Is LIBOR coming for you?
Failure to adequately prepare for the LIBOR transition could lead to significant risks for firms as contracts transition to alternative reference rates. As such, there is potential for the underlying value to shift from one party to another.
A research study conducted by Duff & Phelps found that 77% of financial institutions do not have a comprehensive plan in place for LIBOR transition, which is due to take place on 31 December 2021.
Over half of the firms (54%) identified LIBOR exposures, but haven’t resolved their liability nor have they taken any action towards it, as most had not cataloged transition provision, and nearly half were unsure of what to do next.
The data was gathered from a sample of 27 respondents, comprised of private equity firms (43%), professional service providers (25%), hedge funds (11%), banks (4%), and others (18%).
Quite astonishing is the finding that almost a quarter (23%) of the firms surveyed have not begun any formal processes to identify exposure.
Jennifer Press, Managing Director, Alternative Asset Advisory Services at Duff & Phelps, said: “The LIBOR transition is one of the greatest regulatory-driven changes ever, and inevitably it requires complex planning, thought and analysis. It’s therefore quite surprising to see that just nine months away from the hard deadline, the majority of financial institutions who were polled do not have a comprehensive plan in place.”
Marcus Morton, Managing Director, Valuation Services at Duff & Phelps, said: “The results indicate that although the majority of firms have identified their LIBOR exposures, many have yet to formally catalog the transition provisions. There is a real fear that many are pinning their hopes on fallback provisions written within existing contracts. The reality is that fallback language may not suit each and every party, and in some cases, contracts will fail if such provisions are inadequate. It will pay in the long term to properly assess the exposure of each and every contract, even if firms are under the impression fallback language is sufficient.”
Rich Vestuto, Managing Director, Legal Management Consulting Services at Duff & Phelps, added: “Employing technologies such as natural language processing and AI to analyze, interpret and extract relevant clauses and LIBOR-influenced language on target contracts could go a long way to help firms fully understand their exposure, but they must start the process now.”
Failure to adequately prepare for the LIBOR transition could lead to significant risks for firms as contracts transition to alternative reference rates. As such, there is potential for the underlying value to shift from one party to another.
A third of respondents (34%) revealed a belief that they are on track for the transition, despite the stunted progress across the majority of the industry. Firms are potentially underestimating the extent and complexity of work required for a successful transition.
Nearly a third of respondents have begun thinking about their transition and are unsure whether they are on track, while 14% have not begun planning, with a further 14% concerned they will not be ready before at least Q1 2022, which is too late.
LIBOR sunsets this year for most currencies
LIBOR sunsets this year for most currencies, exception made for USD where one-, three- and six-month LIBOR will be published until June 2023.
The RFRs replacing LIBOR do not follow such a standardized schedule and treasurers must now assemble multiple agreements for market data access and feed data into upstream processes whenever that data becomes available.
LIBOR offered simple and discrete terms for accrual and settlement calculations. In contrast, RFRs are largely overnight rates, making it necessary to calculate daily compounding over the term.
“Leveraging treasury management technology to integrate compounding methods within interest rate (IR) instruments will simplify this process, enabling correct settlements and accruals to be generated on-demand. Treasurers should also come to appreciate the freedom from volatility offered by RFRs; whereas a spike in the LIBOR rate could result in being locked into high payments for months, RFRs’ short terms smooth out the impact of any such volatile shifts”, said John Clarson, the Director of Quantitative Services at GTreasury.
“With LIBOR, confirming settlements and manage liquidity in a timely fashion was straightforward, because the rate was usually set in advance. RFRs make this more challenging: overnight rates are settled in arrears at the end of each period. However, with the right technology strategy in place to continuously clarify day-to-day cash balances, treasurers will have no problem managing liquidity even when turnaround times are brief”, he added.
Firms will have to make sure their technology strategy allows them to apply the relevant conventions at a transaction level, and to automatically utilize the correct methodology for determining final settlement rates.
“The growing ecosystem of regional benchmarks brings new choices for discounting, whether your exposures are derivatives, cash products, or non-IR products like FX and commodities”, Mr. Clarson stated, adding some RFR markets bring about current liquidity concerns as well, requiring treasurers to have the flexibility to support zero curve-based liquid products and adapt as necessary when the liquidity of other products deepens.
“LIBOR most likely remains at the heart of all your current portfolio items and hedges, each of which will feel the impact of the transition to RFRs. Taking inventory of these items and hedges to catalog your LIBOR exposures and carefully monitoring these positions is critical to planning and a successful transition away from LIBOR”, he continued.
GTreasury’s Clarson concluded that the smart approach should offer a singular viewpoint of all exposure, and allow for effective and comprehensive monitoring and reporting. A cloud-centric technology strategy can enhance this versatility, allowing full access to information from any location.
