The economic crisis of 2007-2008 revealed the inadequacies of our existing financial systems, including the use of Inter-Bank Offer Rates (IBORs), such as LIBOR and Euribor. Upon identifying instances of manipulation by panel banks in IBORs, UK’s Financial Conduct Authority (FCA) decided on July 27, 2017 to phase out LIBOR with an alternative, market-driven rate, i.e. Risk-Free Rate (RFR) by the end of 2021. As part of the IBOR transition, many other regulators have also decided to move to an Alternative Reference Rate (ARR). The State Bank of Pakistan may also consider replacing KIBOR with an ARR in the future.
This significant transition will bring tremendous disruption, especially when IBORs are exceptionally low due to the pandemic. Internationally, solely the contracts that use LIBOR as a reference rate are estimated at $400 trillion. Therefore, there are huge implications for the business community and the financial services industry, including exposure to potential legal, financial and reputation risks. Therefore, financial institutions the world over need to prepare themselves by year end.
Planning and assessment areas:
For starters, an assessment needs to be made of all securities, instruments, products, valuation models, agreements, and documents where IBOR is used as reference rate. Then, individual key areas should be evaluated in detail. Some of the areas that could potentially face implications are discussed below:
Contractual obligations
All contractual terms should be evaluated to assess the obligations, and the potential impact of RFR/ ARR on existing financial contracts. To narrow down this impact, certain clauses, especially the spread, should be renegotiated with counterparties.
Performance reporting
A huge effect will be observed on Performance Benchmarking Index as the basic drivers of RFR are fundamentally different than the existing IBOR. All portfolio benchmarking will now move to an RFR, which will ultimately influence performance reporting at both the financial instrument as well as the portfolio levels.
Valuation models
Usually, IBOR is considered as the base or discount rate in valuation models. Therefore, all such models will be impacted due to the change of discount rate from IBOR to RFR. This practice is fully synchronized with existing processes and systems; therefore, any potential system changes should also be evaluated and implemented on a timely basis in order to address the upcoming transition.
Financial reporting
Phasing out IBOR will also impact the financial reporting process of the corporate sector under IFRS 9. There will be a transitional impact on profit and loss due to a change in the basis of determining contractual cash flows. However, there will be a relief subject to the following conditions:
(a) The change in the basis for determining contractual cash flows must be a direct consequence of the IBOR transition, and
(b) The new basis (RFR / ARR) for determining the contractual cash flows must be economically equivalent to the previous basis (IBOR) immediately preceding the change.
External communication
All corporate communication to clients, regulators, and other stakeholders should incorporate the transition in a seamless manner so as to avoid any confusion or misunderstandings. Legal and compliance departments should gear up in assessing any potential repercussions of change in the benchmark rate.
Hedge instruments
All cash flow hedges where the designated hedged risk is IBOR (LIBOR / Euribor / other discontinued rate) are going to be fundamentally affected and, therefore, need reassessment to avoid volatility on the profit and loss statement.
Transition approach:
At present, there is no global coordination among the regulators and hence, there is no consensus on the implementation strategy. Considering best practices, a smooth IBOR transition could be planned in the following three stages:
1) Identification of key areas impacted and the changes required – an assessment exercise to identify all affected internal and external stakeholders, agreements, documents, and publications.
2) Quantification of financial impact – this is not limited to determination of the RFR impact on existing and new contracts, but also includes cost required in implementing new contractual, reporting, process and system changes.
3) Action Plan – Efficient and effective execution strategy to implement the changes as determined in the first two stages. This strategy could also outline the “new” ARR compliant products that need to be introduced. Concurrence from the regulator will add more weight to the chosen action path.
You can learn more about IBOR transition in our upcoming Masterclass titled “ARR – The Game Changer” scheduled in May 2021 and stay ahead from your peers.
The coming years would be drastically different in terms of how we structure our financial markets and institutions, due to the IBOR transition. Humankind will benefit from stronger controls and better models of doing business in the future as we all learn from our previous shortcomings and mistakes. Transitioning is a natural process in the evolution of our societies and economic models. We only need to make sure that all changes come naturally and seamlessly.
The author, Nabeel Shaikh, is a Chartered Accountant and holds an MSc degree from the University of Northampton. He is leading the Fund Services department of one of the largest investment banks in the GCC region.
