The targets of this article are all firms that have interest rate exposure, and particular, those providing or receiving credit in some form.
In a low rate, low volatility and vanilla single-benchmark environment firms require careful planning and execution to meet their needs. However, in a more volatile and splintering lending rate benchmark environment this introduces new headwinds and dangerous squalls. This is the second of two articles. The previous article focused on the steps that the banks themselves are taking – focused on interest rate derivatives (IRD), the banks’ exposure discovery process, the scheduled CCP changes mid-2020, and the banks’ broader set of operational and technical changes. By comparison, this article is from view of other firms – those that trade with the banks and represent a far broader set of corporations. This article assumes basic knowledge of the IBOR Transition (see previous posts). It firstly outlines the range of activities impacted, then how relationships with banks will change, and ends with a few simple tips on how to prepare for the IBOR transition.
To begin – IBOR transition will change a very wide set of activities across the real economy. well beyond just the financial sector. The IBOR regulation is different from other regulation, its impact is inherently extraterritorial. The global financial system relies upon certain reserve currencies, and the interbank lending rates of these, currently set in London. This means that regulatory discontinuation of, for example, USD LIBOR has significant impact across many more countries. USD LIBOR is often used as a proxy for the risk-free rate for valuation purposes, as well as setting an appropriate lending and interest rate (outside of the US itself). Domestic lending rates may not necessarily fulfil the same role as USD LIBOR, and none have the characteristic deep liquidity. For example – domestic rates may be used in retail and mortgage market, but not for corporate lending and trade finance. In some local jurisdictions, domestic rates are simply USD LIBOR plus an appropriate cross currency (swap) conversion. The end of LIBOR will require existing contracts to change for a whole range of corporates and financial institutions. Lending through loan agreements, or credit line facilities, and even margin financing terms will need to reference a new ARR (alternative reference rate). Even late payment penalties for commodity or equity products often reference LIBOR and will need to change. Insurance firms will need to re-align some of their commitments and re-invest some of their fixed income portfolios. Those that distribute floating rate notes (FRNs) and other cash fixed income will need to address non supported contracts. Those that arrange lending through syndicated debt will need to review terms of legacy agreements. Project Finance as well as Trade Finance, will also require scrutiny and change. Without remediation, floating rates become fixed – with economic winners and losers. Corporate Treasurys’ market operations will no longer use bps above IBOR as the benchmark of how much money costs. This makes funding even less predictable – more winners and losers are created. All firms that have interest rate liabilities may already be hedging these with banks, through various Interest Rate Derivatives (IRDs) including swaps. In summary, all activities that involve interest rates, be it for short term or long term credit, receiving and providing, using cash and derivatives products – all this will need to be analysed and changes required (well before December 2021). Any activity and interaction with banks will also change.
As mentioned in previous posts (IBOR Changes Pt 1: Swaps) the global Tier1 Banks’ are already under way with their exposure discovery. They are also getting ready for the CCP changes to cleared interest rate derivatives. However, these are just two steps within a far larger programme of operational and technical changes. Banks will need to run systems in parallel (for pricing, valuation, risk management, trading, booking, collateral exchange, compression and the full contract lifecycle). This parallel run covers the bifurcation of rates, and may need to support multiple rates per currency as a permanent outcome. The parallel run will also cover the runoff of their existing backbooks (of IBOR referencing contracts, with their clients). This will continue alongside their market side activities (including hedging client book exposures). You may wonder, how does the banks’ transition preparation affect clients? Banks will be under pressure from this parallel run and will want to reduce complexity and risk. Banks are constrained by the regulatory deadline and are already expected to evidence progress at reducing their IBOR exposures. However, without finalisation of ISDA fallback protocol (recently delayed again – announced Feb 2020) then their client outreach and renegotiation efforts can’t be accelerated. All client outreach must adhere to conduct standards and be in the clients’ (and not the banks’) interests. This makes for a tricky balancing act.
Clients will be under increasing pressure to agree new terms, or new trades – and should make sure this is in their interests. Which brings us to the third point.
Thirdly and finally, what should these firms do in order to prepare for the inevitable renegotiation and rebooking. In many ways this mirrors what the larger Banks are doing. However, it needs to be done throughout all activities that reference interest rates, and all products and credit (be it received or provided). It needs to cover cash as well as derivative instruments, and Funding and Treasury functions need to be considered. The notional exposures as well as the frequency of trades may be far less than the banks, but the operational lift on a diverse set of activities and exposures will require careful planning and execution. This requires deep and broad exposure discovery, mapping of data and process, and agreeing readiness strategies. This may require rationalisation of activities, and which bank side products and counterparties are used.
In summary, IBOR Transition is now becoming apparent to the wider economy, and not just to Banks. Outside the US and Europe, regulatory focus has been slower, but is picking up (see last Article on Taiwan authority pronouncements – 25th February 2020). This article has outlined various types of firms and activities that will be impacted. It has also highlighted how the relationship with banks will change – as both seek to comply with the regulatory December 2021 deadline. It is far better to act now, sufficiently in advance, and to develop tailored readiness strategies.
More information on the IBOR Transition for IRD and Fixed Income cash products, as well as IBOR Readiness Strategies is available upon request.
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