Also, changing the discounting curve or the reference rate within will potentially change the NPV of FRN or derivatives. Investors should receive an appropriate compensation or the terms be adjusted in a “fair” manner. The NPV change when the ISDA fallback is triggered can be significant. So, there “will be winners and losers” as stated by ISDA CEO Scott O’Malia7. It is critical that buy side firms are able to independently calculate and verify the fair value adjustments when engaging in the relevant conversations with their sell-side counterparties. Otherwise, they will be at a disadvantage and exposed to significant economic risk.
For more information and an example of impact on portfolio valuation and benchmarks, refer to Appendix 2.
- Analyze your portfolios to identify (L)IBOR impacted instruments and exposures maturing after 2021.
- Analyze (L)IBOR internal and external portfolio benchmarks.
- Calculate potential value transfer for portfolios with large derivative and (or) FRN holdings.
2. Legal and portfolio documentation
Impacted legal documents can be grouped in three classes:
i. Fund documentation such as prospectus, KIIDs and additional required or marketing documentation, since all of these documents can refer to (L)IBOR as benchmark, can include instruments which refer to (L)IBOR, or mentions (L)IBORs in valuation specifics. If changes are needed, regulatory approval might be required.
ii. Instrument-related contracts such as master agreements, confirmations or collateral and clearing agreements which govern the different instruments or determine the rate that is used for calculating interest on collateral.
iii. Client documents, such as Investor Master Agreements which are used for institutional portfolios for the same reason as for the fund documents, but here these need to be re-documented on a bilateral basis.
Changes to these legal documents / contracts might follow a market standardized process such as the ISDA agreements where ISDA might provide a protocol solution8. Other documents might need a client consensus, regulatory approval or bi-lateral negotiations. At many firms the number of documents that need to be reviewed, categorized, updated, and reviewed can easily be in the thousands or even ten thousands. To make this exercise more manageable and operationally efficient, firms should consider new technologies like AI and NLP to support them. The gigantic re-papering exercises under MiFID II have shown that these tools can add significant value.
To avoid legal risks, investors need to develop a strategy specifically for investments in LIBOR / EURIBOR instruments in the next two years, where both benchmarks will still be available, and need to make sure that appropriate fallbacks are defined, as for example recently published by the ARRC working group or ISDA for different (L)IBORs9,10.
- Analyze investor and institutional contracts such as prospectus or IMA to understand (L)IBOR impact arising from benchmarks, valuation specific clauses, or investment guidelines.
- Inventorize your trading / derivative / repo agreements and take decision on adherence to ISDA benchmark supplement.
- Take decision within investment teams or risk departments which (L)IBOR instruments should still be allowed to be traded prior to cessation.
As highlighted above, it’s not only investment managers who are directly impacted but all participants within their network namely, their clients, their counterparties, their solution providers as well as their internal and external portfolio managers. This requires a good communication strategy and training of everyone who has touchpoints with the participants in the network.
For more information on regulatory requests and timelines, see Appendix 3.
- Set up enterprise-wide “IBOR transition office” to centralize internal and external communication and to coordinate activities across different investment teams as well as risk and operations.
- Ensure active participation within industry working groups and consultations.
- Reach out to your vendors as well as partners including external portfolio managers to align time plan.
4. Operations and technology
The impact on operations and IT infrastructure will depend on individual firms’ current setup, e.g. the degree of outsourcing and automation, but significant changes should certainly be anticipated. These relate to T+1 settlement of ARRs, new instruments, and migration of legacy contracts
i. Change of fixing time to T+1
Overnight rates from ARRs are available one day later than currently. The operational platform needs to be adapted in order to embrace the T+1 settlement of the rates and later calculation of interest payments. The data flow will change, thus impacting fixing cycles of contracts and collateral as well as payment and report generation.
- Analyze impact on operations due to change in fixing date and time of new ARRs such as €STR compared to EONIA.
- A holistic change management approach including business process impact assessment related to e.g. Risk and Portfolio management.
- Special attention should be given to classical failure points such as handovers between parallel or co-existing systems, where customized flows may need adjustments.
ii. New instruments based on ARR
Operational challenges may arise from the introduction of new ARR instruments such as SOFR / €STR swaps and futures or SOFR & €STR FRN’s. The term rates needed in these instruments are typically constructed by compounding of the relevant ARR, which suggests that fixing-in-arrears will be more common across all products. In addition, a suspension period may be a common feature in the coupon calculation of FRNs
- Buy-side firms must validate that their platform is sufficiently flexible to manage the securities and derivatives structures that are emerging as market standard, including new calculation methods for accrued interest and adjusted valuation and risk models.
For more recommended actions, see Appendix 4.
iii. Exchange of compensation payments for legacy contracts
(L)IBOR contracts with long-dated maturities will need to be converted into ARR contracts. The first FRN has been converted from LIBOR to SONIA10, but the process seem challenging for FRNs in general since bond holders need to accept the new terms. From that perspective the process is simpler for OTC contracts, since these are inherently bilateral. During Q4/2019, ISDA is expected to issue guidance on the protocol for contract migration. The OTC contracts can be migrated into an ARR by addition of an adjustment spread with the purpose of minimizing the value impact11. The adjustment spread is to be published daily by an independent organization12.
The change of terms for existing legacy instruments will lead to the exchange of compensation payments and will follow a negotiation process or market actions, such as triggered by clearing houses. These changes need to be anticipated, compensation amounts need to be pre-calculated, settled and booked correctly to avoid impacts on accounting and valuation and risk measures as well.
It is pertinent that the operational platform supports the complex conversion of a legacy position into the new instrument structure. Equally important, this technical conversion needs to be done without impacting income by realizing P/L, while also allowing for a one-off payment that compensates for the value transfer.
See Appendix 5 for examples of new market standard instruments and the expected migration process.
- Take decision within Investment teams on which new ARR products should be introduced and when.
- Analyze impact on operations front-to-back when re-structuring existing portfolio of instruments incl. change of valuation, risk, operations, confirmations, accounting, tax and legal.
Open questions and expected developments
By now market participants have more clarity on the timing of the expected cessation for different (L)IBOR rates, the successor ARR rates (see Appendix 1), and expected fallback mechanism on derivative agreements13 and accounting standards14.
However, some key questions are not fully answered and need to be carefully considered, both at firm level and at industry level, for example:
- How will term structures be developed and how quickly will markets gain liquidity in the new ARR rates to start the transition?
- The transitioning of derivative contracts to ARR will require exchange of adjustment payments in magnitude of millions €. How can firms ensure that they are not at a disadvantage to the sell-side during this process?
- Many legal documents, e.g. investment agreements, KIIDs, or collateral agreements among others refer to IBORs and need to be updated. How can this process be structured and executed cost efficiently and with minimal legal risk?
- New derivative instruments are emerging that reference ARRs, rather than IBORs. What changes to investment guidelines and risk governance are required so that they can be traded?
- At the same time these new instruments and the transitioning of existing contracts has tremendous impact across most operational systems. Is this change reflected appropriately in the project backlog for operational teams? Have sufficient resources been allocated?
Regulators across the world are getting more and more interested in understanding industry progress and also buy-side readiness for the (L)IBOR reform. It is crucial that firms can show executive ownership and a tangible action plan to address the firm-specific implications of the reform.
Appendix 1: IBOR Working Groups
Appendix 2: Portfolio valuation and benchmarks
From October 2, 2019, EONIA will be entirely based on €STR, being calculated as €STR + 8.5 bps15. Therefore, existing EONIA swaps are now effectively locked to €STR projections. Larger and more evident impact should be expected for derivatives where the ISDA fallback is triggered. In such cases, an IBOR reference rate is replaced with an ARR, adjusted with a benchmark spread calculated from historical IBOR vs ARR spread. As an example, for a fix/float GBP-LIBOR swap with 10M notional and 20Y maturity, a deviation of three bps between the historical and the actual GBP-LIBOR versus SONIA spread will yield an immediate value transfer of 50k GBP. Across an investor’s interest rate portfolios, the adjustments can easily total up to significant sums, in the range of millions...
Appendix 3: Communication - regulatory requests and timelines
Appendix 4: Operations and technology – pricing and analytics
The changes to the platform go beyond management of trades and positions. Pricing and analytics is based on projections of future values of ARR and ARR term rates from dedicated yield curves. Yield curve types that are commonly deployed in a modern valuation framework can represent term structures for ARRs as well as the term rates built from ARR. However, the individual yield curve constructors, such as e.g. swaps, deposits, and futures will need to be adapted to include the new structures and the calibration algorithms need to accommodate these. Specific examples are futures on ARR terms as well as swaps with fixing-in-arrears. The operational platform must be sufficiently flexible to include these anticipated changes and be prepared to include the instruments and market standards that will emerge within the next two years.
Appendix 5: Examples of new market standard instruments and the expected migration process
The table below gives a few examples of expected new market standard instruments and the expected migration process.
8. Protocol to be published Q4-2019: https://www.isda.org/2019/05/29/another-step-to-benchmark-fallbacks/
13. ISDA Benchmark Supplement: https://www.isda.org/book/isda-benchmarks-supplement/, ISDA Consultations: https://www.isda.org/2019/05/16/isda-publishes-two-consultations-on-benchmark-fallbacks/, https://www.isda.org/2018/11/27/isda-publishes-preliminary-results-of-benchmark-consultation/
14. https://www.ey.com/Publication/vwLUAssets/ey-devel-144-fi-hedging-ibor-reform-proposals-feb2019/$FILE/ey-devel-144-fi-hedging-ibor-reform-proposals-feb2019.pdf, https://www.ey.com/Publication/vwLUAssets/ey-ifrs-ibor-reform-the-iasbs-proposals-part-3/$FILE/ey-ifrs-ibor-reform-the-iasbs-proposals-part-3.pdf