Market must “wake up” over Libor misinterpretations

While the pandemic has distracted market participants many are still sleep walking towards the transition away from the London Interbank Offered Rate (Libor), with concerns raised over a lack of understanding behind the methodologies shaping the fallback language and the new rates.

“If you look at corporates, they use credit agreements, CP backup lines – some of them are multi-currency and unfortunately, the different currencies don’t use the same Risk-Free Rate (RFR), and they’re technically different. Some are collateralised, some are not,” says Xavier Pujos, managing partner at Sionic.

“They don’t think about it twice, it’s a habit. If they don’t wake up, if they don’t tackle their potential issues very quickly, the risk for them is that they will not be treated favourably in the market,” he says.

Umesh Gajria, global head of index-linked products at Bloomberg, highlights the divergence across markets and products in how the transition is occurring.

“Given the complicated nature of all the various areas of readiness – whether there’s cash, there’s the futures market, and it’s happening on a global basis – clients could be prepared in one area, in terms of impact on their portfolio, or fallback languages that relate to cash security, but they might be behind in another area,” he says.

For this reason, market participants must understand the methodology around transitioning away from Libor to be fully prepared for the switch.

“When it comes to fallbacks specifically, the first step for market participants, for banks, the buy-side, everybody, is to understand the methodology. You see various degrees of understanding and readiness among market participants,” says Gajria.

“If you’re an asset manager or a bank, the level of understanding depends on the size of the team that’s focused on Libor transition at the client level. Some clients need more help, while others are ahead of the game. Once they understand how these rates are essentially derived, they then start to get operationally ready.”

Pedro Porfirio, global head of capital markets at Finastra, says the focus needs to be on new indexes, with alignment between the loan, bond and derivatives markets to allow seamless hedging and transparency on interest accruals and curve building for valuation and payments.

“The focus should also be on how to manage the legacy portfolios as the market liquidity moves away from Libor based products to the new indexes,” he explained, via email.

Paul Kaufman, treasury practice leader and managing director at Broadridge Financial Solutions, says the treasury function faces substantial reengineering.

“Treasury will need to manage a change in interest rate profiles as the market evolves, for example, if the Libor market becomes less liquid, and as alternative rates are adopted in financing arrangements,” said Kaufman.

“Also, there they will need to determine the impact of emerging fallback scenarios and understand the associated financial implications. This process will be further aggravated due to limited time-series data and varied transition timelines by currency aggravating cross-currency exposures.”

Kaufman says treasurers will need to focus on the review of funding management; cash and working capital management; the impact on TMS; hedge accounting; cash flow forecasting; and payments.

Banks should also facilitate a smooth transition away from Libor by enabling global coordination, liquidity growth in new products whilst managing legacy products that reference global Ibors and providing dedicated CP outreach, according to Kaufman.

They will need to ensure that the switch is occurring by electing protocols for new transactions and granting compounded setting in arrears for each RFR.

In July, the UK’s Financial Conduct Authority stressed that the Libor deadline was not going to change – stating that the next four to six months will be the most critical ones in the transition away from Libor.

“The time to act is now,” said Edwin Schooling Latter, director markets and wholesale policy at the FCA, during a recent webinar.

Bank of England governor Andrew Bailey also affirmed the pandemic had reiterated the necessity to discontinue Libor.

“In my view, what we saw in financial markets in March in response to the shock of coronavirus only reinforces the importance of removing the financial system’s dependence on Libor in a timely way,” he said at a Bloomberg webinar.

Pujos believes urgency has only increased over the last months, in which market participants that haven’t done anything yet will be late in the switch and will hit a wall sooner than later.

The transition from Libor to RFRs presents significant operational, reputational, and legal risks for financial firms, even where fallback provisions don’t lock financial firms into loss-making arrangements.

“To minimise these reputational and legal risks, firms will need to communicate a clear, consistent, and justifiable transition approach to clients and regulators,” said Kaufman.

Isda is set to publish its updated definitions that will explain the protocol of using the new rates in the upcoming months – which Gajria believes will be vital to facilitate the switch.

“That will help bring a state of readiness for the market as we get close to Libor or any of the Ibors coming to an end. Market participants can rest assured that they have a continuation in their derivatives, documentation and they can continue to perform essentially without any disruption,” he says.