The London Inter-bank Offered Rate or LIBOR has been a popular interest-rate average calculator used by financial institutions across the world. But with LIBOR being phased out, financial institutions need to have a clear strategy in place to embrace a world with a different reference rate.
But LIBOR transition brings with it several challenges that need to be dealt with caution. Learn about the top things financial institutions need to consider while transitioning from LIBOR and successfully circumvent the many challenges.
Introduction to LIBOR Transition
As an average interbank interest rate, LIBOR has enabled financial institutions to use a standard rate for lending purposes. Offered in over 7 maturities – from overnight to 12 months – and in 5 different currencies, LIBOR is adopted both by institutions and private individuals as a benchmark rate.
Today, financial contracts worth $350 trillion reference LIBOR globally.
With its widespread adoption that started in the 1970s, LIBOR has been an industry benchmark for decades. But with interest rate manipulations becoming a common phenomenon, along with lack of liquidity and poor alignment with current market trends, LIBOR has become extremely vulnerable.
For these reasons, LIBOR is expected to be discontinued on December 31, 2021. This means banks, agencies, product companies, clearinghouses, market data providers, regulators, and insurance companies need to build a robust transition plan to move away from LIBOR to an alternative reference rate such as SOFR (USD), SONIA(GBP), ESTER(EUR), TONAR(JPY), or SARON(CHF).
Since the rate is referenced globally, the transition could affect organizations of all types and sizes through direct or indirect exposure. And, although the impact of the LIBOR transition on the Indian market is not clearly quantified, regulators have begun discussion on how best to deal with this major transformation.
Challenges (and Solutions) for Financial Institutions
The LIBOR countdown has begun, and banks and financial institutions worldwide have drawn up their plans to consider the implications and prepare for the transition to alternative benchmarks.
For a successful transition, organizations need to have basic groundwork and know about the steps involved in phasing out LIBOR that all streams of a financial institution, such as Legal, Operations, Finance, Technology, and Business, would need to undertake.
But there are several challenges that financial institutions need to be prepared for while embarking on the transition from LIBOR:
- Legal and Admin: Moving from LIBOR to an alternative rate such as SONIA or SOFR is not just about simply phasing out LIBOR and adopting the new rate. Financial organizations will have to make several tedious efforts in preparing new documentation and ensure compliance with necessary legal requirements. At the same time, they will also have to work towards educating clients on the transition, explaining the need, as well as seeking consent from them.
- Validations: Moving away from LIBOR requires organizations to make several model changes as well as undertake the laborious process of validations: right from conducting mappings to testing, sensitivity calculation, and stress testing. They also have to have a plan in place to overcome the many operational risks across new interest calculations, valuations, margin, and collateral requirements for tens of thousands of contracts.
- Trade operations: When it comes to LIBOR transition, financial bodies have to deal with trade processing and settlements. They need to undertake negotiations to re-document existing transactions. They need to get a complete view of the impact of the transition on each customer as well as the estimated economic impact across products and currencies. For products that are booked across different businesses, they have to be very careful of Data Management.
- Infrastructure: Moving from LIBOR to another alternative rate brings it with the operational challenge of managing the infrastructure. Since LIBOR is deeply integrated with core processes, organizations are likely to face potential compliance and reputation risk that can lead to several disputes. To overcome these challenges, they need to embrace the right technology systems and determine the impact and updates needed to be made to existing policies, processes, and control systems.
What organizations need to consider
As a leading benchmark interest rate that has been adopted by financial institutions for decades, LIBOR has long served as the basis for interest rate calculation on various debt instruments. But with the benchmark vulnerable to undue modifications, it is on its way out. Moving from LIBOR to another alternative has to be done on an urgent basis, but even a single glitch or error during the transition could lead to credit market confusion and a wave of financial lawsuits.
Successful transition to alternative rates requires careful planning and close collaboration with a qualified outsourcing and consulting firm with deep domain knowledge and technology expertise. Since LIBOR transition has its impact lines flow across legal, financial, business, regulatory, technology, and the business in general, a partner can help in:
- Carrying out detailed impact analysis across multiple areas of business
- Identifying tax implications that will arise due to the adoption of the new reference rate
- Addressing challenges linked to updating technology infrastructure and systems
- Calculating new rates and implementing them across pay-offs, pay-ins, cash flows, and more
- Making necessary changes to financial reports and close gaps post-transition to enable seamless customer experiences
The pressure to transition from LIBOR to an alternative interest rate benchmark is intense, but the risks around a poorly planned transition are also too many.
For a successful transition, organizations must properly deal with challenges around legal, admin, validations, trade operations, and infrastructure. Engaging with a qualified partner is a great way to understand the many risks, prepare for remediation measures, and smoothly chart out the LIBOR exit.