Co-Author: S Gomathi
In 2005, few banks around the world manipulated the LIBOR 1 (London Interbank Offered Rate) benchmark rate for their own profits (decreased the interbank borrowing rate to increase the creditworthiness of banks and changed the rate for the individual traders to gain profits). This came to light in the year 2012. After this LIBOR ceased to remain a good benchmark. The ICE (Intercontinental Exchange) took over LIBOR management and ARRC (Alternate Reference Rate Committee) was formed to replace LIBOR and lay down a transition plan by the end of 2021.
The transition from LIBOR to SOFR (Secured Overnight Financing Rate, US) posed a significant challenge to the stakeholders as transactions worth $350 trillion involving LIBOR were at stake. Converting existing transactions (maturity after 2021) to the new reference rates involved operational challenges as well as financial risks (credit and liquidity risks). Moreover, most of the suggested rates are overnight ones (LIBOR is overnight as well as term) which leads to uncertainty (unknown interest rate) for organizations when they forecast cashflows.
The transition from LIBOR to Alternate Reference Rates like SOFR poses a high-level challenge to all the stakeholders as there were transactions worth $350 trillion involving LIBOR. #LIBOR #SOFR #financialservices @hclfs
How SOFR Works?
After the scandal, ARRC (Alternate Reference Rate Committee) suggested that ARR (Alternate Reference Rate) can be a good alternative for LIBOR. Few of the suggested ARRs in the market are SOFR, SONIA (Sterling Overnight Interbank Average Rate, UK), TONAR (Tokyo Overnight Average Rate, Japan), SARON (Swiss Average Rate Overnight, Switzerland). SOFR rate appears to have a larger acceptance in the banking community.
SOFR is an overnight secured rate collateralized by treasury securities. It is based on actual transactions backed with securities, calculated and published daily by ICE Benchmark Administration. SOFR is published each business day at the Federal Reserve Bank’s website. On April 2018, the Federal Reserve Bank started publishing SOFR rates as an effort to replace LIBOR.
Since SOFR is a secured overnight rate (backed with securities), it tends to be lower than LIBOR. In order to avoid funding loss (amending old contracts/issuing new contracts) with new ARR’s, banks add a Credit Adjustment Spread (CSA) with the rates. Banks expect that the committee responsible for ARR’s would recommend a common methodology for arriving at the CSA.
For example, in US the ARRC (Alternate Reference Rate Committee) is expected to recommend a common methodology for computing CSA for SOFR rate.
There are currently three potential methodologies in discussion and remains a work in progress
- Static CSA: As the name implies, this method of computing CSA is Static. This will measure LIBOR SOFR at a cessation time period. Once calculated, the static CSA remains constant.
- Dynamic CSA: This method also measures the difference between LIBOR and SOFR which is accurate but harder to calculate.
- Static CSA with break the glass component: During the period of credit stress, ARRC could add a temporary additional spread to the CSA to account.
Benefits of SOFR
- Risk free rate: As SOFR is based on treasury transactions, credit risk can be avoided.
- Secured: The transactions are collateralized by treasury repurchase agreements.
- Lower risk of manipulation: Not based on expert judgement like LIBOR but on actual transactions.
- Transparent Rate: Based on actual transaction data provided by BNYM (Bank of New York Melon).
SOFR Transition Plan
The paced transition plan developed by ARRC lays out the process for building market structure and liquidity.
- Adoption of SOFR by the derivatives market.
- Raising enough liquidity in derivatives trading referencing SOFR.
- Extend the use of SOFR beyond overnight to longer durations of up to one year.
- Expansion of term ‘SOFR’
- Extending from overnight to different periods
- Facilitate the transition to SOFR for non-derivatives cash products such as loans and bonds.
Financial Markets have started adopting SOFR. Fannie Mae and Barclays are examples
- Fannie Mae mobilised its first $6 billion in securities tied to SOFR in July 2018. In the same year in October, it raised its second issue of $5 billion tied to SOFR.
- In August 2018, Barclays became the first bank to issue commercial paper based on the SOFR, selling US $525 million of short-term debt.
LIBOR to ARR Transition Impacts on Financial Institutions
|The existing LIBOR based pricing model of credit products (bank loans and derivatives) and associated contracts will be impacted||Current interest rates and profit spread will be impacted which will result in reassessing financial institution’s strategy, key performance indicators and LIBOR exposures|
|A detailed scenario analysis model will be required to study the major transition impacts||Restructuring existing systems to adapt to SOFR rates will impact the system’s database, reporting templates / models, communication channels etc.|
How HCL can help?
Alternate reference rates will replace LIBOR by the end of 2021. Financial institutions have already started adopting alternate reference rates like SOFR for building liquidity to support the transition. However, banks would find difficult to implement the change due to various uncertainties, risks and operational challenges.
HCL’s Key Offerings
- BUSINESS IMPACTS & SOLUTIONS
Uncertainty in Rate Change
- HCL can help study the current pricing model in the existing system and with the help architecting new RFRs pricing and can help in changes required in pricing modules of existing systems.
IT & Operational Challenges
- Providing customized solution for banks on amending their existing contracts in software applications.
- HCL can provide end to end impact analysis on operations for new ARR products and restructuring existing portfolio (change of valuation, risk, tax and legal).
- HCL can provide a faster transition plan - data migration and system changes to adopt to newer ARRs.
- HCL can help develop LIBOR to ARR convertion & yield calculators. Calculators will help stakeholders know what is going to be changed in their current investments tied to LIBOR (estimated value) can be added to CRM (Customer Relationship Management) systems.
- Digital communication channels like chat bots can be used to answer customer's queries.
- HCL can help in analysing the existing communication reporting process for suggestion of suitable models.
- SYSTEM IMPACTS & SOLUTIONS:
- HCL can offer support services to banks in both internal and regulatory reporting requirements.
- Financial Reporting - All the benchmark tabs of LIBOR should be changed to ARRs, HCL can provide banks with updated softwares that is compliant to the changed standards.
- Hedge Accounting - HCL can provide software updation and support services to reframe all hedged documents and reports.
- HCL can study the current pricing model in the existing system and with the help of knowledge in new ARRs pricing can help in changes required in pricing modules of existing systems.
- As currently, banks are using the system which is listed with the index rates based on LIBOR, HCL can help banks in Sourcing and Loading the new price index and structure based on ARRs.
- For the outstanding contracts, which is changing from LIBOR to ARRs, HCL can offer a feature to add CSA ( Credit Spread Adjustment) to capture difference between LIBOR and ARR.
- HCL can help in Servicing the transition for existing contracts through online channels.
- HCL can help in enhancing the comparison and pricing transition transparency among different products.
- HCL can help in providing consultation services for scenario analysis modelling.
- Refer to New York Times & Reuters Business News.