Banks Brace for ‘World’s Largest Corporate Action’ as Libor Switch Looms

Beset by scandal, reputationally bankrupt and now increasingly under pressure, Libor is nonetheless still the key reference rate used in nearly all major financial instruments globally. As regulators have mandated a shift away from the benchmark by 2021, however, the industry is beginning to realize the scale of the challenge before it.

Part of the problem is that replacing Libor, an averaged interbank offered rate (IBOR) governed by submissions from panel banks, with an overnight rate calculated from actual transactions, is that it isn’t just a like-for-like transplant to a new benchmark. It’s also geographically fragmented, with the US opting for the Secured Overnight Financing Rate (SOFR), the UK going with the Sterling Overnight Index Average (Sonia), and continental Europe using the European Overnight Index Average (Eonia).

That, by itself, is challenging enough, but add creaking systems and aging infrastructure to the mix, along with a near-unfathomable amount of contract re-papering that needs to take place, and you have a toxic cocktail that will almost certainly turn trading operations on their head over the next few years.

“It is a bit like Brexit,” says Alastair Sharpe, head of London rates trading at Credit Suisse. “There are a lot of issues that are very difficult to resolve.”

Crunch Time

Developing an understanding of how problematic this may be requires an appreciation of just how embedded Libor is within finance—and how unprepared bank technology is for the change. Libor is used in everything from loans on the retail side, to derivatives documentation and monetary policy on the institutional end. Changing the mechanism by which key aspects of these contracts are governed, such as the interest charged on mortgages and the particulars of rates trading contracts, isn’t simply a case of running a find-and-replace on the word “Libor” and substituting it with “Sonia.”

Just ask Adam Schneider, partner at Oliver Wyman, who says it doesn’t matter what the new rate is—when Libor is out, the new reality will be “a hard technology and operations exercise that the industry has not seen before.”

Schneider says if Libor was to end tomorrow, it easily would be “the world’s largest corporate action,” because no one has benchmark references automated, so once the formulas shift to the new rate, it will create a lot of work “and a lot of that is buried in detailed documentation” that can’t be parsed through automation and would require humans to read. 

That hasn’t stopped many from turning to emerging technologies to assist, given the unpalatable—and, most likely, impossible (for humans)—scale of paperwork to amend.

“There are probably enough documents out there that it would take you and me until the end of the universe to read them without a computer,” says Credit Suisse’s Sharp. “That is the point: Libor is embedded into so many things.”

One possibly augmentative approach—if not an outright solution in and of itself, may be to use artificial intelligence (AI). Paul Feldman, a director in Chatham’s risk management consulting practice, has had clients asking about the use of natural-language processing (NLP) as a way to help in moving to the new rates. Some of these clients have a back book with tens of thousands of loan contracts, each of which exists as a document and a reference in a corporate book of records, a loan management system, or a trade-capture system. 

Feldman says technologies like NLP are being considered for scanning many documents quickly. “To prepare, or train, the system for use, a human expert evaluates and annotates an adequate sample of loan documents,” he says. “The trained system can then be applied to a large inventory of many thousands of documents. The system is able to do the annotations on its own in those documents, capturing the relevant classifications, fall-back language and other terms and conditions into a structured data format. While this tool does not completely replace personnel, it has the promise to dramatically reduce the degree of time and effort required to complete the IBOR transformation task.” 

He says there will still clearly need to be human review of the work, as this particular machine-learning application is nascent, but it has promise. “It is something that leading entities are using in the IBOR transformation process, and many of our clients are asking us about,” he says.    

In many ways, the industry has had a test case for such an exercise already. During recent regulatory reform around margin requirements for non-cleared derivatives, for instance, dealer banks were required to hire battalions of lawyers to comb through agreements and amend clauses where necessary.

NLP proved its worth here for many, allowing for the rapid re-papering of many thousands of contracts in time for a tight deadline, but the scale of the challenge surrounding Libor is many factors larger.

“We don’t exactly know how we are going to re-paper every single Libor-related deal,” says one official at a major bank.  “Or, indeed, whether that is going to happen. They might come up against obstacles that are as yet unknown. And so that still needs to be done and is on-going. And I am sure that institutions like ours and others like that are well ahead of the field, but even then there is a long way to go.”

Checking Boxes

Perhaps the only challenge more daunting than the uncertainty around how the task will be managed from what is already known, is attempting to have the proper technology in place to deal with upcoming gray areas. Philip Whitehurst, head of service development, rates at London Stock Exchange Group (LSEG)-owned clearinghouse LCH, says that systems trying to process Libor-based trades expect that the fixing information provided covers the entire three-to-six-month term rate period. He says systems given that information can calculate the payment and move on to other issues with the contract, such as forward-rate projections. 

“The difference with an overnight rate is that your system hasn’t, at the start of the period, gotten all the information it needs to understand the payment that will occur,” Whitehurst says. This results in a “wait for a series of fixings” during which the system checks more information over a longer period of time, just to be certain of the payment. “This disrupts the workflow,” he says.  

Indeed, a major complaint with risk-free rates like Sonia and SOFR is that they are overnight rates, in a time when end users prefer term-rates for periods of three or six months. 

“Libor is a price. I bet you get coffee at Costa Coffee or Starbucks, and they don’t change the price of coffee every day, even though the price of the beans moved a little,” says Oliver Wyman’s Schneider. “So, as a price, Libor is a little stickier than a calculation that results from yesterday’s trades, which is what SOFR and Sonia basically are.”  

Some have proposed using listed derivatives for the future to apply the fixing, which could ease some pricing aspects of using overnight rates. It could also reduce the scope for benchmark manipulation, even if it doesn’t get rid of the possibility of that occurring. But the problem is risk-free rate (RFR) futures are not as liquid as the over-the-counter (OTC) market in the UK. It leads to the question of who would want to write a financial contract against a fixing that would be, as yet, unknown. 

Another problem is that, in order to use a listed derivative, a model is required, which may apply futures prices and come up with rates for three months or six months that might not be the same that is being quoted in the market. When rates are stable and there is a very flat yield curve, the prediction is likely to be pretty close. But if it is stress-tested to a time when rates are moving, such as back in 2008 to 2009 during the global financial crisis, the model would not be able to come up with the correct answer without being continuously amended. The rate produced by the model does not equal the rate produced by dealing in three-month Sonia or SOFR. 

“The UK is favoring a quote-based methodology because it is point-in-time,” says Credit Suisse’s Sharp. “And they have sampled quotes that people can deal on, take a bid market, and that is how they plan to fix it.”

However, at the moment, the market in short-term rates is essentially done via voice brokerage, apart from listed derivatives. Sharp notes that almost no one trades electronically. It isn’t that nobody has tradeable prices on a platform like Tradeweb or a Bloomberg, but that is a tiny percentage of the market. “I would say less than 1%. Until that changes, it is going to be very difficult to have this sort of quoting system,” he says.  

“There are many places, and Credit Suisse is one, that don’t publish firm prices in Sonia or Eonia,” he says. “So we have a page where you can look at Sonia prices, but they are not firm quotes, so it won’t be suitable for making a fixing offer—we are one of the top one or two market-makers in Sonia and we don’t quote firm prices. Until that changes, until we invest in that technology, it will be difficult to get representative, quote-based fixing because there just won’t be enough independent sources that will be able to be used for it. That needs to be changed and money needs to be invested in that, both by us and by the majority of the players because I would say only a few have that currently.”

Libor Beyond 2021? 

What makes the RFRs more robust is that unlike Libor, they are based on actual transactions. The Libor scandal of the past few years implicated a number of top banks in the manipulation of interest rates, and resulted in fines totalling billions of US dollars, along with jail sentences for a number of executives and traders. In contrast to Libor, anyone attempting to manipulate RFRs would likely have to alter the actual volume of transactions to have any notable influence on the rates, which offers stronger protection against manipulation. 

Adopting one of these RFRs doesn’t mean banks won’t face new challenges. “It doesn’t seem very obvious at the beginning, but there is tons of stuff in the background that actually needs to be done before we could transition every single deal we have to Sonia,” says Sharp.

Yet, banks may just be asked to do the impossible, as regulatory patience is certainly not unlimited, particularly on the part of UK watchdogs that have often emerged as loud voices in the debate over shifting from Libor. And 2021 is not far away, so the industry doesn’t have too long to figure out how to fill the gaps.

“The main point is that we are expecting Libor to conclude at the end of 2021 and therefore firms are all encouraged to transition to risk-free rates and transition is progressing,” says Nausicaa Delfas, executive director of international at the Financial Conduct Authority (FCA). “We are doing a lot of work here and also in the US and our CEO is also co-chairing a group with Jake Powell from the [US Federal Reserve] on that. So our interest is that firms transition. Obviously there are challenges from moving from one rate to another but we do expect that progress to continue.”   

While regulators are keen for Libor to go, experts are divided about how long its departure could take. “I am 100% convinced Libor will continue to exist. I am fairly controversial on this issue,” says Sharp. “I think people will still want it, but instead of being 90% of the market, it will be like 10% or 20% of the market. And RFR will be the main financially traded instrument.” 

Regulators have also accepted that some element of Libor will remain, even if the bulk of the market transitions to using Sonia, SOFR, Eonia or another derivation thereof. In a speech in January 2019, Edwin Schooling-Latter, director of markets and wholesale policy at the FCA, said that the regulator was aware that Libor cannot simply be dropped in some instances.

 “While contracts of this kind should be a diminishing share of the total over time, there may, because of historical issuance, still be a material volume of such contracts in cash markets into the 2030s,” he said. 

There have also been some interesting initiatives to help with the benchmark switch. Last year, CurveGlobal, the interest rate derivatives joint venture between the LSEG and a number of major banks, introduced an inter-commodity spread that allows people to put into the market a price to sell Libor and buy Sonia. It is one way to transfer risk between the two rates. 

“First of all it, implies prices into the market, so if you want that spread to trade, you are selling Libor and buying Sonia, someone on one side might be buying Sonia and someone on the other side might be selling Libor, and the fact that you have got a spread position means that you get filled on that trade,” says Andy Ross, CEO at CurveGlobal. “It is on screen, it is visible for people that they can see it. Second thing is it is a great example of technology helping achieve a regulatory aim, which is the transition from Libor into Sonia.”

Fear of the Unknown

While Sonia is perhaps more robust than Libor, it also comes with a lot of unknown factors—but these do not necessarily have to be roadblocks. Yolaine Kermarrec is a partner and co-head of CFO advisory capital markets at Ernst & Young who advises investment banks on regulatory change and financial transformation. She says there is a wide range of preparation underway, and that those who start this project with the right attitude are best-positioned to win. “Certain banks are opting for a strategy of accelerated adoption of new risk rates; they focus on being ready to meet new client demand on products referencing risk-free rates,” she says. “They see the IBOR transition as an opportunity to protect and/or improve their client franchise. On the other side of the spectrum, a number of banks are in a ‘wait and see’ approach and are wary of spending too much effort and money onto their IBOR program.” 

She says she sees it as a real opportunity for banks to improve their infrastructure in areas where there has been, historically, a degree of under-investment. “A number of banks want to rationalize and revamp their treasury processes and technology,” she says. “Some are using IBOR as an opportunity to reconsider the methodology for fund transfer pricing to ensure it is consistent across geographies, and to fix some data issues once and for all.” 

Therefore, the transition away from Libor could accelerate some of the existing strategic transformation banks had planned already. Kermarrec thinks it is important that banks don’t only see this as a risk management and compliance program, but really go beyond the compliance agenda to take it as an opportunity. 

For banks there can also be a pricing considerations. “Certain banks have voiced that Libor continuing beyond 2021 could represent an important conduct risk. This is because it would increase the length of the period during which they will operate in a dual-rate environment.  There is a risk that clients come back to their banks a few months after a transaction, and contest the price they have been offered for one or the other type of products,” says Kermarrec.  

But while some in the banking industry are adopting a wait-and-see approach, Libor is slowly starting to shrink in terms of market proportion. “Sonia is now about 20% of OTC swaps trading in sterling right across the curve,” says LCH’s Whitehurst. “About 18 months ago, that figure was much closer to 10%. This is obviously very strong and positive growth for Sonia relative to Libor.”

A banker working in the global markets spoke on the side-lines of an industry event on condition of anonymity. She complained the 2021 timeline was too short, although the intention was good. “How do you deal with that mismatch between the hedging of the asset, which is based on Sonia, and the funding of the book, which is based on the three-month Libor? There is still an issue.” It’s a headache for quants at banks creating models and curves around the new rates.  

Oliver Wyman’s Schneider compares the Libor rate to drinking coffee. Many people don’t know where the beans in their drink come from, or how the caffeine is extracted. They don’t need to. They just order coffee. Similarly, Libor is ubiquitous, but many people don’t know the hows and whys. 

“The average response to Libor going away is literally, ‘you are kidding,’” says Schneider. “That is the average response. And now it is beginning [to shift to] ‘I guess we have to get our work together because, of course our infrastructure is critically dependent on it.’ It is like saying the centigrade is going away; it is just hard to get that in your head. That is exactly what we should be talking about right now.”