Emerging challenges in IBOR benchmark reform

An estimated 80% of derivatives positions today are based on LIBOR.

This was written for Bloomberg Professional Services byEdmund Lee, Bloomberg's Business Strategy Manager - APAC and Vicky Cheng, Head of Government Affairs - APAC.

The transition plan for the possible dissolution of LIBOR, with its interdependencies and long time horizon, makes preparation a complex endeavor.

Of critical importance is understanding the nature of this change, as well as cultivating market awareness and enhancing systems to support the transition. There appears to be process divergence between larger, developed markets and smaller, regional ones — a gap that widens with the size of firms. In Asia, the focus has been two-fold:

Participants are concerned about benchmark developments in the U.S. and Europe;

They are focused on possible local benchmark changes and any relevant regulations.

There are also concerns over the variances in regional regulators’ plans in handling the global benchmark transition.

Bloomberg recently hosted a series of roundtables across Asia with senior heads of treasury from all segments of the financial market, including corporates, buy side, sell side local regulators and ISDA.

The discussions centered on participant challenges posed by the prospect of IBOR transition reform and the impact of a long time horizon. Three key areas of concern are:

Liquidity risk

Impact on hedge accounting
Regional variances and benchmark mismatch
Liquidity risk

In the face of uncertainty, risk management can prove challenging for a wide range of financial products. The current focus is on the fallback to existing benchmark rates — which to date has not been clearly determined for future post-2020 trades. There are concerns whether there will be sufficient liquidity on the fallback rate instruments.

Questions were also raised over liquidity on fallback-based instruments and participants having the necessary tools and systems to move forward. Historical back-testing data and forward-projection models can potentially be used to help

support the transition and handle risk decisions through the development of five- to ten-year data history and margining models. Firms dealing with the popular long-term duration exposure would likely have to grapple with convexity adjustment.

Hedge accounting and P&L impact

Existing financial contracts are built on assumptions that may no longer be accurate when a contract re-papers.

Adding to that unpredictability is uncertainty over which side in a counterparty agreement absorbs any potential losses derived from the change in benchmarks.

Guidelines have yet to be determined on how existing contracts should be treated during this transition phase. Many firms are concerned that they may not have the multi-level bandwidth to effectively address the possible issues on bilateral re-negotiations.

Pension funds and insurers, for example, currently use LIBOR-linked curves to discount their liabilities. Their view is that hedge accounting impact can be enormous. These participants look forward to regulatory guidance to determine industry rules related to liabilities in a world without LIBOR and/or multiple IBORs-based benchmarks.

Currency variance

The International Swaps and Derivatives Association (ISDA) has indicated that methodologies for fallbacks will be different

for each currency, and that contract counterparties will need to ascertain how to factor for this reality. As regional authorities examine their next steps on reforming existing benchmarks, participants face further challenges on divergence of methods on how future regional benchmarks are modelled. This raises the specter of cross-currency swaps mismatch impacting risk management practices. HIBOR and its relevant development, for example, will be closely followed as many participants have book exposure to it and its links to major currencies.

Firms will need to focus on regulation-agnostic processes and evolve their workflow systems.

It is vital that they manage the possibility of facing disparate methodologies across jurisdictions, and reassess hedging strategies for currency risk.

Crafting a solution

Impending IBOR transition in Europe and the U.S. creates structural and institutional challenges for Asia due to the region’s substantial exposure to the dollar funding business.

Information sharing will play a pivotal role in building solutions that are beneficial to all stakeholders and participants. Both the buy side and sell side will need to work together in planning strategies for benchmark transition.

ISDA is facilitating the change by encouraging all counterparties (buy side and sell side) to review and respond to its consultation paper by October 12, 2018. Lack of sufficient responses from diverse stakeholders may result in transition processes being skewed towards those employed by the largest institutional participants.

Participants are looking to more engagements between central banks, regional authorities and institutional players to draw out concerns and address potential change strategies. The local Asian offices of global conglomerates should voice their unique regional concerns to their company’s headquarters.

With all the currencies and fallbacks in play, paramount in navigating benchmark transition are robust data modeling, dynamic currency scenarios, and back-testing data for outcomes to manage risk. As guidelines for the transition continue to evolve, third-party solutions that offer salient data and tools to power analytics across various markets and asset classes are needed in order to forecast scenarios and mitigate risk.

For more information on Secured Overnight Financing Rate (SOFR) support and analytics, existing clients can go to SOFR <GO> on the Bloomberg Terminal.