IBOR transition: Term Risk Free Rates (TRFRs) and industry actions

In recent years, the financial industry has been navigating uncertainties relating to the Interbank Offered Rates (IBOR) transition. New developments and challenges are surfacing as market players are evaluating options and implementing solutions to transition away from IBOR rates.

Benchmark alternatives: complexities, applications and liquidity concerns

New overnight Risk Free Rates (RFRs) such as Secured Overnight Financing Rate (SOFR), Reformed Sterling Overnight Index Average (SONIA) and Euro Short Term Rate (EuroSTR) have been selected by regulatory bodies and industry working groups as benchmark alternatives to existing IBORs. While EuroSTR will only be officially published in October 2019, SONIA and SOFR linked instruments have seen a slow but steady increase in liquidity this year.

However, the adoption of overnight RFRs is raising new concerns in terms of pricing, liquidity, market fragmentation and a potential divergence between cash and derivatives markets. As an example, for derivatives products, relatively simple instruments such as interest rate and cross-currency swaps are becoming more complex to value as financial institutions are looking to replace IBORs with RFRs that are currently lacking observability and industry standards. In addition to this, RFRs are expected to behave differently to IBORs in stressed market conditions which adds to the overall complexity of the product.

Similarly, for cash instruments, RFRs are also proving more difficult to use than IBORs with the added complexity of translating overnight rates into a term rate. One way of doing this is to compound daily RFR fixings to a term. The problem with this approach is that the exact value of a coupon payment is unknown until the last day of the accrual period - creating headaches for debt issuers and treasury functions.

2019 has seen many new developments across derivatives markets with ISDA leading the way with multiple industry consultations that recently concluded. The objective of these consultations being the standardization of fallback languages across all derivatives products to ensure a smooth transition away from IBORs. However, applying these rules to cash products may prove a bit more difficult.

With just under two and a half years left before a possible discontinuation of IBORs, building liquidity and driving adoption of RFRs is increasingly critical.

The case for TRFRs

A solution is an easy to use, forward-looking term risk free rate (TRFR) that supports transactions across fixed income, securitization, loans and derivatives instruments. TRFRs provide greater certainty to both buy and sell-side users (eg. investors, corporations, small businesses, retail borrowers and issuers). They ease the operational burden and most importantly, support liquidity management and cash flow planning by providing a term rate fixed in advance as opposed to having to calculate a coupon payment based on compounded rates in arrears.

TRFRs are typically listed at the top of the waterfall for IBOR replacements by official working groups across all jurisdictions. The Alternative Reference Rates Committee (ARRC), for example, confirmed this approach in their recommendations regarding more robust fallback language for new issuances of USD LIBOR Floating Rate Notes (FRN) published on 25 April 2019. Please click here to read the release.

Looking ahead: what should the industry start doing?

The IBOR transition calls for actions from legal, compliance, operations, valuation professionals as well as many other functions due to its impact on everything that touches IBOR benchmarks. Financial institutions should gain a head start on the following:

• Develop an IBOR transition project roadmap and establish program governance.
• Run an inventory of all IBOR-linked transactions and contracts.
• Analyze the impacts of converting IBOR trades to benchmark alternatives. This is key to make informed decisions and prioritize the transition of large complex portfolios over trades that could potentially rely on fallback language.
• Ensure operational readiness of trading infrastructure, technology and support systems to manage new business processes.
• The transition involves many changes in products and processes that could create new parameters of risks. Preparation should start immediately to minimize financial and operational impacts when LIBOR disappears after 2021.

As a leading global provider of financial services technology, data, and analytics, IHS Markit has been actively engaging market participants and regulators to build and offer front-to-back benchmark transition solutions. With capabilities in pricing, valuation, risk, regulation and portfolio management, we are uniquely positioned to help financial institutions embark on this journey.

Posted 12 September 2019 by Julien Rey, Executive Director, Data, Valuations & Analytics, Strategic Initiatives, S&P Global Market Intelligence

S&P Global provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.