Now Is the Time for Banks to Prepare for Interest Rate Benchmark Reforms
The replacement of the Interbank Offered Rates (IBORs) will have a major impact on financial services firms around the world, and regulatory agencies are pressuring institutions to begin their transitions to alternate or reformed benchmark rates ahead of a proposed 2021 deadline..
Fraud and conspiracy scandals surrounding IBOR manipulations go back as far as the early 1990s, prompting the industry to start considering risk-free reference rates (RFRs). In 2017, the stage was set for a worldwide transition when the UK’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 3, 2019, letter to the chief executive officers of significant financial institutions, the European Central Bank emphasized that a clear understanding of the risks associated with global benchmark reform is needed for a successful transition. The Central Bank appears concerned about the ability of financial institutions to meet all the regulatory requirements by the end of 2021.
Similarly, on July 12, the U.S. Securities and Exchange Commission (SEC) issued a statementon LIBOR transition, while the UK’s FCA LIBOR transition briefing to chief executive officers on July 15 added another layer to the warnings. The statements highlight potential transition risks and provide guidance on related disclosure obligations and risk management efforts related to the discontinuation of current IBOR interest rate benchmarks.
LIBOR rates (and equivalent global indexes) have been the reference rates for the financial industry for more than 40 years — $350 trillion in financial products are LIBOR-indexed. The transition to alternative risk-free rates will come with a vast number of challenges for financial institutions that must comply with 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 (€STR) is expected, as is the transition to €STR from the Euro OverNight Index Average (EONIA), which is the 1-day interbank interest rate for the Euro zone. €STR is an interbank interest rate calculated by the European Central Bank 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 fallback 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). It is expected to publish a forward-looking SOFR term rate by the end of 2021. 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 UK’s FCA and by Jan 1, 2022, EU Benchmarks Regulation (BMR) compliance will be required for all European Union users and administrators of European and third-country benchmark rates.
Expect cross-functional disruption
IBOR transition represents a major cross-functional undertaking for all global financial institutions. It is important for financial markets participants not to delay the completion of an IBOR transition impact assessment for their front-to-back value chain. DXC Technology has compiled a high-level view of IBOR impacts across organizations, as shown in Figure 1.
Considering all the 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 or 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, flexible and compliant with local laws. Above all, they must 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. The smartest 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 speed up the process.
A strong change and program management function is paramount. It must be a multidisciplinary team capable of managing the transition from business, operational, legal and IT perspectives. This team should understand how the transition will affect the organization’s operating model. In addition, the development of an independent risk-monitoring framework would strengthen the overall program structure.
Far reaching change like this requires a robust, end-to-end testing strategy. From market data acquisition to pricing, margin call and risk-monitoring processes, a test factory or center of excellence would ensure that 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 necessary and fully documented to facilitate regulatory auditing. The testing factory setup would mix business and function capabilities.
Getting ready for IBOR transition
The European Central Bank’s letter 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 plan to:
Mitigate such risks
Address pricing issues
Implement process changes
Contact points at management level to oversee the implementation of these plans
Banks were asked to submit their responses by July 31, 2019.
Despite the uncertainties relating to IBOR transition, institutions should mobilize quickly to minimize the risks of straying from the IBOR replacement timeline and not staying aligned with their peers. The deadline may be 2 years off, but the time to start IBOR reform is now.
DXC’s end-to-end IBOR transition offering includes consulting, analytics and information governance, application services, platform implementation, contract remediation and testing services. We leverage digital tooling such as automation and AI to accelerate the delivery of your replacement programs. Contact us now to see how DXC can help you make a successful transition.
Rajesh Sadhwani is a client partner with DXC's Banking and Capital Markets practice in London. Mr. Sadhwani has over 15 years consulting, program management and business development experience. He works with capital markets firms, structuring and delivering global transformation programs to achieve post-merger integration and strategic cost reduction, as well as responding to regulatory changes. Rajesh is passionate about helping capital-market clients navigate the strategic, technological and execution-related challenges and opportunities created by the digital revolution.
Sylvain Collado is a partner with DXC’s Banking and Capital Markets practice in Paris. Mr. Collado helps guide financial institutions through operating model transformations driven by regulatory constraints and cost requirements.