Factors
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Financial market participants and regulators have made efforts since 2012 to strengthen the governance, transparency, and reliability of LIBOR as a benchmark rate. However, reports show that the decline in liquidity in interbank unsecured funding markets in the post-financial crisis period. Thus, LIBOR has been rendered an unsuitable reference rate, necessitating replacing it with a new reference rate.
This has led to the formation of national working groups in efforts to develop risk-free alternative rates (RFRs). Working groups have recommended the Sterling Overnight Index Average (SONIA) in the UK and Secured Overnight Financing Rate (SOFR) in the US as their preferred rates.
The transition from LIBOR to alternative reference rates should be promoted to more robust and effective markets.
The following are themes are relevant in promoting fair and effective market transitions:
“Firms should have a taxonomy for the identification and assessment of common conduct risks that may occur in market transactions and that are relevant to their business.”
Regulatory commentary has focused on:
Conducting impact assessments – Firms should adopt a comprehensive approach to assessing the effects of the transition from LIBOR to other reference rates.
Considering sufficiency of existing conduct risk frameworks – Firms should consider whether some LIBOR-related risks can be handled within the existing risk frameworks or there is a need for a separate risk framework.
“Firms should develop management information based on their conduct risk taxonomies that allow governance for a and senior management to consider and challenge the conduct risks identified in the market transactions of the firms.”
Key governance themes deriving from regulatory commentary include:
Board level understanding of risks – Senior managers and boards should understand LIBOR transition-related risks and take appropriate action to move to alternative reference rates by the end of 2021.
Robustness of governance arrangements – Firms are expected to have existing robust governance arrangements managing risks in their business.
Record keeping – Firms are expected to appropriately keep records of all meetings as an indication of acting with due diligence, skills, and care in LIBOR transition.
Systems changes – Transition is expected to occur in financial agreements and systems and policies whose reference is LIBOR.
Governance of product – Firms are expected to consider the design and the risks related to new products that reference LIBOR and explain the effects of the LIBOR cessation as part of their product governance obligations.
Communicating with Customers
“Market participants should communicate in a manner that is clear, accurate, professional and not misleading.”
Key themes when communicating with customers include:
Ensuring timely disclosures – Firms are expected to present information on time to enable customers to make informed decisions about relevant products and potential risk exposure.
Comprehensive disclosures – Firms are expected to disclose a comprehensive report on the risks and explain the impacts of the discontinuity of LIBOR.
Discussing product options – Banks are expected to discuss non-LIBOR reliable products with customers and explain potential risks if LIBOR continues to be used as the reference rate.
Internal and external communication strategies – comprehensive internal and external communication strategies should be developed to enhance education on transition among stakeholders.
Objective overview of alternative products – Firms should consider discussing and presenting alternative products, state the benefits, costs, and risks associated with such products.
“Firms should take appropriate measures to identify conflicts of interest between the firm and a client, between clients, or between the firm’s employees and the firm and/or a client.”
“Firms should ensure they have effective measures (including appropriate governance) in place designed to prevent or appropriately manage and mitigate those conflicts of interest that have been identified and/or which may arise from time to time.”
Regulatory commentary has focused on:
Identifying conflicts of interest – Firms are expected to identify and manage potential conflicts of interest.
Mitigating conflicts of interest – Firms are expected to mitigate or manage conflicts of interest resulting from the LIBOR transition.
Benchmark performance – conflict of interest could arise when fund managers change performance benchmarks and make sure that these changes correctly reflect performance.
There is no FMSB principle that is directly linked to fair customer treatment.
Regulatory commentary has focused on:
Fall back – Firms should insert robust fallback provisions contracts in place prior to or at the time of LIBOR ending to ensure the product continues to operate effectively.
Replacement rates – In cases where customers prefer new rates, the replacements rates should not be higher than what LIBOR would have been.
LIBOR-SONIA spread – Firms that receive interest linked to LIBOR should not give up the spread between LIBOR and SONIA.
Firms investing on behalf of customers – Firms are expected to protect their customers’ best interest by managing the exposure of customers to LIBOR.
Customer needs – Firms that continue to use long-dated products linked to LIBOR should ensure that these products meet customer needs.
“Market participants should clearly and effectively identify and appropriately limit access to confidential information.”
“Firms should ensure that the output of their risk identification and assessment process informs the development of monitoring and surveillance to address the identified risks.”
“Member firms should have a clear organizational structure for delivering a risk-based program of conduct training that is appropriate to their firm, taking into account their business model, scale and complexity…”
Regulatory commentary has focused on:
Acknowledging a range of potential risks – Market participants are expected to consider potential risks of market manipulation and ensure traders’ awareness.
Contributing to benchmarks – Potential risks related to contributing to LIBOR benchmarks should be considered.
With the forthcoming cessation of LIBOR and the increasing risks associated with new LIBOR-linked transactions, traders are switching to alternative RFRs for new transactions. It is believed that a smoother transition can be achieved when LIBOR-linked exposures are avoided. However, while LIBOR-linked products are expected to mature by the end of 2021, part of the products that reference alternative rates are still very immature and are subject to limited liquidity and evolving conventions. Moreover, there is a high uncertainty for these alternative reference rates.
Given this level of uncertainty, banks offering alternative rates and the buy-side are subject to a number of risks.
Market participants may:
The following case studies will help us illustrate the above risks:
Case Study A: Bilateral or syndicated corporate sterling borrowing through a SONIA-based, or Bank of England base rate, loan.
Case Study B: Corporate sterling borrowing through a SONIA-based loan and simultaneously entering into an interest rate swap to fix the interest payments.
Case Study C: Corporate entering into a USD LIBOR-SONIA swap to hedge exposure arising from GBP loan and USD investment.
The bank communicates appropriately with clients in an effort to address communication issues noted in FMSB principles. This includes providing information on:
The bank should keep a record of all important information relating to its operations and clients.
Risk identification – Clients need to understand alternative products offered and the benefits and risks related to these products.
Independent advice – clients should seek advice from independent professional advisers on their options, including understanding alternative products offered and benefits and risks related to these products.
Bilateral loan – A UK-based mid-size corporate borrower seeks 5-year finance to enable the expansion of its business. The borrower approaches bank A. Bank A lends money to the borrower referencing alternative rates, fixed-rate loan options, and LIBOR since LIBOR is anticipated to cease by the end of 2021. The borrower takes a SONIA-based loan with a notional of £10 million, maturity of five years, with quarterly SONIA-based interest payments compounded in arrears with a lookback period of five days. The loan is priced at SONIA + 200 basis points compared to indicative pricing for a comparable LIBOR loan of 3m GBP LIBOR + 185bp, implying that we have a spread of 15bps between LIBOR and SONIA.
Syndicated loan – A large corporate is seeking to borrow £100 million. Since the borrowing is big enough, the loan is syndicated. Bank A acts as the lead as the arranger, while Banks B and C act as participants in the syndicate. Both the duration and pricing of the loan are similar to the bilateral loan above.
Small corporate borrower – A small corporate borrower is seeking to enter into a new GBP loan. The borrower approaches bank A. Bank A lends money to the borrower referencing alternative rates and fixed-rate loan options. The borrower takes a Bank of England base rate loan with a notional of £0.5 million. Both the duration and pricing of the loan are similar to the bilateral loan above.
Based on future developments, customers would think that it would have been better if Bank A could adopt an alternative approach.
For example:
Bank
Communicating with clients – product options and pros/cons
The bank communicates with the borrower about the future availability of forward-looking term SONIA rate.
The bank also informs the borrower of the anticipated changes in products conventions.
The methodology and the data sources used to calculate the 15bps spread between LIBOR and SONIA are provided by the bank.
When we have information that is not clear enough to customers, the bank should make additional efforts to explain such issues to customers.
The corporate evaluates whether to wait for a potential forward-looking term rate. However, it may prefer to use available SONIA-based loans instead of waiting for future LIBOR loans.
While upgrading its treasury system, the bank should determine whether it can book the SONIA-based loan.
The corporate may seek advice from other independent advisors on what SONIA loans imply.
A UK-based corporate borrower seeks 5-year finance to invest in a new manufacturing business. The borrower approaches bank B. The borrower takes a SONIA-based loan with a notional of £10 million, maturity of five years, with quarterly SONIA-based interest payments compounded in arrears with a lookback period of five days. Simultaneously, Bank B and the corporate enter into an interest rate swap based on SONIA with a notional of £10 million, maturity of five years but with interest period ending on the interest reset date with no five-day lookback.
Communicating with clients – product options and pros/cons
Following on from Case Study B, while the corporate borrower is based in the UK, the manufacturing facility is based in the US. The UK-based corporate wishes to borrow in GBP, and Bank C offers the borrower a loan referencing alternative rates, and the corporate selects a SONIA-based loan. Among the available options, the corporate also chooses to enter into a USD LIBOR-SONIA swap to allow hedging of the cross-currency exposure arising from the GBP loan and USD investment. This way, corporate is paying USD LIBOR-based interest rate.
Risks to Market Effectiveness or Market Fairness
Several fixed income funds and alternative strategies with distinct characteristics that use benchmarks based on LIBOR or performance targets are available to a fund manager. Following the anticipated ceasing of LIBOR, the fund manager proposes that it will change its Funds, A, B, C from GBP 3M LIBOR + 185bp to SONIA + 200bp, which implies a spread of 15bps between LIBOR and SONIA.
Fund A – seeks to generate an investment return that is closer to a benchmark based on GBP LIBOR. Therefore, a correlation exists between the benchmark and underlying fund assets. No performance fee is charged.
Fund B – GBP LIBOR-linked index is used as the benchmark for the fund performance. The investment is therefore driven by the underlying strategy. Again, no fee is charged.
Fund C – is similar to fund, however, it charges a performance fee.