The December 14 deadline for responses to the recent FCA/PRA letter on Libor transition has significantly increased the industry’s focus on benchmark reform. As transition planning accelerates it will also, indirectly, succeed in starting to highlight the enormous complexity of the challenge ahead.
That complexity can be thought of in two categories:
Transitioning from existing benchmarks raises a host of technical questions. Most are well documented and progress has been made; the various risk-free rates (RFR) working groups have largely identified preferred alternative rates for the major Ibors. However, many uncertainties remain. Most emphasised are the interlinked issues that alternative RFRs lack equivalent embedded credit spreads and are all overnight rates. They therefore can’t be used to directly replace the most commonly used Ibor tenors. Working groups are keenly aware of these limitations. Most have, for example, initiated sub-groups to develop robust RFR-derived term rates.
A second tranche of technical questions will need to be resolved at the organisational and product level. Accelerating the design and roll out of new products referencing RFRs is crucial because of the impact it will have on the overall stock of products maturing post-2021 and therefore the size of the legacy book to be transitioned. However, the external and internal dependencies mean it is likely to be some time before Ibors are completely phased out in new products, and even longer before legacy portfolios can be transitioned (if they are transitioned at all).
While the technical issues are significant, logistical complexity will pose at least as big a challenge. Some of the logistics will be driven by technical considerations. For example, avoiding basis risk between primary and hedging products will require a linked transition. However, sheer volume will be the main driver of complexity for the overall programme. First, because of the range of products and functions that will be affected. Derivatives, wholesale funding and lending products, and many retail products all reference Ibors. Internal processes and models will also, in many cases, embed those same rates. This will lead to a range of co-ordination problems. Second, because of the contractual challenge: the need to access, review and potentially amend huge numbers of underlying contracts.
The contractual challenge
At first sight, any contract which generates Ibor exposure for an organisation is in scope for review and transition. Immediate and accurate reduction of that scope will, of course, be key. For example, definitively determining roll-off dates early in the process should enable swathes of contracts to be classified as out of scope. In 2016 the Alternative Reference Rates Committee (ARRC) estimated that 82% of US dollar Libor exposure would roll-off by 2021. It may also be possible to unilaterally amend certain longer dated products, again avoiding or reducing the need for diligence. (Certainly, Isda is supporting this type of solution for OTC derivatives by amending the 2006 definitions and developing a protocol as well as standardised bilateral language.)
Nevertheless, understanding existing fallback language and being positioned to amend it where necessary across a range of products is likely to be a daunting task for most organisations. Even market participants who consider themselves to have excellent access to their underlying contractual data are highly unlikely to have captured details of Ibor fallback provisions or other related terms in a systematic way. The physical copies of executed contracts will therefore be the only reliable source of this information. The challenge is further complicated because many products will only occasionally reference Libor and include fallback provisions, and where present those references will be spread across a range of terms relating to termination, payment timing and future dated payment calculation.
Despite these challenges, we believe benchmark reform is an opportunity to improve contract data management in general and to provide additional organisational benefits beyond the primary business continuity objective.
Set up correctly, every contract touched as part of the transition should support future contract data and repapering exercises, and this is achievable without incurring excessive additional cost. It will be tempting to set up a temporary data room, extract minimal information and record it in a separate project specific database. However, while this approach will get the job done the opportunity for technology enabled process improvement and the enrichment of any existing contractual data model beyond Ibor related terms will be lost. This would be a shame given the potential these enhancements have to reduce the costs of future repapering exercises and business as usual activities.
The breadth of benchmark reform also presents a secondary opportunity: to initiate a more coordinated approach to regulatory change. An organisation’s most important clients will, in many cases, be adjusting their documentation across multiple fronts over the next few years. Ibor transition will generate changes across a range of products while margin reform, Brexit, QFC and BRRD are also likely to touch many of the same contracts. Implementing a more coordinated approach both internally and externally has the potential to significantly improve client experience and to drive efficiencies through a single (or at least reduced number of) outreach campaigns.
Benchmark reform is going to be a long and arduous process for most large organisations. But its breadth and the need for co-ordination across so much of the business means that it presents an opportunity to set-up better for the future. A forward-looking approach, combined with careful selection and deployment of the right contract data management tools, has the potential to support the inevitable upcoming contract data initiatives while also reducing repapering costs and improving client experience.
Delivery lead - Financial Trade Documentation
Thomson Reuters Legal Managed Services
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