Highlight from the 3rd Annual Future of Securities Markets: A (LIBOR) Transition to Alternative Reference Rates

Debevoise & Plimpton in partnership with RMA recently presented the 3rd Annual Future of Securities Markets featuring a panel of discussions focused on the current market forces and trends with a view to how they will affect change going forward.

An informative panel addressed the timely issue of the LIBOR transition, indicating that the pace for transition is accelerating. Regulators have emphasized that the efforts to transition from LIBOR to SOFR must accelerate and the financial services industry should prepare for discontinuation of LIBOR. Volumes of listed derivatives referencing SOFR in the U.S. are increasing and swaps are trading. A small set of institutions has issued SOFR-linked debt instruments including SOFR-linked FRNs, CDs, and ABCP. Industry groups are making progress on introducing proposed new fallback language for derivative and cash products including derivatives, floating rate notes, syndicated loans, bilateral business loans, and securitizations.

Key Transition Challenges
Organizations must assess their firm-wide exposure to fully understand the implications of the transition challenges across all business lines and functions.

Fran Garritt, Director, Securities Lending & Market Risk at RMA, identified how to manage risk in the transition process over the next three years. He stated that firms preparing to trade SOFR derivatives should be taking immediate actions, such as going through their new product approval process to implement the front-to-back processes for pricing, trade capture, confirmation, margining, and settlements of listed and over-the-counter derivatives referencing SOFR. Firms will also have to determine historical market data proxy curves for SOFR risk factors and onboard products referencing SOFR to their risk management systems such as those used for value-at-risk, counterparty exposure modeling, risk-based margining and stress testing, and related models used for regulatory capital or margin, as appropriate. 

With the possibility of LIBOR discontinuance and derivatives liquidity moving to other benchmarks, Garritt stated that firms may need to reassess their asset-liability management hedging strategies and limits to manage the possibility for increased basis risk that will result when bank credit spreads or tenor resets are not symmetrically captured in asset, liability, and hedge products.

The transition from IBOR (LIBOR) to Alternative Reference Rates (ARRs), in particular SOFR in the U.S., will require major reviews and changes to model development, model validation, model risk management, and risk management more broadly at all financial institutions. For example, in derivative models, the term structure of IBOR is important along with its embedded unsecured credit component. However, SOFR is an overnight rate based on secured funding with no current term structure and the secured nature implies the rate is risk free. Therefore, new models will need to incorporate a basis risk between the IBOR and SOFR as well as incorporate some type of term structure to ensure that pricing and hedging is appropriate. From a model validation perspective, typically historical performance (e.g., hedging) plays an important role, but given the lack of historical data, this will be difficult to employ in the validation process. 

More broadly, risk management will need to create a historical time series for VaR and counterparty risk management purposes and the question of modelable versus non-modelable risk factors related to the FRTB will also need to be addressed, complicating the risk management landscape. This reinforces that within every firm, there needs to be a massive amount of communication between many different areas including the line of business, the risk functions, legal, and compliance so that these issues can be discussed in more detail.

Preparing for the Transition
A transition away from IBOR to ARRs is exceptionally complex and therefore, all firms should proactively take action now to adequately prepare and manage the significant risks of a near future where LIBOR ceases to exist. Governance should be under the auspices of the board and is typically led by treasury or global markets.

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