Beyond IBOR: An important paradigm shift for markets has been saved
Beyond IBOR: An important paradigm shift for markets
ME PoV Summer 2020 issue
In July 2017, the UK Financial Conduct Authority (FCA) reported that the London Interbank Offered Rate (LIBOR) will be phased out as the interest rate index used in calculating floating or adjustable rates for loans, bonds, derivatives and other financial contracts by the end of 2021. But with LIBOR underpinning approximately US$350 trillion in financial products globally, what are the implications for businesses?
Interbank Offered Rates (IBORs), of which LIBOR is one of the most significant, are reference rates used by financial market participants and quoted on a daily basis by different banks with the adjusted average representing the quoted rate for unsecured borrowing and lending.
Other commonly used reference rates are the Euro Inter-Bank Offered Rate (EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR).
The decision to replace LIBOR followed a review initiated in 2013 by the FCA to address concerns regarding its long-term sustainability. LIBOR was discredited when, during the 2008 financial crisis, the authorities in the United States and the UK found that traders had manipulated it to make a profit.
In 2013, the G20 commissioned the Financial Stability Board (FSB) to review the major interest rate benchmarks following concerns raised in the market regarding the reliability and robustness of benchmarks. In 2014 the FSB concluded that risk-free reference rates (RFRs) could be considered, in many cases, more suitable than IBOR reference rates.
Who is impacted by the change?
The proposed change heavily impacts financial institutions, corporate and individual borrowers with billions of contracts locked in with a reference rate that is lined up for phasing out. Business segments, as noted in figure 1, will be affected globally and in the Middle East. Certain financial institutions as well as the regulatory bodies in the Middle East region are working on the initial analysis, gap assessment and different scenarios for the transition.
What are the challenges associated with the reform?
Due to the scale of usage of IBORs across products and financial markets, the task to replace the use of these rates (in legacy and new trades) is vast. Banks and corporates may face a number of significant transition challenges:
- Changes to entities’ operating models are expected to be significant given the extent to which IBORs are likely to be embedded in processes, systems and controls, including IT infrastructure.
- Identification of areas where there are dependencies between different contracts tied to IBOR and potential complications in meeting regulatory capital rules and other requirements.
- Amending legacy contracts to refer to RFRs could be more challenging and financially dis-advantageous and managing a range of fallback replacements across different products and currencies.
- Entities have to assess the impact on liquidity and funding, and also treasury teams will have to analyze the impacts on the products traded by them.
- Insufficient and uncoordinated training on new RFR products and transition impacts could lead to conflicting messages from different business areas, including finance, risk management, operations, treasury, etc.
- Counterparties will need to assess the accounting issues, whether a reference rate replacement for a legacy contract constitutes a substantial modification and therefore derecognition under IFRS.
- Entities will need to consider whether a change in a hedging instruments’ terms will lead to a cessation of the hedge relationship and assess any implications for designated cash flow hedges that hedge IBOR cash flows beyond transition.
- Entities will need to consider whether amendments to existing contracts could give rise to a disposal of the existing contract for tax purposes and the related tax implications.
Update on financial reporting requirements on reform (IFRS perspective)
The International Accounting Standards Board (IASB) is engaged in a two-phase process of amending its guidance to assist in a smoother IBOR transition.
Phase 1 – The first phase of amendments to IFRS 9, IAS 39 and IFRS 7 are focused on hedging relationships and associated disclosure requirements, effective from 1 January 2020. These amendments provide certain reliefs and exemptions for hedge accounting requirements under IFRS.
Phase 2 – The second phase exposure draft on 9 April 2020 focuses on the financial reporting issues that may arise when IBOR rates are either reformed or replaced.
As a practical expedient, the IASB proposes that the entities apply the change to the contractual cash flows prospectively by revising the effective interest rate, instead of substantial modification requirements under IFRS 9, if both the below conditions are met:
a) The modification is required as a direct consequence of IBOR reform; and
b) The new basis of determining the contractual cash flows is economically equivalent to the previous basis.
Similar reliefs are proposed for impact on lease arrangements and insurance contracts arising from IBOR reform.
Entities will need to amend their hedge documentation to reflect any modifications arising from IBOR reform. Also, entities would be required to disclose how they are managing the transition and the risks arising from this transition.
Global transition initiatives
Regulators have urged entities to take action to ensure a smooth and orderly transition away from IBORs at the end of 2021. There has been a heightened focus on conduct risk mitigation by global regulators in relation to transition from IBOR.
Working groups made up of regulators, central banks and industry experts, have identified alternative RFRs for key currencies to use as a replacement for IBORs. Listed below are some alternative RFRs for key currencies: RFRs and IBORs work in different ways. For example, SOFR is calculated using actual transactions and is a broad measure of cost of borrowing overnight that is collateralized by treasury securities, whereas LIBOR is set by a panel of banks submitting their estimates of what they think their borrowing costs are.
Many regulators, including the Securities and Exchange Commission, Financial Reporting Council, Prudential Regulation Authority, European Central Bank, Swiss National Bank, The Association of Banks in Singapore and the Bank of Japan have issued key questionnaires, checklists and conduct recommendations for adequate governance during the transition process, as well as clear communication strategies and robust management of conflicts of interest.
Next steps for impacted entities
Entities need to establish a transition plan under the supervision of their Board of Directors and execute planned work steps over a dedicated timeframe, providing internal and external feedback on progress.
The key activities and work streams to consider when setting out the roadmap include:
Transition program and governance
- Structure the team and build a transition program.
- Identify the risks arising from transition and develop relevant mitigation plans.
- Arrange staff trainings and implement an internal communications strategy.
Initial assessment and strategic direction
- Perform an initial assessment of the potential impact of the IBOR reform on the business.
- Establish a strategy and target for reducing IBOR exposure.
- Perform an impact assessment for accounting and tax exposures, operating model challenges and legal impacts by applying different transition scenarios.
- Analyze contractual language and affected counterparties.
- Assess and document legal impacts (e.g. changes to fallback provisions, implications for non-standard contracts).
- Amend regulatory reporting requirements.
- Identify instruments that might be affected by accounting and tax issues and address the reporting requirements.
- Update key processes, systems and controls associated with reform.
- Redesign or discontinue existing products due to reform.
- Deliver training on reform and establish a process for employees to escalate issues arising during transition.
- Ensure customers understand the risks or outcomes they might face from transition.
- Review feedback from clients and other stakeholders and any disagreements/litigations that might need to be addressed.
Execution and monitoring
- Roll out a transition program and discontinue legacy IBOR processes, systems and technology.
- Post go-live, governance and control framework need to ensure quality of input data, transparency of methodology and clear communication to stakeholders.
- Ongoing monitoring of IBOR reform and archival of transition implementation documentation.
Although the transition from IBOR is not expected before end-2021, the reform will have a major impact on financial products already being offered and the risk management approaches adopted by financial institutions and corporates. As there may be many uncertainties associated with the transition, entities will have to move forward within a transition scenario scripted to minimize the downside risks and manage the operational challenges without triggering a crisis. As put by William C. Dudley, former President and CEO of the Federal Reserve Bank of New York: “The impact of a disorderly transition would be huge. Therefore, a half-hearted effort or a failure to act would be inexcusable, especially after all we have learned from the experience of the financial crisis. Moving this core piece of the global financial system to a firm and durable foundation is essential and worth the cost”.
by Syed Samar Abbas, Director, Audit & Assurance, Deloitte Middle East