Key Challenges

Alexandra Barysheva^a, Sergejs Solovjovs^a

^aEconophysica Ltd., Annecy Court, Ferry Works, Summer Road, Thames Ditton, Surrey KT7 0QJ, United Kingdom 

Abstract

This report considers an impact of IBOR transition on regulatory capital of financial institutions. In particular, we show a change in the value of an interest rate swap when its floating rate is shifted from LIBOR to an alternative reference rate.

INTRODUCTION

Background

LIBOR is deeply embedded in today’s financial markets. However, with the transaction volume in the market on the decline, LIBOR has been based increasingly on expert judgement. After the revelation of collusive actions by several banks contributing to LIBOR in 2012, doubts started to arise on the reliability of such judgement, and the LIBOR moved into the spotlight. The banks will no longer be compelled to submit LIBOR data after December 2021. Various working groups are currently moving forward different Alternative Reference Rates (ARRs) that are to replace LIBOR, but they currently still lack homogeneity in collateralization and publication time [1]. Developed Alternative Reference Rates (ARR) for main currencies are presented in the table below [2].

Expected Workflow

Regulators are pressing for the input of new LIBOR business to cease by the end of 2020, and for the transition of existing business away from LIBOR by the end of 2021. The following is a brief LIBOR transition timeline [3]:

Financial institutions have a fully developed infrastructure for handling LIBOR linked products. This infrastructure will have to be adjusted to handle ARR linked products. Some parts of the existing infrastructure (for example, particular models) could possibly be still used with appropriate changes (big or small), and the rest will have to be redeveloped from scratch. Infrastructure changes will include costs of two types: capital changes due to new modelling techniques and costs related to change the infrastructure itself (for example, development of new models). Every institution will have to decide which cost type makes the largest impact and proceed accordingly: either invest into new infrastructure reducing capital impact or try to adjust the old infrastructure accepting the capital increase.

Multicurrency Environment

Cross-border lenders should consider potential operational impacts of using ARRs. LIBOR is based on five currencies and serves seven different maturities: overnight, one week, and 1, 2, 3, 6, and 12 months. Thus, there are 35 different LIBOR rates each business day. LIBOR is quoted on the same basis for each LIBOR currency, whereas the ARRs are currency specific. There is the potential for issues in the loan market when drawings in different LIBOR currencies under the same facility are priced at the same margin. If different ARRs are used for different currencies, it may require a different margin per currency, which could create added complexity for borrowers and lenders, particularly for syndicated loans, which can often be structured using multiple currencies [4]. Moreover, LIBOR publication times are the same for all currencies, while this is not necessarily true for ARRs in other currencies.

NOTE. We might see the splitting out of multi-currency borrowing facilities into their separate currencies since different currencies have selected different ARRs and are transitioning at different speeds [5].

IMPACT

IBOR transition will significantly impact all financial institution processes, including the following [6]:

Pricing

• ARR linked products have different pricing dynamic and different convention from IBOR products which requires changes in the valuation approaches.

• Derived term structure modelling is susceptible to model risk and creates computational challenges. Switching from simultaneously bootstrapped Forward LIBOR and discount OIS curves to “self-discounting” ARR curve is required.

• Low liquidity of the current market of ARR products is an issue for construction of forward-looking term rates and hedging.

• Derived and implied term-structure for new ARR will affect interest payments creating valuation differences for existing financial products.

• The spread between LIBOR and ARR which arises due to different securitization of rates (for some ARR) should be considered. Adding a credit-sensitive spread to these ARR for loan products could be helpful for transition.

Data & Systems

• Additional market data are required to build ARR rate curve of a good quality (looking-forward).

• Changes in existing IT systems to support new valuation methodologies and possible new data format sourcing are required

Risk Management

•  Economic risk. Switching to new discounting rates will lead to valuation changes and, as result, may lead to significant impact on P&L and economic loss. Transition to ARR could increase financial institution capital requirement since the shallow market of ARR-based products could lead to lack of hedging instruments.

• Operational risk due to the risk of errors in including fallback provisions for derivative contracts arises.

•  Conduct risk. Long-dated contracts that extend beyond LIBOR transition may expose banks to conduct risk due to information asymmetry between counterparty and banks regarding LIBOR fallback. Conflict of interest between counterparties may arise due to the lack of adequate approval and control framework during transition.

• Basis risk. Divergence in application of fallback methodology across CCPs will cause basis risk in a counterparty’s cleared trading book.

• Reputational risk. Legal and reputational risk arises due to variance in long-term benchmark rates.

Governance

• Litigation risk. Incorporation of an ARR fundamentally different from a cost-of-funding based rate like LIBOR into the contract runs into risk of legal implications

• A solid governance should be established on the overall transition process.

AN EXAMPLE OF RELATED CHANGES FOR A FIXED-TO-FLOATING IR SWAP

Now let us consider an example of the IBOR transition process for a simple swap. Firstly, the short theoretical description for the product is given from both LIBOR and ARR points of view. Then, important changes in valuation/hedging methodologies are highlighted and the impact of switching to a fallback approach on the contract price is shown.

London Interbank Offered Rate (Libor)

Product

A company is entering into an interest rate (IR) swap where it agreed to make semiannual payment at the fixed rate R^fixed and receive LIBOR on a notional principal of $100 million.

Product Pricing

The following formula is used for swap pricing [7], [8]:

where

•  n is the number of the outstanding payments,

• Floating Cash Flow_i equals Principal Amount ^. Forward LIBOR_i ^. ΔT ,
  

• Fixed Cash Flow_i always equals Principal Amount ^. R^fixed.ΔT .

A classic approach to valuate a swap assumes that forward rates are realized. For the sake of simplicity, we disregard day count convention issues.

Product Pricing Data

The following data are needed to price the product:

1. Discount curve. Discount curve is built by matching OIS quotes¹.
   
2. Forward LIBOR curve. The market standard of forward curve construction is to get rates from the observed market prices of instruments with different tenors (IR Swaps, FRAs, Futures, etc.)

Both discount and LIBOR curve are calculated via the bootstrap method. The quality of constructed curves depends on chosen market data, interpolation methods used across tenors and other contract parameters, extrapolation, and overlapping handling.

Hedging

DO NOT hedge your position on a product-based level.

To build a proper hedge a sensitivities approach is often used. Sensitivity is a change in the portfolio price due to the change in underlying risk factor by 1 basis point. In terms of a rate curve, IR sensitivity can be calculated by applying a shift to the curve. The shift might be a parallel or a nonparallel. Nonparallel shift captures more volatile behavior of short-term rates and allows to get good hedging performance. To hedge the portfolio against IR risk, instruments available in the market are chosen in such way that its total IR sensitivity is the same as the portfolio has (perfect hedge). Fixed-rate or floating-rate bonds, swap and other IR linked instruments are used.

Sensitivities are calculated as the portfolio price change with respect to small bumps of the market points (term structure). For example, if a curve is built by using LIBORs, bumps will be applied to LIBORs. Typically, sensitivities are reported by buckets associated with the tenors of the underlying market instruments. Because of this, a transition to IBOR will require a significant revision of the hedging strategies.

Risks

• Pricing. LIBOR-linked products have a high liquidity and are traded for a long time. Financial institution uses sophisticated models that meet regulatory requirements to price the IR linked contracts. The full model life cycle management, including validation is in place.

• Data & Systems. Current banks’ infrastructure allows to get required data of a high quality in a form which is supported by the internal systems to price/calculate corresponding risks.

• Risk Management. Possible risks are identified and calculated on a regular basis. Risks related to an IR Swap with LIBOR floating leg are market, credit, and model risks².

• Governance. A proper governance is established in banks around the whole bank processes, including development pricing, risk models, models validation procedure, communications policies between a bank and its counterparties/clients.

Secured Overnight Financing Rate (SOFR)

Product

A company is entering into an IR swap where it agreed to make semiannual payment at the swap rate R^fixed and receive SOFR on a notional principal of $100 million.

Product Pricing

The same formula as for LIBOR rate, where LIBOR is changed to SOFR.

Product Pricing Data

The following data are needed to price the product:

1. Discount curve. Since SOFR is an overnight (O/N) rate, the “self-discounting” can be used.

2. Forward SORF curve. According to Alternative Reference Rates Committee (ARRC) transition plan, a forward-looking term SOFR rate will be created by the end of 2021

Generally, there are two possible ways to build a rate curve. The first one relies on the historical data and a model, which then is calibrated to reproduce the market quotes. The second approach assumes to get future rates directly from the market quotes of contracts with different maturities, that gives information about market expectations. We propose the following:

• Bootstrap the curve using existing SOFR linked and related instruments and information (SOFR rates, SOFR index, CME contracts, ICE or other exchanges or even OTC SOFR swaps, spreads, basis swaps, Fed Funds (FF), ED futures, FOMC announcement).
• Apply a parametrization on the obtained curve to get long tenor’s rates.

Hedging

The hedging approach for SOFR-referencing swap is the same for LIBOR one, but since the SOFR-referencing product market is in process of being developed, there might be no appropriate products to hedge the IR risk (liquidity problem). SOFR-FF basis swap may be more useful hedge instrument because it is the most relevant SOFR instrument available concerning the discounting risk.

Risks

• Pricing. Financial institutions will have to update/replace existing valuation methodologies due to different convention between SOFR and LIBOR. SOFR is more volatile than OIS, thus switching from OIS to SOFR discounting may lead to a significant impact on profit and loss (P&L). Moreover, it will reshape future cashflows since the swap and LIBOR rates, which are commonly used as the underlying of the interest products, will be impacted by the SOFR discounting [9]. Tight deadlines and the absence of standardized approach may lead to additional economic losses.

• Data & Systems. Significant changes need to be implemented in IT systems to support new valuation methodologies and required data sourcing.

• Risk Management. New risk models should be developed in response to new valuation methodologies. Conduct and Operational risks need to be assessed.

• Governance. Clear governance process needs to be established around the IBOR transition to decrease the possible operational risk. New policies should be written for employees on how the existing processes will be changed.

Impact Analysis

DO NOT consider only the impact on a contract price, but also look at the impact on the risk corresponding to the contract.

ISDA Regulations

According to International Swaps and Derivatives Association (ISDA) the historical median approach should be used as a fallback for IBOR [10]. The following adjustments are needed to compensate for the difference in IBOR and the low-risk ARR:

• Daily ARRs are compounded over the relevant IBOR period.

• A spread adjustment is added to the compounded rate. The spread adjustment will be based on the median over a five-year period of the historical differences between the IBOR in the relevant tenor and the relevant RFR compounded over each corresponding period.

ISDA announced that Bloomberg Index Services Limited (together with its affiliates, Bloomberg) will produce and publish the compounded setting in arrears rate, the spread adjustment and the “all in” fallback rate (i.e., the compounded setting in arrears rate plus the spread) [10].

Product Description

We consider a simple swap with the following trade details:

ISDA Regulations

To exclude the impact of the curve building model on the results, we used realized rates for calculations. First, the contract price was calculated by using 3M LIBOR as a floating rate. Second, floating rate according to the fallback approach (adjusted SOFR plus spread) was fetched from Bloomberg, and the contract price was recalculated.

• Impact on the Contract Price
  

The obtained spread for the payment dates is presented in Figure 1. The relative difference in swap price after switching from LIBOR to fallback approach for the contract under consideration is 0.19%. Even though such a difference can be considered insignificant, one should know that the impact on price can be much bigger. To show this, we also calculated the price of the same contract, but which starts on a different date. The results are presented in Figure 2 (the marker corresponds to the relative change in the price of the contract under consideration). It can be clearly seen that when the difference between LIBOR and Fallback rate moves increases (Figure 3), the difference in the swap price also increases. The main reason is that spread which aimed to compensate the difference in rates is based on 5-year historical data and changes slower than the rates change.

Figure 1

Figure 2

Figure 3

NOTE. The spread cannot react fast to the changes in difference between LIBOR and fallback rate. The transition date should be chosen carefully.

It is obvious that the switch to ARR will impact not only the price of a portfolio, but also the corresponding risks. Consider a VaR model, which is used to calculate the required capital, namely, the 10-day VaR value is an estimate of the required capital. One of the commonly used metrics for risk is the volatility of the portfolio P&Ls. Since IR Swap is linear to IR risk, the volatility of contract moves is a linear function of rate moves volatility. 10-day moves in LIBOR and Fallback rates (adjusted SOFR plus spread) are presented in the figure on the right.

As it can be seen from the figure, the LIBOR moves are more volatile than fallback rate moves. The standard deviation of LIBOR rate moves is 9.97% during two-year period (April 2018 – April 2020) versus 6.84% standard deviation of Fallback rate moves.

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