announces that it intends to stop submitting data”. This raises a real prospect that the FCA could remove the EU Benchmark Regulation supervisory endorsement for individual LIBOR currencies or even tenors at different times.
This phased approach, combined with the signs of fragmentation already emerging between Derivatives and Cash markets, increases the probability of a multi-rate environment which will increase transition complexity and introduce basis risk.
While the Derivative market has made significant progress agreeing the primary methodology for calculating fall-back rates and has also aligned an agreement that Term Reference Rates (TRRs) are not required, the Cash market has been much slower and less decisive, with many areas insisting that TRRs will be required.
Since a large proportion of the derivatives market is designed to hedge against losses in cash products, hedging basis risk will occur. Basis risk between LIBOR and ARRs as well as across different ARR tenors are both abundant when moving existing back-book instruments from LIBOR to ARRs.
First, other than a simple dichotomy of secured versus unsecured rates, there is currently no definitive methodology to determine which ARR to transition each product to. While the ISDA Benchmark supplement proposes a waterfall of selection stages, this approach is better suited to simple products (e.g. single reference rate); complicated products (e.g. cross-currency swaps) could be open to multiple reference rates due to their cross-border nature. The difference in liquidity (and rates) between LIBOR and ARRs would lead to LIBOR-ARR basis risk, which would also vary by tenor.
The second issue is the lack of ARR Term Reference Rates (TRRs). Term structures can be constructed by multiple methodologies and differing approaches can lead to ARR term-structure basis risk.
While basis risk concentrates on the back-book, it is also critical to determine the strategy for front-book origination. In this uncertain period, with no clarity on the LIBOR end-date, some long-dated products beyond 2021 continue to be created referencing LIBOR. It is important that financial services firms ramp up their transition efforts now to minimise remediation work required at a later date.
So the key question to ask is what should financial services firms do now to minimise their basis risk in this uncertain period? For the back-book, the first step would be a holistic review of all products to consider their purpose and interactions with each other, in order to determine a suitable ARR. This may require negotiation with trade counter-parties, as they may have a different view. Ensuring a match between cash products and their paired derivative tracks also helps to minimise hedging basis risk. Where multiple ARRs may be required, heuristics need to be determined. This could include such considerations as:
- Minimising LIBOR-ARR basis risk, across all terms;
- Considering the suitability of the official ARR or other potential fixing alternatives; and
- Avoiding ARRs which do not have ARR term structures, where the product requires it.
Where contracts cannot be renegotiated, heuristics are required to select whether contracts would enter the legacy runoff or indeed potentially close out. The criteria should be based on the potential risks and downsides. Contingencies following forced close outs due to a LIBOR hard-stop should also be considered.
For the front-book, work should begin now on product review and modification. Similar heuristics to the back-book could be chosen for the selection of ARRs on new products. The focus here would be on the redesign or modification of products. In some cases, entirely new products may be required to capture some of the specific features of the new reference rates (e.g. different volatilities, spreads etc.).
Typically, new product approval process can take 3-6 months to execute per product. A streamlined framework for the wholesale re-design and approval process for whole families of products is needed, while still being robust enough to capture all key risks, especially basis risks.
The above modifications to the back- and front-books would be supported by quantitative analytics, since extensive modelling would be required to capture the dynamics of the new ARRs. This is likely to impact existing LIBOR market models (e.g. HJM, BGM, LMM). The absence of adjustments or recalibration of models could lead to model risks in both pricing and valuations. As with all other suggestions, such work should begin now, rather than awaiting clarity of the LIBOR end date.
For more information contact:
Global Advisory Practice