As the pace of global regulatory change increases, it is clear that the Inter-Bank Offered Rates (IBORs) of major currencies will evolve or that alternate nearly risk-free reference rates (ARRs) will soon be introduced. These changes will have an impact across a wide range of organisations, including banks, buy-side, sell-side and corporates. In this environment, organisations in Asia-Pacific with IBOR exposures should be taking active steps to understand the scale of the transition and the associated risks in order to prepare for the changes ahead.
Since the announcement in July 2017 by the UK’s Financial Conduct Authority (FCA) that it would no longer persuade or compel banks to make London Inter-Bank Offered Rate (LIBOR) submissions from the end of 2021, global regulators have started to select ARRs. In Asia-Pacific countries too, regulators have begun proactively assessing the implications of this change to their respective markets. Amongst the considerations for regulators across the region is the potential need to revisit their own IBOR characteristics or, alternatively, to create their own ARR.
Although the pace of change around IBOR is accelerating, regulators’ progress and approach to the transition varies significantly across markets. The table provides a quick snapshot of the current state of play across the globe.
The enhancements come as an opportunity for organizations to overcome the potential liquidity issues in benchmark by further strengthening their internal methodologies, processes and governance around selecting the eligible transactions for deriving rates.
In June 2018, the International Swaps and Derivative Associations (ISDA) and other trade associations released a market survey facilitated by EY assessing the market’s readiness for IBOR transition. The research found that around half of the survey participants intend to trade using new IBORs within the next two years. However, while 53% said they have initiated internal discussions for transitioning, only 11% have allocated budgets and resources to support the change.
Operational and financial challenges
To avoid adverse scenarios as a result of the transition, market participants will need to consider either actively re-trading their IBOR positions maturing beyond 2021 and replacing them with ARR equivalents or amending existing contractual terms to clarify what should happen in the event that the reference IBOR permanently ceases to exist.
Both of these options introduce a number of operational and financial challenges where significant costs are likely to be incurred. These include:
Legal: If amending reference rates for legacy positions while the relevant IBORs still exist, counterparties may decide to sue if they can see that the newly negotiated terms have resulted in worse outcomes than they would have had if they had remained on their original terms.
Risk management and finance: As ARRs are not equivalent to IBORs – in terms of credit spread and term premiums, for example – the transition may impact products’ profitability, as well as treasury and risk management activities. As IBOR is used throughout the finance and accounting operations, including valuations, models, forecasts, regulatory and financial reporting, these processes and systems will need to be revised to accommodate new ARRs. Additionally, the IBOR transition will pose major challenges on hedge accounting strategies and may ultimately bring volatility to the income statement.
Operations: Day-to-day processes, such as reconciliations between the banking and trading book, and the measurement and monitoring of market risks, will need to be significantly updated for financial institutions. Corporates, on the other hand, will need to reinforce the skillset of their teams in the treasury and finance departments around areas such as credit risk and risk modelling. Significant investments in technology may also be required for a broad range of impacted systems, such as trade data repositories, data providers and middleware, core retail and commercial banking systems, and non-financial corporate systems.
Tax: IBORs have historically been considered to be the relevant reference rates for tax calculations. With the IBOR transition, it is unclear whether new ARRs will be widely accepted for this purpose, especially across various jurisdictions.
Given the scale and complexity of this inevitable transition, impacted Asia-Pacific organizations should begin initiating steps now to prepare for this change. Identifying IBOR exposures, development of tailored road maps up to launch, and the implementation of IBOR programs should all be part of transition journey.
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by Asian Banking & Finance. The author was not remunerated for this article.
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Gary Mellody is the EY ASEAN Financial Services Risk Advisory leader, whislt Patricia Tay is a Hong-Kong Financial Services partner, Ernst & Young Partnership.