Buyside urged to address benchmark reform
Australian buy-side institutions are being urged to get a clear handle on their exposure to the London Interbank Offered Rate (LIBOR) before the reference benchmark ceases to exist in December next year.
Speaking on a webcast hosted by Fund Business, Nathan Bourne, Senior Executive Leader Market Infrastructure at the Australian Securities & Investments Commission (ASIC); Ross Allen, Managing Director Data Strategy at IHS Markit; John Feeney, Partner at Martialis Consulting; and Kristye van de Geer, Senior Manager Interest Rate Products at the Australian Securities Exchange discussed the challenges facing Australian market participants and how to prepare for the shift to risk-free rates (RFRs).
The challenges are substantial, which is partly a reflection of the significant role that LIBOR plays in the financial system. It has long been the reference interest rate for anything ranging from syndicated loans through to derivatives contracts. Replacing what has always been a credit-based reference rate with a “risk-free” overnight benchmark rate such as the Sterling Overnight Index Average (SONIA) is easier said than done. Since the alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR, which in turn, will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies.
Bourne said that while progress is being made, Australian institutions exposure to LIBOR remains substantial and that across the market, there are varying levels of preparedness, particularly where the buyside is concerned.
“In our engagement with the industry we have found that there are differences among the firms we are communicating with,” he said. “Large [sell-side] intermediaries are much more advanced [but] where we have found it to be more patchy is definitely on the buyside – so the asset management and superannuation side of the equation,” he said.
The transition challenges apply to both legacy transactions – those currently outstanding transactions that reference LIBOR and that have an expiry date beyond December 2021 – as well as new transactions, though it’s renegotiating the legacy deals that could end up being most time consuming.
Bourne told the audience that when ASIC gathered intelligence from ten Australian firms in May 2019, approximately 40 per cent of a total of ten trillion AUD worth of transactions outstanding had an expiry date post 2021. “That is a fairly substantial amount that we are looking at from a legacy point of view,” Bourne said.
To manage the transition from LIBOR to RFRs in legacy trades, firms will need to renegotiate the fallback back language in their contractual agreements. Fallback language refers to the contractual provisions that specify the events that will trigger the transition to a replacement rate should, for example, LIBOR become unavailable; the replacement rate in question and the spread adjustment that aligns the replacement rate with the benchmark that is being replaced. Simply transferring the fallback provisions as they currently are could have significantly adverse P&L implications, so it is critical that firms pay attention.
“There is a whole range of fallbacks that are currently available. The problem is that most of those will leave you with a significantly poor outcome. For example, if you fall back to a fixed rate, that fixed rate is likely to be much lower than you would have expected to receive for the duration of the contract,” Feeney said. Another common fallback clause requires four other market participants to provide LIBOR quotes, something which is going to be practically impossible post December 2021.
IHS Markit’s Allen said that at a minimum, firms needed to understand the level of exposure to LIBOR and be mindful of the fact that contract negotiation would take some time. “At this point in time, it is really important that firms are able to assess their exposures, know where they have fall back language in place and where they need to engage with their counterparties to put in alternative fall backs - either where there are no fallbacks available or where the fallbacks are no longer appropriate. That assessment and mitigation process is certainly something that I would hope most people have already started, because those contract negotiations will certainly take some time,” he said.
Feeney also stressed that firms that left it to the last minute would likely struggle to get access to the legal resources. “It is going to take a lot of work on the legal side to review and change these documents, many of which will have to be done bilaterally and some of them will have to be done multilaterally. For example, for debt instruments that require changes to be made to a prospectus, that has to be done with the full consent of the majority, if not all of the holders, so that is something that is going to take time, effort and legal resources,” Feeney said. He quipped that in terms of legal impact, LIBOR would not be dissimilar to the Dodd Frank Act, which was nicknamed the “full employment for US Attorney’s Act” for the amount of legal paperwork it generated.
New transactions face their own set of challenges. While LIBOR is a credit-based reference rate that essentially reflects banks’ unsecured cost of borrowing over an extended term, SONIA is an overnight benchmark rate that is based on unsecured borrowing transactions with, as yet, not much liquidity further out on the curve.
“Growth in RFRs has been difficult to achieve – there is some trading on the short end, so zero to one or two years, but much less past two years,” Feeney said.
The absence of observable transactions is hampering the development of the forward yield curve that – in a classic case of a chicken and egg problem – is necessary to stimulate trading in RFRs.
As a result, many new transactions continue to reference LIBOR, which is adding to the backlog of transactions that will need to transition come 2021.
IHS Markit’s Allen said that at present, 30 per cent of OTC derivatives swaps transactions are SONIA based with the remainder still references LIBOR. In the US, which is shifting to the Secured Overnight Financing Rate (SOFR) as the alternative to LIBOR, the uptake is even more challenging, with only 1 per cent of new transactions currently referencing SOFR.
However, Allen said that across most major currency jurisdictions there are active processes in place to support the development of term rates, which will also facilitate the adoption of RFRs.
A final point to consider is the fact that the transition away from LIBOR effectively introduces a multiple interest rate environment, in which overnight RFR’s, Term RFR’s and credit-sensitive reference rates will all be available to banks, debt issuers and investors alike. That in turn, introduces operational challenges – in particular the need to have the appropriate tools in place to assess financial instruments that are priced under different interest rate curves or conventions.
“Whether migrating existing risk or assessing new investment opportunities, participants should ensure they have the tools to perform price comparison, under different conventions. Achieving best execution, and equally important ensuring you’re entering into new transactions where you can effectively manage the future cash flows and risks through the life of the trade, will be key as part of the transition,” Allen said. He said market participants would be wise to engage with their vendors to ensure the tools they use support the “new normal” of a multi-rate environment.
To help Australian market participants, ASIC – together with the Australian Prudential Regulation Authority and the Reserve Bank of Australia – has launched an outreach program aimed at bringing Australian market participants up to speed on the transition requirements. Bourne said that as a result of this program, progress has been made, but that further work is necessary, particularly on the buyside.