Global benchmark reform: the transition to risk free rates

Video | December 2019 | 05:57

Video Details

Global benchmark reform: the transition to risk free rates
Alan Bainbridge As we move to the next stage of IBOR transition, all of the banks are in a further state of readiness. I’m joined today by Hannah Meakin and Davide Barzilai from our regulatory and banking teams to talk about some of those key issues facing the banks. Davide, in relation to the FCA’s recent announcement about Q3 2022 and transitioning for new loans, how prepared is the loan market already?
Davide Barzilai So there’s been a lot of talk over the last year or so about how the loan market needs to speed up its readiness. Component parts of the agreements are not market ready yet. They’re out for consultation and they’re out for the market to test where the parameters are and where the eventual drafting will land up. So we’ve got three agreements: two are for new loans going forward, one for SONIA and one for SOFR, the US dollar rate, and then one amendment agreement to determine reference rates so that you can amend your legacy book in a more straightforward and streamlined manner once the market has adopted a future structure. So they are exposure drafts and that means that the market needs to feedback and come to some conclusions. So there are several areas that the market’s looking at in order to determine what we need to do going forward. They are how you calculate the rate, so we’re using compounding averaging, which has been used in the floating rate note markets. The question there is, where there is no screen rate – so at the moment there is no screen rate availability – who’s going to calculate that, how are they going to calculate that - and it’s inevitable that the market will come to some conclusions and, in line with expectations, particularly for the SONIA market to be ready by Q3 2020, I think we’ve got all the building blocks in place for that, and looking forward to the first part of next year into the second quarter next year, we will hope to have full agreements and a, sort of, market position on this.
Interviewer Hannah, what about the tension between the banks requiring to transition and needing to act in the best interests of the clients? What are the issues and how are they being addressed?
Hannah Meakin The first thing to say is that this kind of balancing act between the encouragement from the regulators to move fairly quickly but also to be making sure you’re acting in the client’s best interests is something that’s relevant to institutions that are acting for all types of client. It’s just that what you need to do to make sure you are acting in the client’s best interests might be slightly different depending on the type of client, or counterparty even, that you’re dealing with, so I think that’s the first thing. The second thing I would say is that there are then probably three key areas to be thinking about, so I think these three areas are relevant to all type of client or counterparties, but again, the way you approach them, you might flex them slightly depending on the type of entity you’re dealing with. So the first one I would say is governance, second one is conduct and then the third one would be communications. So if we start off with governance, I guess there’s a few examples we can give in relation to that. So we know that for any financial institution embarking on a regulatory change project, which is essentially what this is, they need to have a very clear project plan in place. That project plan needs to have been – really, kind of, start off with a risk assessment so in this case you’re looking at, “Where are our exposures to LIBOR specifically?” I think the second, kind of, example might be in relation to the types of people that you have involved in your transition project. That was governance. The second area I mentioned was really conduct. I guess conduct means different things to different firms but all firms really should be thinking about conduct risk in everything they do and I think some of the areas where this becomes particularly relevant in relation to LIBOR are things like – so where you have a legacy contract where you’ve got a contract that’s going to expire after the end of 2021, you’ll be needing to change your LIBOR rate reference to a risk-free rate. It’s thinking about how you’re going to do that and what might be the economic consequences for the client. Most clients will have entered into these types of contracts for a particular person so, for example, Davide was talking about loans – quite often a loan has a derivative that hedges the risk of that loan, so if you’re changing the rate on one of those contracts, you also want to be looking at how that impacts on the rate for the other contract and so there are linked contracts that need to be thought about hand in hand but in relation to new contracts there’s also the same types of issues to take into account, especially in terms of making sure that the clients really understand how the risk-free rates work and how they might have been different to what they might have been used to in the past. Then I think the third area, and this is perhaps a subset of conduct risk is communication, so this is all about making sure that clients really understand what the change is and why it needs to happen but also so that they understand what the risks are in that change for them and what they need to do in order to manage that risk.

Welcome to Banking horizons. With insights and commentary from across our global banks group, the series will explore some of the hot topics that we see as being front of mind for our bank clients.

The transition away from the Interbank Offered Rate (IBOR) towards alternative risk-free rates represents one of the biggest challenges facing the banking industry at present. In our latest video, Alan Bainbridge, partner and global head of banks, Davide Barzilai, banking and finance partner, and Hannah Meakin, financial services regulatory partner, discuss some of the issues facing banks as they go through this transition.

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