IBOR Transition – Planning Priorities for Internal Audit 2021 | Deloitte UK has been saved
Limited functionality available
Explore the latest Financial Services Internal Audit (IA) suggested areas of focus for 2021: www.deloitte.co.uk/planningpriorities2021
Why is this Important?
The FCA has remained consistent with its message that firms cannot rely on LIBOR - dubbed the ‘world’s most important number’ – being published after 2021.
It is difficult to understate how widespread references to LIBOR are across a products and functions for financial services firms and corporates, and transitioning away to alternative rates is a significant industry challenge. Whilst some would note that firms should be starting to move into the home stretch of transition - offering new products to clients, amending existing contracts to alternative Risk-Free-Rates (RFRs) and updating systems and processes to enable non-LIBOR business, there remains a significant amount of activity for the industry to deliver in a limited time.
Table: Summary by jurisdiction of LIBORs, currency working groups and alternative rates recommended as replacements
Failure to successfully transition could lead to significant costs – economic, legal, and regulatory. Given the scale of work required across lines of defence, business and control functions, internal auditors looking to assess their firm’s programs have a wide scope of topics to address. By planning ahead, internal audit have the opportunity to provide timely assurance and feedback from their work on transition to internal stakeholders, such that if change is needed, it can be done in a timely manner, to help support transition timeframes.
In recent months, there have been developments impacting transition timelines and the work of internal audit, of which a selection is below:
- The UK’s RFRWG has moved several of their interim target dates for loan contracts. Market participants are expected to be able to offer non-LIBOR loan products by October 2020 and to cease issuing LIBOR loans that mature after 2021 and also accelerate transition of legacy contracts in Q1 2021.
- The FCA has suggested that announcements on the end dates for at least some of the LIBOR currency / tenor combinations (LIBOR is currently published daily for 5 currencies across 7 tenors or time periods, such as overnight, 1 week or 3 months) may be announced before the end of this year – such an announcement would fix the credit spread adjustment for derivatives under ISDA Definitions.
- In the US, the Alternative Reference Rates Committee (ARRC) has released a ‘Best Practices’ document, laying out USD LIBOR transition timelines.
Operations and Technology:
- Clearing Houses in July 2020 switched euro-denominated swaps from EONIA (European Overnight Index Average) to the €STR for discounting and Price Alignment Interest purposes – USD contracts will move from Fed Funds to SOFR in October 2020.
- The ARRC has released a transition aid for internal systems and processes, laying out suggested activities for functions to consider as well as possible downstream impact and dependencies.
- Tough Legacy –– some contracts cannot practically be transitioned to alternative rates (for example bonds where 100% of noteholder consent is required to amend the language). In the EU, US and UK legislative solutions have been proposed to deal with tough legacy contracts – but none of these have yet been passed into law.
- Hong Kong’s HKMA has announced key milestones for transition – alternative rates should be offered from January 2021 and new LIBOR products maturing after 2021 should cease from the end of June 2021.
- In Singapore, the SC-STS (Steering Committee for SOR Transition to SORA) and other institutions have released a report on the future of SGD benchmarks, recommending SIBOR is discontinued to focus liquidity in SORA (the Singapore Overnight Rate Average), the recommended replacement for SOR (Singapore Swap Offer Rate), which uses USD LIBOR as an input.
- ISDA is expected to imminently publish updated 2006 Definitions – providing fallbacks for new derivative contracts – and is releasing a corresponding Protocol which will allow adhering parties to include fallback language in existing contracts.
The impact of the current environment has led to a shift in target milestones set by regulatory convened working groups. Furthermore, as LIBOR transition has developed, the transition of other IBORs has also gathered pace (e.g. transition of the SOR and HIBOR (Hong Kong Interbank Offered Rate) benchmarks. With moving milestones for LIBOR transition and a gathering of pace in the reform of other similar benchmarks, transition programs will not only need to keep abreast of changes, but will also need to be flexible enough to respond and adapt to scope and remit changes accordingly.
Internal audit should be able to assess the extent to which a program keeps track of changes to milestones and regulatory expectations, and how the impact of the reform of other benchmarks is being considered.
Example considerations for IA include:
- Changing Milestones - how has the program taken into account recent industry developments and milestone changes, such as those released by the UK and US Working Groups?
- Resourcing – are the program and underlying businesses sufficiently resourced to respond in a timely fashion to increased regulatory scrutiny? Given the global nature of the transition, are the right resources in the right locations?
- Global Engagement - where IBORs use LIBOR as an input (several benchmarks used in APAC, such as SOR, or in Thailand the Thai Baht Interest Rate Fixing (THBFIX), use USD LIBOR as part of their rate calculation methodology) which will also need to be transitioned or reformed, how is the program engaging with authorities and working groups for those IBORs and keeping up to date with any developments?
Conduct Risk Mitigation Efforts
Managing conduct risks over the transition is also a topic which has been previously raised as a significant area of focus, and will continue to be as RFR market liquidity develops further, and contracts start to transition away from LIBOR. Institutions will need to be able to demonstrate that conduct concerns have been adequately assessed and mitigation measures taken – failure to do so could lead to reputational, legal and financial costs – especially as due warning has been provided. Internal audit should be able to validate and assess risk management measures taken by their firm in respect of conduct risk management. Example considerations for IA include:
- Controls - how has the impact of the transition on the firm’s existing conduct risk framework been considered? Are existing controls sufficient or are amendments required?
- Internal Training - has sufficient training been carried out internally – especially for employees speaking with clients?
- Client Communications – firms will need to show they are treating clients suitably and appropriately during the transition. Are clients given enough time to consider transition options and provided with sufficient information (such as differing features of RFRs and changes in externally set target dates) to make informed decisions?
- Conflicts of Interest - what controls are in place to ensure that customers are being treated fairly and that any information asymmetries (such as knowledge of client transition timelines) are not exploited for commercial gain? Can it be demonstrated that clients are not being moved to economically unfavourable rates? How have conflict registers been updated for these considerations?
The contractual transition of legacy contracts away from LIBOR and on to RFRs may prove to be a significant undertaking. Aside from conduct concerns noted above, contracts may need to be bilaterally agreed with counterparties. Internal auditors have the opportunity to plan their assurance work in a manner which adapts to management’s transition style. Example considerations for IA include:
- Exposures – how are these being tracked and reported as they are managed down - is this taking into account all contract types? Is exposure monitoring used as an input to strategy and timeframes for contractual transition?
- “Switching off” LIBOR - to what extent have program teams adapted their control environment to restrict LIBOR trading beyond their target transition dates (and external milestone dates).
- Legal and Litigation Risk - how is this being assessed, measured, monitored and reduced over the course of negotiations with customers?
- Forward Looking Term Rates - how is the program tracking the timeframe for the delivery of RFR Term Rates, and establishing a control process for their ongoing use? Is the use of term rates a discussion topic with customers?
- Tough Legacy Contracts – has the program identified an inventory of such contracts? Where transition of such contracts is planned to rely on proposed legislative solutions (i.e. EU; UK or US), have the impacts and differences between solutions been analysed and is there a contingency option if legislation is not passed?
The next few months will be crucial for the transition. Regulators have noted that the current environment has impacted the pace of transition, and have adjusted interim milestones accordingly. Internal auditors can play a key role in the coming months as an independent control function challenging programs, assessing plans and progress against those plans, and reporting on any risks or issues identified whilst there is still time to resolve them ahead of the end of 2021.
Industry Working Group Resources:
Hong Kong - https://www.tma.org.hk/en_market_LIBOR.aspx
Steve is the Head of ESG Assurance in our Audit and Assurance practice for our UK and North and South Europe partnership. Steve is a chartered accountant and has extensive experience in audit, internal audit and regulatory implementation programs. He has worked with a wide range of companies across all major industries, having developed a thorough technical understanding of products and control practices for non-financial risk management. Steve has significant experience in partnering engagements for the provision of ISAE 3000 / 3410 independent assurance over sustainability information and in relation to the sufficiency of design and operating effectiveness of processes and controls to report on non-financial information.
Mark is a Partner in our Regulatory Assurance team. He is our AI Assurance, Internet Regulation and Global Algorithm Assurance Leader with 20 years of experience across financial services audit and assurance, regulatory compliance, regulatory investigations and disputes. He has led the development of our assurance practice as it relates to our approach to assisting firms gain confidence over their algorithmic and AI systems and processes. He has a particular sub-sector specialism in the area of algorithmic trading with varied experience supporting firms enhance their governance and control environments, as well as investigate and validate such systems. More recently he has supported and led our work across a number of emerging AI assurance related engagements.
Rickesh is a Senior Manager in our Banking & Capital Markets Audit Group in London and leads our Benchmark Advisory and Assurance work in the UK. Rickesh has extensive experience working with large multi-national financial institutions focussed on financial benchmark reform such as LIBOR, front to back controls frameworks and implementation, market abuse regulations, IOSCO principles for financial benchmarks and compliance with EU Benchmark Regulation.
Henry is a Senior Manager within Markets Assurance & Advisory based in London, with experience in benchmark reform; the EU Benchmarks Regulation; Front Office controls and FIC business management. In recent years he has worked in investment banks focusing on large scale regulatory change and control implementation programmes.