SM: How do you get rid of the world’s most important number?
What do you do when the authorities say you can no longer use it?
And how does the global financial sector react when the way it prices almost all of its financial products has to change because of it?
I’m Scott Martin from Deloitte’s Centre for Regulatory Strategy and you’re listening to Regulated Radio.
I’ve got Ed Moorby and Sherine El-Sayed with me here today to dig into some of the toughest questions to answer on LIBOR.
That’s right, LIBOR, the London Interbank Offered Rate. If you work in finance, you’ve definitely heard of it, and you probably have a sense of just how important it is for financial institutions each and every day.
But as the UK FCA has said, there is an end-game for LIBOR, and the transition away from it will be a process that will carry plenty of risks and opportunities for the financial sector.
So, all this, coming up in the next 20 minutes or less.
This is the show that will give you what you need to know about this, one of the biggest regulatory trends for 2019.
This is Regulated Radio.
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SM: Some days we have to spend our time dealing with problems that only affect a small number of people.
This is not one of those days. Moving off LIBOR is a challenge of a really significant scale.
Financial contracts based on the LIBOR rate run into the hundreds of trillions of dollars, to the point that some have often referred to LIBOR as the world’s most important number.
But, nevertheless, it’s been an international policy goal to move to a more robust benchmark rate since 2012. A lot of work has been happening since then to make this a reality, but so much work still lies ahead to get the job done.
But let’s jump right in. I’m really delighted to have Ed Moorby, a Partner in Deloitte’s Financial Services Risk Advisory practice joining us on the show.
Ed, welcome to Regulated Radio, it is good to have you here.
EM: Great to be here Scott.
SM: So Ed, could you tell us a bit about LIBOR and why it is so important to global financial markets?
EM: Sure Scott. LIBOR is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It is calculated based on submissions from selected panel banks and is published in five currencies and a range of maturity terms.
It’s important because, essentially, LIBOR is embedded in firms’ operating models. When I say firms, I mean banks, asset managers, insurers, and corporates. They use LIBOR as a reference rate in derivative, bond and loan based contracts and consumer lending instruments, like mortgages and student loans.
SM: So that’s obviously a pretty wide net you’re casting, but do you have a specific sense of just how widespread this kind of use for it is?
EM: Well, in terms of scale, it’s often said that LIBOR affects contracts estimated at around $300 trillion, on a gross notional basis. So to state the obvious, the scale is huge. It’s also important to note that while it might be administered and regulated in the UK, LIBOR is used globally. So any withdrawal of LIBOR is a systemic issue across jurisdictions, unless planned properly.
I should also add that although we talk specifically about LIBOR transition on this show, there are transition initiatives underway for other Interbank offered rates. For example, Euribor in the Eurozone and TIBOR in Japan.
SM: So Ed, I imagine an uninitiated listener might be a bit confused by what we’re talking about here. The LIBOR rate is clearly of extreme importance to financial markets, but we’re also busy trying to phase it out. Can you tell us what’s so wrong with LIBOR that it can’t carry on?
EM: There are two main reasons, Scott: the robustness of the rate and panel banks’ reluctance to continue contributing to LIBOR.
On the first point, authorities are concerned because the underlying market that LIBOR seeks to measure is no longer sufficiently active, which creates a few problems. For example, it raises the question of whether the benchmark is actually representative of what it’s seeking to measure. Another example would be that where LIBOR continues to rely on the use of “expert judgement”, because of limited real transaction data, it is left vulnerable to manipulation.
SM: Okay, so that’s been the concern from the perspective of regulators. You said there was some concern on the part of the industry as well?
EM: Yes, exactly. Where there is little actual borrowing activity LIBOR panel banks are having to provide submissions based on judgements with little evidence to back these up, and they’d rather not be doing this. Behind the scenes, the UK Financial Conduct Authority has actually spent a lot of time persuading panel banks to continue submitting to LIBOR.
SM: All right, now I also want to bring in Sherine El-Sayed, a colleague of mine in the Centre for Regulatory Strategy who specialises in LIBOR transition.
Sherine, welcome to the show.
SE: Lovely to be here, Scott
SM: Sherine, as we’ve been saying, this is a major piece of policy work for the international regulatory community with already a lot of history to it. Can you walk us through how we got to where we are today?
SE: Well, Scott, this has been a long time coming. We all know about the manipulation scandals, which emerged in 2012 and beyond. Regulators have been busy addressing ways to reform benchmarks since then. In particular, in 2014 the Financial Stability Board set out recommendations which included the development of alternative risk free rates. As a result, over the past few years, risk free rates have been identified in the UK, US, Switzerland, Japan and Eurozone. All are now live, with the exception of the Euro rate, which should go live in October 2019.
Ed’s point on underlying market forces and how these have drawn into question the representativeness and robustness of the rate, have also been strong drivers for moving away from LIBOR.
SM: Okay, but why is momentum for this transition picking up now?
SE: Well, the key reason is that Andrew Bailey, who is the CEO of the FCA, gave a speech in 2017. And in that speech, he announced that by the end 2021, the FCA would no longer intend to compel or persuade panel banks to submit quotes for LIBOR. This made clear that reliance on LIBOR could no longer be assured beyond that date.
SM: So you’ve mentioned the term “risk free rate”, I wonder can you tell us what exactly that means and maybe how it’s different from LIBOR or an Interbank Offered Rate?
SE: Sure. Risk free rates measure overnight borrowing costs in either unsecured or secured financial markets. Some of the differences are that LIBOR and other interbank offered rates are usually published for forward-looking tenors and incorporate a bank credit risk premium, while risk free rates do not. In many cases, risk free rates are fully transaction-based and they are often administered by central banks.
SM: All right, so, as you say, we’re now in a period with much more momentum behind the regulatory activity pushing this transition. What’s the latest on the work that the FCA has been doing to keep this all on track?
SE: There has been a lot of activity. But I think the most significant development was a “Dear CEO” letter addressed to large banks and insurers, from the FCA and PRA. The letter was sent out in September last year and it asked Boards to sign-off on a comprehensive risk assessment of LIBOR transition for their firms, looking at the prudential and conduct risks. They also asked firms to identify a Senior Manager to be accountable for and oversee LIBOR programmes, in accordance with the UK Senior Managers and Certification Regime.
SM: That is a… fairly big step for the FCA to have taken
SE: Yes, this is was significant. It sent a strong signal that regulators are serious about transition and that they expect accountability at the highest levels within a firm.
SM: Now, Ed, both you and Sherine have mentioned that this is not just a UK or EU-specific initiative, but really a global issue. Have regulators further afield been doing similar work as well?
EM: Well, it’s a good question Scott, because we’ve seen different approaches to driving LIBOR transition, and also different approaches to implementing risk free rates.
For LIBOR transition I think the FCA and the PRA are seen as leading the charge, and the actions they’ve taken, for example, the Dear CEO clearly demonstrate this. FINMA in Switzerland are also being very proactive, for example we have recently seen them ask firms to complete a ‘self-assessment’. The Fed in the US have also been active, but haven’t taken as a direct approach as we’ve seen in the UK and Switzerland.
Looking beyond LIBOR I’d say the regulators in the Eurozone and Japan, overall, haven’t driven the adoption of risk-free-rates with as much vigour, and indeed, it look likely we will see Euribor continuing beyond 2021.
SM: Do you think that that’s going to be a problem for the market?
EM: Well, a key concern will be that if for any reason the pace of adoption of Risk Free Rates is slower than anticipated, there will be limited liquidity for these rates in the market. This could then put at risk completion of the transition away from LIBOR in the timescales that the regulators have discussed
SM: And just revisiting your earlier point about systemic risk – how could we conceivably get to the point where the transition of a benchmark rate, even if poorly executed, could threaten the stability of the financial system?
EM: I think this could conceivably happen if firms, and that includes corporates as well as financial services firms, have not prepared themselves for the cessation of LIBOR, and are not ready in time to switch to using Risk Free Rates for new products. This would mean they would not be able to trade and manage their own financial exposures and risks in the way that they need to, and it would also mean that banks wouldn’t be able to meet the needs of their customers.
SM: Okay, but have regulators been saying anything about this risk yet?
EM: They have, Scott. The Bank of England’s Financial Policy Committee has highlighted these issues and made it clear that continued reliance on LIBOR is creating systemic risks for the medium-term.
F
rom the Bank’s point of view, as long as the stock of LIBOR‑linked sterling derivatives continues to increase, the medium‑term risks to financial stability will grow.
SM: Right, that will be very important to watch. Now, a lot of people talk about the big task that the sector will face in amending contracts for financial products where those contracts reference LIBOR. What are some of the options that firms have when they’re looking to do this?
EM:. The first point to note here is that there is an important distinction between amending existing contracts and issuing new ones. For new contracts, firms need to decide when they plan to start issuing new products linked to risk free rates. This is going to vary by product type, and possibly type of customer, but in reality markets in risk free rates exist now and firms can move to these now. This ultimately goes back to the point I made earlier about systemic risk and that as long as firms continue using LIBOR-linked long-dated products, it kicks the can down the road and can create problems later.
SM: And you mentioned that there’s different considerations for existing contracts?
EM: I did, yes. For existing contracts, amendments would typically require a market protocol or counterparty/client consents depending on the contract type. As you’d expect there are initiatives underway by risk free rates working groups and trade associations regarding the incorporation of standard market language.. Overall, I’d expect firms to make good progress on this ‘back-book’ transition ahead of the end of 2021.
Another point to note is that the FCA and US risk free rates working groups have raised the question of incorporating pre-cessation triggers into contracts, which would allow for a switch in reference rates where a benchmark is deemed no longer sufficiently representative. Again, this could possibly lead to different approaches across jurisdictions and could lead to problems with hedges, unless a uniform approach is adopted across products.
SM: So, is the transition then just a matter of repapering, at least for existing contracts? Why would that be such a big challenge for the industry?
EM: Unfortunately, no, it is much bigger than that. For LIBOR transition there’s no specific regulation to comply with, so market participants need to drive transition themselves (with some guidance or direction from regulators). For this to work there needs to be strong market coordination. For example, banks issuing financial products are not going to transition to risk free rates if there is no demand for products that reference risk free rates.
This means that to build momentum for the transition there needs to be extensive customer education and outreach. There are also a whole host of operational changes, accounting impacts and conduct risks that need to be dealt with. And of course firms need to be well coordinated and set up a strong governance framework to oversee and implement the transition.
SM: I’m going to pick up on conduct issues for a moment, but Sherine I’ll bring it back to you for this. If you had to give us some examples, what kind of conduct risks would you say firms should be looking for when they think about LIBOR transition?
SE: Well, a key conduct risk is that by moving legacy products from LIBOR to risk free rate-linked products, this creates so called winners and losers. In other words, one party ends up paying or receiving more or less than it previously did. This could happen because the methodologies for calculating risk free rates are different to LIBOR.
On the flip side, firms that continue to issue new contracts linked to “vulnerable” benchmarks, which have a real risk of permanent discontinuation in the near future could be increasing their conduct risk, and the potential for mis-selling claims. This risk would be heightened in the event of a sudden or disorderly withdrawal of a benchmark.
SM: But is there anything that firms can do to mitigate this risk?
SE: I think the communications strategy piece that Ed touched upon earlier is essential. As a first step, firms need to assess LIBOR exposures from both a financial and conduct-risk lens as this will inform their communications strategy.
To give an example, when identifying exposures at a product-by-product and client type level, a firm could conclude that it has a significant volume of LIBOR exposures linked to retail customers, customers deemed to be vulnerable or simply with far less bargaining power. In particular, this could include large exposures to retail mortgages. In some jurisdictions,, such as the US, LIBOR-linked retail mortgages are not uncommon.
The next step is making a call on when to reach out to retail clients and deciding on the communications strategy itself. In my view, once firms have a good idea of their existing financial exposures, and have decided on their strategy, they should be raising awareness among their retail clients as soon as possible. What this means is at a minimum, firms roll out initial communications and outreach programmes to let clients know that change is coming and what the implications are.
SM: would a different approach be taken for retail vs wholesale clients?
SE: Yes, I think the communications strategy for retail and even SME clients is likely to be different... For example, firms may need to provide more detailed or frequent disclosures to ensure clients are engaged, and that they really understand how any changes might affect them. Firms should also clearly document their reasoning for taking certain decisions and justify how they’ve acted in the client’s best interests.
SM: And what about internal communications within firms?
SE: Yes, this is really important too. Internally, there should be a firm-wide awareness raising exercise and for some staff, there should be focussed training. Enhanced monitoring of client communications, both during and post transition, might be needed too.
SM: Okay, so there is clearly quite a bit to do! 2021 is looking quite close now. Ed, we’ve spoken about what firms should do, but what are we seeing in the market in terms of actual progress that firms are making?
EM: Generally, the largest banks have made the most progress, particularly following the Dear CEO letter Sherine mentioned earlier. Programmes are mobilised, but now there is a need to complete impact assessment and crystallise transition strategies.
Large insurers, on the other hand, also received the letter and have been working through the issues, but I don’t get the sense that there has been the same level of progress in getting transition plans moving. Having said that, there have been issuances of risk free rate linked products from both banks and insurers.
On the asset management side, firms are working through what they need to do to be ready for risk-free-rate products and some have started testing the pipes
SM: And what about non-financial companies? Say, corporates that still conduct a lot of financial activities?
EM: Exactly Scott, that’s important too. Large corporates are increasingly looking to reduce their LIBOR exposures by moving to risk free rates and one way they are starting to do this is moving away from LIBOR for any new lending facilities. There is still a lot of awareness raising and progress that needs to happen among the smaller corporates, though.
SM: So, what, in your view, should be the top priority for firms in 2019 and what are the potential pinch-points/issues that could create challenges?
EM: The top priority for firms is to work out what they need to do to be ready to adopt use of Risk Free Rates such as preparing new products and ensuring operationally they can manage Risk Free Rate-based products. Customer engagement is also critical, and this should move away from generic messages we’ve seen to date to being customer specific
The pinch points are the outstanding issues that are still to be resolved. The one we hear most about is the term-rate structure. The need for this has been challenged, and there is also concern that any term rate would not be as robust as the risk free rate itself. Having said that I think it is accepted that it will be needed in some niches.
Other pinch points are confirmation of how accounting rules will be applied, where there is still uncertainty, and also answering questions of how the transition from LIBOR interacts with other regulations. An example here is the question of whether firms will still be meeting the best execution requirements under MiFID II if they are continuing to sell LIBOR linked products to customers today?
SM: To finish, Ed, Sherine, before I let you go, in the time we’ve got left I’d like to challenge both of you to go out on a limb and give me one gutsy LIBOR prediction for 2019.
Sherine?
SE: Well, for me, I think the supervisory scrutiny will grow. But I also think that there will need to be a degree of flexibility among both regulators and firms. We are already seeing some examples of this. So, despite regulators making it clear that there is an end-game for LIBOR, in a recent speech, the FCA suggested that allowing continued publication of LIBOR past 2021 for legacy contracts could help prevent otherwise unavoidable disruption in cash markets. . For firms, if term rates take time to implement or will not be implemented in certain jurisdictions, they cannot just sit back and do nothing. They need to work around these issues.
SM: And Ed? You’ve got the last word
EM: So for me I think 2019 will be the final year where we see LIBOR issuance continuing across all product types. As we move through 2020 LIBOR products maturing beyond 2021 will cease to be issued, and the problem will have finally stopped getting worse!
SM: All right, Ed, Sherine, thank you both for coming on Regulated Radio.
And there you go, 2019 is barely started but the work of the financial sector, and the work of its regulators, doesn’t quite take a ski holiday in the Alps!
Challenges like LIBOR transitions will keep us all very busy indeed.
But that’s why we do what we do – that’s why we bring you Regulated Radio – to give you a short briefing on what you most need to know about the top issues.
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