IBOR Transition: Challenges and Impacts for Corporate Treasurers
By Ulrich De Prins, Partner FRM, KPMG South Africa and Auguste Claude-Nguetsop, Head of Market Risk, KPMG South Africa
South Africa’s major corporates seem not to have awakened yet to the fact that in a few years interbank offered rates (such as LIBOR and JIBAR) will transition to alternative reference rates. This transition will be one of the most significant transformations of interest rate benchmarks in the last 25 years, but are major corporate treasurers fully aware of the challenges ahead? How can they ensure their business is well prepared to handle the possible disruption caused by this transition?
IBOR transition is a fundamental issue for financial market participants. Regulators across the world have made it clear that the discontinuation of interbank offered rates (IBOR) rates by the end of 2021 and their replacement with a new set of reference rates, the so-called Risk Free Rates (RFR), is a certainty and market participants are urged to plan accordingly.
IBOR rates have been, and still are, at the core of the financial system, providing a reference for the pricing of a wide array of financial contracts, including derivatives, loans and securities. Hundreds of trillions of dollars’ worth of financial contracts reference interbank offered rates in one of the major currencies and it is difficult to overstate the scale of funding and investment activity based on IBOR rates.
Notwithstanding the combined efforts of regulators, central banks and industry groups focusing on developing alternative reference rates and robust contractual fallbacks to manage the transition as smoothly as possible, firms cannot just sit and wait, but will instead have to take action in order to adequately prepare for the discontinuation of interbank offered rates.
The purpose of this article is to discuss the potential impact of the IBOR transition, which expands across many critical aspects of organisations, touching on financing and transactions, clients and contracts, operations, systems, models, processes, and accounting. To meet the 2021 timeline, planning needs to be underway and the scale and complexity of the transition should not be underestimated.
Concerns about benchmark rates have been swirling for years. Indeed, even before the LIBOR scandal hit in 2012, unsecured wholesale borrowing activity had been in decline. The LIBOR scandal made clear that the potential for manipulation was high and when in July 2017 the UK’s Financial Conduct Authority (FCA) announced it would no longer compel panel banks to make LIBOR submissions after 2021, the writing was on the wall: the IBORs’ days were numbered.
Over the past years, it has become increasingly clear that global regulatory preference was to replace IBOR with risk-free (overnight) rates based on transactional data. Central banks have encouraged the forming of industry working groups to help in solving issues arising from establishing and then transitioning to new more trustworthy benchmark rates. In the run-up to 2021, working groups and several industry advocates have been working to ensure that the new rates will have established robust underlying cash markets, sufficient liquidity in hedging instruments and broad acceptance from market participants.
IBORs currently underpin a huge range of financial products and valuations, from loans and mortgages through securitisations and to derivatives across multiple jurisdictions. They are used in determining all sorts of tax, pension, insurance and leasing agreements and are embedded in a wide range of finance processes such as remuneration plans and budgeting tools. The impact will, therefore, be felt far and wide. The challenge will be particularly acute for central counterparties, exchanges, banks, insurers, and asset managers, but the ripple effects will also be felt by corporations and consumers as the transition impacts for example the valuation and accounting of derivatives, corporate bonds and business & consumer loans.
In most of the major currency areas the ‘successors’ of the IBORs seem to have been identified; SOFR in the US, €STR in the euro area, SONIA in the UK and TONA in Japan. It is interesting to see that the US has opted for a secured rate (as has Switzerland), while the chosen RFRs in the other currency areas are unsecured. The latter type of rates is expected to be influenced less by the supply and demand in collateral markets, avoiding in this way for example the risk of rates falling during flight-to-safety episodes when sovereign bonds (that serve as collateral) are in high demand.
Between the different currency areas the transition paths have been all but aligned. In the US for example the Alternative Reference Rates Committee (ARRC) published its ‘paced transition plan’ in 2017 and the Fed began publication of SOFR in April 2018. The ECB on the other hand convened its working group for the first time in 2018 and will start publishing the €STR from 2 October 2019. Organisations therefore have to manage multiple timelines.
Creating a robust demand for the new RFRs and developing the liquidity required to support the hedging and risk management relating to the new RFRs, is key to ensuring a smooth transition. It remains to be seen to what extent the multiple rate approach based on a reformed term IBOR and a new overnight rate (potentially becoming the standard approach in the euro and JPY currency areas) could potentially cannibalise the transition of liquidity from IBORs to RFRs.
The new RFRs are overnight indices and currently have no term structure (unlike IBORs). The consensus across the market is that term rates might be required, at least for cash products (where users often prefer knowing future cash flows), as well as to support and ease the transition process. In its paced transition plan the ARRC foresees the creation of a term reference rate based on SOFR derivatives markets, but only by the end 2021.
In August 2018, the South African Reserve Bank (SARB) published a ‘Consultation paper on selected interest rate benchmarks in South Africa’, outlining proposals for reforming key interest rate benchmarks used in South Africa as well as suggestions for new benchmarks that could potentially be used as alternative reference interest rates. The Reserve Bank has also established the ‘SARB Working Group on Rand Interest Rate Benchmarks’ to undertake a comprehensive review of interest rate benchmarks in South Africa. In parallel, a Market Practitioners Group and various work streams were established to facilitate and operationalise decisions on alternate reference rates.
A subsequent report was published in May 2019 on stakeholder feedback, highlighting industry preferences for the proposed alternative RFR and new benchmarks, as well as the SARB’s recommendation. (See Figure 1.)
Fig 1 - Summary of the SARB Proposal