Top challenges with LIBOR transition and how to overcome them

The London Interbank Offered Rate (LIBOR) has been a popular interest-rate average calculator used by financial institutions globally. Financial institutions need a clear strategy to embrace a world with a different reference rate LIBOR phased out. 

But LIBOR transition comes with 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 7maturities – from overnight to 12 months – and in 5 different currencies, LIBOR is adopted 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 a lack of liquidity and poor alignment with current market trends, LIBOR has become vulnerable.  

For these reasons, LIBOR will discontinue on December 31, 2021. This means banks, agencies, product companies, clearinghouses, market data providers, regulators, and insurance companies must build a robust transition plan to move away from LIBOR. They need to move 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. Although the impact of the LIBOR transition on the Indian market is not quantified, regulators have begun discussions on how best to deal with this 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 do the basic groundwork to know 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: 

1. Legal and Admin: LIBOR transition 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 ensuring compliance with necessary legal requirements. At the same time, they will also have to work towards educating clients on the transition, explaining the need, and seeking consent from them. 
2. Validations: Moving away from LIBOR requires organizations to make several model changes and undertake the laborious process of validation. Right from conducting mappings to testing, sensitivity calculation, and stress testing. They also need a plan to overcome the many operational risks across new interest calculations, valuations, margin, and collateral requirements for tens of thousands of contracts. 
3. Trade operations: During the LIBOR transition, financial bodies deal with trade processing and settlements. They need to undertake negotiations to re-document existing transactions. Financial bodies 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 booked across different businesses, they need to be very careful with Data Management. 
4. Infrastructure: Moving from LIBOR to another alternative rate brings the operational challenge of managing the infrastructure. Since LIBOR is deeply integrated with core processes, organizations might 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 on the existing policies, processes, and control systems. 

What organizations need to consider 

LIBOR has long served as the basis for interest rate calculation on various debt instruments. The interest rate adopted by financial institutions for decades has been the leading benchmark vulnerable to undue modifications and 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 the 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 closing gaps post-transition to enable seamless customer experiences

The pressure to transition from LIBOR to an alternative interest rate benchmark is intense, and the risk of a poorly planned transition is too many. 

For a successful transition, organizations must learn to effectively overcome legal, admin, validations, trade operations, and infrastructure challenges. 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. 

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