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IBOR Transition – Are you Prepared?

IBOR Transition – Are you Prepared?

The phase-out of the interbank lending rate (IBOR) will impact big changes to financial services – are you prepared?

Interbank offered rates (IBORs), especially the London Interbank Offered Rate (LIBOR), have set the benchmark rate for lending, underpinning the worldwide trade in financial products – from bonds and loans to derivatives and mortgage-backed securities.  Since the 2012 IBOR crisis the UK FCA shifted supervision of the index to the Intercontinental Exchange Benchmark Administration (IBA).  Despite steps taken by the IBA to strengthen the benchmark, the ongoing slowdown in unsecured debt market activity has diluted IBOR’s relevance – three-month US dollar LIBOR, the most heavily referenced IBOR benchmark, is supported by less than $1 billion in transactions per day.

Both the UK and US plan to phase out IBOR and move to a new benchmark – known as alternate reference rates (ARR) – by the end of 2021. Many other countries are planning to do the same.

The transition from IBORs to ARRs will impact the global financial system in two critical ways:

  • Legacy contracts. While firms are pivoting away from IBORs, trillions of dollars of debt and derivatives products will continue to reference the index after the 2021 deadline.
  • ARRs and IBORs are distinctly different. No ARR will be equivalent to the related IBOR because of structural differences between the two. IBOR underpins unsecured and uncollateralized debt and continues to rely on a good deal of expert judgment. ARRs are based on actual overnight transactions and secured by collateral.
This variation between IBORs and ARRs means that the risk profile and valuation of trillions of dollars of financial contracts will likely change once they’re benchmarked by ARRs. To mitigate the uncertainty, firms will need to determine the appropriate spreads to be applied to ARRs ahead of the transition, requiring the recalibration of a wide range of financial and risk models. This transition will demand a significant transformational effort from both financial services firms and market participants with extensive exposure, bringing a number of challenges along the way. For further reading, please see this Bank Of England paper on the IBOR transition: https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/what-you-need-to-know-about-libor-transition