The impending move from interbank offered rates to alternate reference rates will require important changes to many valuation and risk management processes and infrastructure. EY Financial Services’ Shankar Mukherjee, Michael Sheptin and John Boyle explore the impact of the transition, as well as what firms can do to prepare
The transition from interbank offered rates (Ibors) to alternate reference rates (ARRs) will require firms to assess and manage several significant valuation and risk management challenges.
Two key structural differences distinguish ARRs from their respective Ibors. The first is the nearly risk-free nature of the ARRs, such as the US dollar-denominated secured overnight financing rate (SOFR) or the Swiss franc-denominated Swiss average overnight rate (Saron). As Ibors are based on unsecured lending, they include bank credit spread premiums that are not included in ARRs. The second key difference is that Ibors are quoted for multiple defined floating-rate tenors, while most of the proposed alternatives currently do not; for example, SOFR is currently only quoted for overnight tenors. These key structural differences will drive ARR-Ibor basis risk that will need to be measured and managed. Additionally, differences in market liquidity and the supply-and-demand dynamics for underlying collateral in the repurchase agreement market may also contribute to the ARR-Ibor basis for ARRs based on secured rates.
Because of these differences, transference of market value could occur if firms transition existing transactions referencing Ibors by simply selecting an ARR in its current form as a new reference or ‘fallback’ rate if Ibors are discontinued. To manage this risk, firms will need to determine appropriate spreads to be applied to ARRs to mitigate significant value transfer, as well as the associated legal and reputational risks. While the mechanics of determining appropriate spreads to ARRs remains a work in progress, the launch of some ARR-based underlying futures and the evolution of the ARR swaps market will assist market participants with price discovery through market-implied basis spreads between ARRs and Ibors.
Firms preparing to trade new cash and derivatives products referencing ARRs should take immediate action to implement front-to-back processes for trade capture, confirmation, margining and settlements, as well as curve construction and pricing. For risk management of ARR risk and its basis to Ibors, firms will also need to determine historical market data proxies in the absence of full empirical historical time series. Such market data may be used for value-at-risk, counterparty exposure modelling (such as potential future exposures or valuation adjustments), risk-based margining, asset-liability management (ALM) modelling and stress testing, among other models.
Desk mandates will also have to be reviewed and updated, and position limits appropriately calibrated to reflect the market depth of new reference rate products. New practices may also need to be implemented to monitor the overall interest rate derivatives market liquidity risk associated with longer-dated exposures as market depth shifts across benchmarks. As ARR markets evolve, they will be used by central counterparties to calculate interest paid on posted variation margin and to discount swap cashflows, requiring firms to update their corresponding discount factor curves.
With Ibors potentially being discontinued and derivatives liquidity moving to other benchmarks, firms may need to reassess their ALM hedging strategies and limits to manage the possibility of increased basis risk arising from asymmetry in bank credit spreads or tenor resets in asset, liability and hedge products. Similarly, firms may have to monitor the risk of contingent asset-liability basis risk in cases where certain legacy cash products have fallback language that differs from derivatives hedging instruments in the event of Ibor discontinuation. Even if Ibors are not discontinued, firms will have to manage valuation risk by actively monitoring the liquidity of longer-dated legacy positions linked to Ibors, and assess whether valuation adjustments need to appropriately reflect bid-ask spreads and the extent to which firms are able to exit such positions.
To fully understand the broad implications on firms’ valuation and risk management infrastructures, it will be important for firms to perform an assessment of their model inventory that references all types of Ibors across the enterprise. This will facilitate an understanding of the holistic uses of the relevant Ibors for interest rate derivative products and in areas such as loan origination, mortgages, ALM and funds transfer pricing. This will allow firms as much lead time as possible to plan for the significant amount of work required to modify, develop or validate models in the new ARR environment before the end of 2021, when panel banks will no longer be compelled to make Libor submissions.
This feature contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgement. Member firms of the global EY organisation cannot accept responsibility for loss to any person relying on this article.