In this context, there are six major tasks IT systems need to be able do to support the transition process:
- Capture new ARR rates and build new curves
- Unwind & renegotiation of existing deals
- Support new instruments/trades and calculations based on ARR’s
- Adapt risk frameworks to support ARR’s
- ‘Proxying in’ of historical values for new rates
- Documentation for new Trades
Market data providers, including Bloomberg, Reuters, MarkIT, are actively tracking the market updates and associated data changes that will underpin IBOR transition. Although activity will vary between vendors, we anticipate that this new functionality will include the following components:
- Landing pages for functions pricing and analytics, data, and tickers for new rates, with past rates/indices and their comparison to new ones
- Basis adjusted swap curves with tickers on various adjusted bases
- Derivatives-pricing engines updated to support ARR curves
- New ARR products supported, including IRS, Futures and FRNs
- IRS electronic trading portals updated to include bank quotes on ARR – OIS, with integration into trading and booking platforms, potentially including pre-trade price, post-trade booking, and trade-order management systems
- Derivative trade reporting interfaces enhanced to display ARR trade reports
It is important to be able to have new rates and indices set up in staging/UAT environments for protracted periods of time to facilitate full testing and evaluation cycles.
Within key vendor platforms such as Murex or Calypso, new rates, indices and curves are already available to customers and it is possible to set these up using normal configuration procedures.
2. Unwind & renegotiation of existing deals:
Tools and applications are available in vendor platforms to identify and analyse legacy trades. These trade populations can be also amended to reflect IBOR transition scenarios and the potential impact on P&L of these changes.
Vendors have built sets of reports detailing the transition impact on each index (e.g. USD LIBOR --> SOFR), which can be used in support of renegotiating legacy contracts. Such reporting packs will need to be run multiple times during the transition period.
Several third-party vendors (e.g. TriOptima, Quantile, Capitalab) also offer tools for portfolio compression, which is usually used to reduce the number of trades in a portfolio (hence reducing portfolio complexity and management costs) while retaining the same risk profile. Using these tools as part of an IBOR transition program will reduce the number of trades that need to be re-booked as part of the migration process.
3. Support new instruments/trades and calculation based on ARRs:
The ISDA consultation process has indicated that fixing in arrears on compounding daily rate is the preferred approach to rate setting, and that futures estimation is the preferred approach for pricing. These approaches will require some adjustment to systems but can be largely supported without significant functional changes.
The preferred IBOR transition mechanisms will require good underlying market liquidity, so it will not be possible to book new trades (beyond short term tenors) until such liquidity is formed, regardless of systems readiness. Close collaboration between technology and market-facing business teams is therefore required to optimize the timing of IBOR transition across products and asset classes.
As many transition details are yet to be finalized, vendors must offer continuing support for development, pricing and clearing of new IBOR based instruments. Assessing the modelling and pricing impacts of new basis risks and efficiently packaging up emerging changes is particularly important.
During transition phases of unwinding deals and replacing them with new ones detailed dashboards to show and control each event (or set of events) in terms of risk and P&L are required, such tools may well require new versions of vendor software.
4. Adapt Risk frameworks to support ARRs:
Most ARRs are based on ‘risk free’ rates, thus will move in a way that is independent of any sector or individual counterparty specific risk. This means that Credit Risk will be embedded solely in rate spreads for ARR based trades. The way in which curves based on ARRs react to market movements will be different because of this; while IBOR rates will respond to changes in bank specific risk, ARRs will not respond.
Credit and Market risk systems will require intensive testing to ensure that their responses and reactions to market ‘shocks’ are accurate and predictable. A detailed review and validation of risk engines between Front Office, Quantitative, and Technology teams is also needed.
5. “Proxying in” of historical values for new rates:
Data for new ARRs will be limited in quantity and quality going back in time. To facilitate Market Risk analysis sourcing reliable proxies for past periods will be required. The spread to matching existing IBOR rates will not be constant either over tenor or historical data range; furthermore, the time required by Risk and Technology team to establish these proxies must not be underestimated or there will be a negative impact on the quality of historical risk scenario analysis and back-testing.
6. Documentation for new trades:
Making sure all existing trade documentation is fully archived, that all new trade information meets ISDA standards, is legally signed off on, and is fully documented & captured is critical. The storage and management of such information needs to be delivered outside the bounds of core trading platforms with the operational aspects of IBOR transition representing a complete program of work in itself.
Order of changes
The order in which IBOR transition changes can be made to systems is important. New rates, curves, & instruments need to be set up first, and are dependent of the specifications for ARRs and products being finalized.
Creating of new instruments and sample trade is next, until longer tenors are available for ARRs though; such instruments may not have sufficient liquidity and or accurate pricing so as to justify basing trades upon. Contract and trade documentation changes can then proceed in parallel with the proxying of historical data for new rates and validation of risk frameworks.
Finally, a migration framework for old trades can be determined, we anticipate that the multi-lateral negotiation of same will take time and needs to have been started as soon as ARR regimes are locked down.
Having a comprehensive view on IBOR transition systems change will give institutions a clearer path on this complex and multi-dimensional marketplace challenge.