Operational uncertainty – An unavoidable challenge

The transition from Libor to a new risk-free rate (RFR) has revealed a number of challenges for all financial markets participants – the nature and scope of what lies ahead is vast, impacting businesses, operations and support functions. KPMG‘s global Libor solution lead, Chris Dias, explores why firms will need to consider the impact of the transition on a number of overlapping dimensions, including strategy, risk, operations, finance, compliance, legal and clients

Chris Dias, KPMG

While the efforts to prepare for the transition away from Libor will be significant, operational readiness may be most demanding of all. The number of operational factors that must be considered grows quickly when links to clients, products, systems and legal departments are entered into the mix. Structural differences between Libor and its proposed replacements make operational uncertainty unavoidable. These challenges are further exacerbated by looming unknowns in market conventions, market structure and legal certainty – not to mention the rapidly approaching Libor end-date.

 

The new RFRs are simply different 

Libor is a somewhat homogenous rate. It comprises five currencies and seven tenors, all of which are published simultaneously every day by a single administrator with oversight from a single regulator. Going forward, there will be five new standalone RFRs to replace Libor. Each of these rates will be published daily, though at different times, by five different administrators, with oversight from five different regulators. This nominal difference will cause firms with cross-border exposure or global footprint to, as a minimum, rethink their valuation and risk measurement processes.

Libor is an unsecured rate with a credit risk adjustment built into the published rate – it is, for the most part, a rate estimated by only a handful of banks. Panel banks submit daily benchmark rates for several tenors from overnight to one year. Institutions have become accustomed to the term structure as well as the credit and term premia, hardwiring this ubiquitous rate into systems, operations and processes. This makes the task of replacing Libor very challenging.

The new rates are characterised as risk-free, with some jurisdictions, such as the US and Switzerland, opting to base the new rates on secured daily transactions, while the UK, Japan and the eurozone have elected to base the new rate on unsecured daily transactions. In addition, the new rates have started life as a daily overnight rate only, with no term structure or additional credit premium. While term structures are expected to evolve for some new RFRs, the timing is uncertain. A static credit adjustment is expected for legacy transactions, but not for new deals. This presents a unique challenge for all institutions – firms will need to deal operationally with replacing a well-entrenched rate with a term structure and a credit component with an overnight rate that currently has neither.

 

The front-book/back-book dilemma

Perhaps the greatest operational problem ahead will be to deal with legacy transactions, while managing new transactions using the new rates. Operational requirements for legacy or back-book trades will require firms to potentially maintain existing infrastructure for a period of time, and to have capabilities to migrate existing transactions to a rate different from Libor. This will require multiple instances of pricing, valuation, accounting and risk systems to coexist until the deals mature, expire or are converted to a market-acceptable rate. The operational problem of switching legacy trades will be further magnified as early adopters of the new RFRs feel empowered to negotiate market conventions yet to be formalised, creating myriad potential outcomes.

New transactions based on the new RFRs will require unique processes. Booking, accounting and risk systems will need to be updated. New processes will need to also coexist with legacy processes for some time, presenting resource challenges and introducing very real operational risk concerns. 

 

Fallbacks will certainly dictate outcomes

The financial services industry – through working groups, industry bodies, individual institutions and regulators – is working intensely to develop a robust fallback language to ensure guardrails exist for transitioning Libor to a new rate. The new language is a good step forward, but the challenge will be to operationalise it.

The first problem will be assessing whether the fallback language is hardwired or relies on an amendment approach. The hardwired approach is predicated on a fallback waterfall – for example, the language could state that parties to the contract fall back to the forward-looking term secured overnight financing rate (SOFR) plus a spread adjustment. If that does not exist, then they fall back to compounded SOFR in arrears plus a spread adjustment and, in some cases, a ‘viable alternative’ to be determined by the lender or agent could be used. From an operational perspective, systems will need to be capable of handling any of the outcomes. In contrast, the amendment approach relies very much on a negotiation between parties to determine the appropriate fallback, which can present a Herculean challenge in terms of anticipating what the negotiation will decide upon. Given that parties to a negotiation will angle for the best outcome possible, operational readiness becomes decidedly more complex. Although the hardwired approach still exudes uncertainty, it is a far better ‘operational readiness’ outcome than the amendment approach. The amendment approach simply ‘kicks the can down the road’ to a time when orchestrating negotiations and translating those negotiations in operations will be taxing on resources and systems. 

 

Don’t put all your faith in timely vendor solutions

Many firms have invested in vendor solutions for financial products and will expect the vendor to provide the fixes required for transition – which may or may not be the case. Vendors will have similar challenges to market participants – they will need to understand the many market conventions around pricing, accrual and settlement, and will have to accept that most RFRs are still evolving. Their reluctance to commit resources to any single solution in an environment that is still fluid is understandable, yet exasperating. However, firms investing in vendor solutions will have to address issues related to version compatibility, system upgrades and testing – all of which could prove costly and time-consuming. Vendors must, therefore, prioritise fixes, upgrades and solution patches to avoid leaving some firms without the required system enhancements until after the market has transitioned. The success of the Libor transition will be highly dependent on firms’ readiness to book new RFR deals.

 

Dealing with operational uncertainty 

The birth of a new rate requires the determination of a number of market conventions and the evolution of market structure – to date, uncertainty exists around both. SOFR pricing has yet to lock in a market-wide convention on either pricing or settlement. Questions yet to be answered include: 

• Whether interest will be calculated using compounding or simple averaging. Simple averaging is easy to implement and has already been used in early SOFR issuances, whereas compounding is a truer reflection of interest but is much harder to implement – particularly when calculating in arrears.
• Whether settlement will be subject to a lock-out or lookback and, in each case, what the appropriate number of days is. 

Operational uncertainty is forcing firms to make choices from the many alternatives. Given that time is quickly winding down and no clear direction has yet emerged, it may make sense to plan for all reasonable approaches. 

 

What to do next?

The easy route is to do nothing and hope for the best, but this could be costly in terms of revenue, opportunity, relationships or any number of other problems. There is no easy solution. Understanding the impact to an operational change of this magnitude is the first step, starting with a determination of the products and systems that will be impacted. Then, developing plans or a playbook to transition considering different scenarios or outcomes and, finally, prioritising high-probability, high-impact systems and processes. Firms should engage with working groups, industry bodies, clients and vendors to better inform work effort, operational choices and, ultimately, mitigate risk. With the end of Libor rapidly approaching, hopes for extensions and reprieves should not be a first choice. In the words of Game Of Thrones’ Jon Snow: “Winter is coming.”

The author

Chris Dias is a principal in KPMG’s Modelling & Valuation group, serving financial services companies as a risk practitioner and strategic adviser. He is an accomplished professional with over 30 years of international experience in financial markets and serves as the global Libor solution co-lead at KPMG.  

^{The KPMG name and logo are registered trademarks or trademarks of KPMG International. This article represents the views of the author and does not necessarily represent the views or professional advice of KPMG LLP.}

 

Libor Risk – Quarterly report Q1 2020
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