The London Interbank Offered Rate (LIBOR), the most important number in the financial markets, is set to be phased out by the end of 2021. Alternative reference rates (ARRs), also known as risk-free rates (RFRs), have been identified as a replacement — although creating alternatives for LIBOR is no easy task. LIBOR is the reference interest rate in millions of contracts worth more than USD 250 trillion, ranging from derivatives to residential mortgages. LIBOR is also embedded into all manner of financial activity, such as risk, valuation, performance modelling and commercial contracts.
The transition from LIBOR will bring considerable costs and risks for financial firms. Since the proposed alternative rates are calculated differently, payments under contracts referencing the new rates will differ from those referencing LIBOR. The transition will change firms’ market risk profiles, requiring changes to risk models, valuation tools, product design and hedging strategies.
Given the market volatility and decoupling of LIBOR from alternative benchmarks, banks have focused their attention on the pricing of credit risk, shifting their resources to maintaining business continuity and mitigating market risk in the near term. This will impact the LIBOR transition milestones and put undue pressure on the market
LIBOR contract remediation is imperative within the specified time frame since the economic impact is significant. Typically, all contracts will have a ‘fallback’ provision however, if contracts are left to convert to this default once LIBOR becomes unavailable, a vast number of price changes would occur in a short period. The associated financial, customer and operational impacts would be high. Financial firms will also face a serious communication challenge with retail customers. Most variable rate mortgage in the US are pegged to LIBOR and explaining the change to SOFR would be a challenge.
The LIBOR transition to risk free rate (RFR) is much more complex than expected. During the transition phase, banks will need to focus on two levels of change — as step one the existing contracts with maturity dates beyond 2021 will have to be amended linking the new RFR and, as step two, all the affected applications will need to be enhanced to accommodate the changes to support new RFR products and processes.
Many banks have launched into the remediation using a manual process which is not the most optimal way ahead. It’s:
- Expensive (Millions of dollars spent with minimal guarantees)
- Time consuming (12 – 36 months)
- Repetitive and prone to error
- High risk to the banks from operational, regulatory and financial standpoints.
Technologies like automation, machine learning, and natural language processing (NLP) with good content management can help mitigate risk from the LIBOR change. Identifying LIBOR contracts from the repository and manually extracting the meta-data or fallback clauses from the agreements will be a tedious and error prone task. Given the complexities, the prudent way forward for banks is to opt for a solution backed by technologies like NLP/NLU, Deep Machine Comprehension, Adversarial Scoring Networks, Dynamic Lineage Mapping, Adaptive Remediation and Amendment Generation to identify the impacted LIBOR contracts, extract the relevant terms and their metadata, classify key terms through pattern analysis and assign confidence scores to measure accuracy.
Additional items to consider will be communication with clients and counterparties throughout the contract lifecycle to reduce the overall risk. Client consent must be obtained once the contracts are amended or repapered. Banks should also consider building a highly interactive LIBOR governance dashboard to track program delivery and milestones, and evaluate profit and loss impact and risks. The dashboard must also have the capability to monitor exposures, contract amendment and consents, as well as valuation difference between LIBOR and RFR. A dashboard built using real time data analytics will give a graphical view of exposure and state of transition
Banks need to act quickly to avoid operational challenges, enable better risk management, avert financial instability and ensure regulatory compliance. LIBOR transition is complex and comes with multiple challenges given banks’ multi-dimensional operational landscape.
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