This article is part of a Risk.net series on the practical aspects of Libor transition. Find the rest of the coverage here.
For many industry participants, the first seismic shift in the move away from Libor came in July, 2017, when the chief executive of the UK Financial Conduct Authority gave a speech suggesting that Libor’s days may be numbered after 2021.
But for the global head of derivatives trading at US insurer Prudential Financial, it was April last year – when US dollar Libor’s replacement, the secured overnight financing rate (SOFR), was first published – that represented the turning point when the changes that lay ahead for the business became very real.
“Building out a team to tackle this began the day after SOFR was first published,” says Chris McAlister, who has spent the past 25 years in the firm’s centralised derivatives subsidiary, Prudential Global Funding.
“At that moment, we began to convene a committee across a number of different functional areas, with the first step to go about gathering data around our Libor exposure for the entire group,” he says.
McAlister has put together a team of 15 people across a swath of different areas within the wider firm, including risk management, auditing and financial reporting, to collate data about its global Libor exposures across several of its businesses, such as investment management, insurance and financial planning.
Those businesses make up part of Prudential’s $1.5 trillion in assets under management and $4 trillion of gross life insurance in force across 40 countries, which means having a centralised view of the firm’s Libor exposure is particularly helpful, says McAlister.
“We have all the derivatives exposure centralised, so we have that data easily to hand,” he says. “The key thing is to gather the relevant data and then make sure we have the relevant people at the table to tackle a situation like this, who own and monitor that risk.”
Given the firm’s size – Prudential is the biggest life insurer in the US and tenth-largest asset manager worldwide – Libor exposures range across many areas, including cash products such as mortgages, business and consumer loans, collateralised debt obligations, securitisations, and more complex financial derivatives, such as swaps.
The one thing we can do is prepare ourselves for the inevitability that Libor will end and test systems and operational processesChris McAlister, Prudential Financial
In that respect, McAlister has nudged the firm into an influential position on the industry-led US Alternative Reference Rates Committee, which has been co-ordinating the transition away from US dollar Libor. Prudential has been represented on the main board since April and has seats at the table in four subcommittees.
Certain factors have held up the adoption of SOFR, such as the limited volume in the swaps market, which year-to-date is roughly $91 billion in notional versus $58.6 trillion in US dollar Libor, according to data published by the International Swaps and Derivatives Association.
The lack of clarity around tax, accounting and regulatory issues, which were discussed most recently at a Financial Stability Board meeting on April 10, have also created uncertainty and dampened enthusiasm for adopting the new rate.
However, this has not stopped Prudential from doing test SOFR trades and highlighting issues that may need to be resolved as the end of 2021 comes into view.
“The one thing we can do is prepare ourselves for the inevitability that Libor will end and, along those lines, we can test systems and operational processes. For example, we have done a very small number of trades that have allowed us to walk through the process of trading SOFR swaps,” says McAlister.
He declines to comment on the notionals involved or the precise makeup of the contracts, but he says doing these trades has allowed the business to become aware of the technical differences between trading these swaps and regular Libor ones.
For example, payment dates will probably be delayed by one or two days when trading SOFR swaps versus Libor equivalents, owing to the fact the floating rate linked to SOFR is set in arrears. This could create problems with hedges if the floating and fixed legs are paid at different times.
“The market standard will likely gravitate towards something that involves a payment date being at least a day or two after that final rate being published. It’s certainly something new for the market to deal with,” says McAlister.
The test trades have also allowed the firm to think through the curve construction of SOFR. This is in part hindered by the lack of SOFR swaps trading in the market today, but Prudential has already begun gathering data to help populate a curve.
“We’re continuing to monitor live liquidity and you need robust data to populate that curve,” he says. “Time is on your side right now, so this is the time to spend on that.”
For new fallback language, Prudential contributed responses to the first consultation published by Isda for sterling, Swiss franc and yen Libor, among others, last year. It also plans to offer its thoughts for the latest consultation on US dollar Libor, Hong Kong’s Hibor and the Canadian dollar offered rate.
“Answering the fallback consultation questions allows us to think through issues that might crop up as a result of adjusting contracts, and allows us to plan ahead,” says McAlister.