A Year End Update on the LIBOR Transition - Sia Partners
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R
E
S
E
A
R
C
H
A Year
End Update
on the LIBOR
Transition. jan 20210
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s i a - p a r t n er s .c o m
@SiaPartners0
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Project Background and
Acknowledgements.
This report is the last in a series of publications Sia Partners have authored
throughout 2020 relating to industry progress in meeting the LIBOR Transition
deadlines. We are exceptionally appreciative for the assistance and cooperation
from almost 100 institutions who have participated in our initiatives globally. This
year our documents included a pre-pandemic review of efforts as a follow-up to
our 2019 industry report. We also produced a series of short snapshots from the
same group of participants and some new joiners plus webcasts, and webinars on
this topic. We will continue these studies in 2021 as the industry progresses with
their transition investments.
This final effort combines both a policy report on the state of the industry as well
as a series of interviews we conducted in December after the release of the draft
consultative document. Mark Chorazak, a Partner in Shearman & Sterling’s Finan-
cial Institutions and Regulatory Reporting Practice joined us in co-authoring por-
tions of this document. Our colleagues at RISKSPAN provided exceptional depth
and analysis to the section on Risk Modeling and Validation which we believe will
be a looming and expanding area of focus in 2021. Finally, Eigen Technologies pro-
vided valuable contributions on the state of the industries embrace of automation
and natural language processing in their contract review efforts.
These efforts would not be possible without the contributions of many of our ma-
nagers and consultants who have worked long hours to support them. My thanks
to Mark Cheng, Harrison Suttle, Affan Khan, Virginia Sideleva, Asli Ersozoglu, and
Danielle Buttinger for their work throughout the year and to Chris Zachodzki for his
continued efforts in providing essential guidance to all of our initiatives. To all our
Sia colleagues who’ve assisted with these projects while working on their engage-
ments full time; thank you for devoting your time and energy to our industry efforts.
Like everyone, Sia Partners has found this a challenging year at best and, as always
we hope you continue to review our material in a healthy and safe environment.
We have conducted hundreds of conversations virtually, which has mirrored our
commitments to clients in our proprietary work in the LIBOR Transition space. We
would be remiss in not thanking everyone for their patience and helping us to
complete our work successfully.0
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Table of Contents.
6
• Market Reaction to Recent Announcements
2 A. How has the Release of the Consultative Documents Affected Transition Implementation
Timing?
B. What will be the Impact of the Official Sector in Implementing the Goal of the Consultative
Documents?
C. H
ow has the Release of the Consultative Documents Impacted the Development of SOFR and
other Alternative Reference Rate Products?
•
D. How has the Consultative Announcements Impacted Client Transition Progress?
11
The LIBOR Transition: End of the Year Update on Industry
Progress & Recent Developments
15 A. Background on Research
19 B. Contract Review and Remediation
21 General Observations
19 Coordinated and Consequential November Announcements
21 Prospects for a Legislative Solution
19 Announcement of ISDA Protocol
21 C. Technology and Operational Readiness
21 D. Model Risk Management and Validation Issues
19 E. C
lient Outreach and Communication0
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Document Overview.
Sia Partners’ divided its following Year End Update on the LIBOR Transition into
two primary sections.
First, we have detailed the industry’s reaction to the announcements made on
November 30 and December 4 by the official sector. We spoke to 25 of our original
participating benchmark firms, which included a balance among foreign banks,
G-SIBs, regional banks, and both financial and corporate end users. We asked for
their feedback on a variety of questions covering both the consultative announ-
cement and year-end feedback on progress for the transition by their peers and
clients. We focused feedback on four related to the impact of the consultative do-
cuments: (a) will the timing of the transition be impacted? (b) the role of the official
sector in interpreting and implementing the consultative recommendations; (c) the
impact on potential delays on the construction of SOFR and other reference rates,
and finally, (d) how have these delays impacted client transition progress?
Second, based on a combination of feedback from research, policy announce-
ments from the ARRC, regulators and fall discussions with participants prior to
the consultative announcements, highlights industry progress and developments
specific to key transition activities. The second section was drafted in conjunction
with Shearman & Sterling.0
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1. Market Reaction
to Recent
Announcement.
How has the Release of the tives. Study participants agreed the operational progress and product en-
Consultative Documents issues surrounding the actual timing hancements but did not expect that
of the transition from LIBOR to SOFR postponement due to the pandemic
Affected Transition Imple- (or other reference rates) and the ro- related issues. Statements from across
mentation Timing? bustness of the liquidity of those ARR the official sector (FCA, Federal Re-
products were foremost on their mind. serve, FSB, etc.) reiterated the year
Industry regulators continue to empha- We summarize those conclusions end-2021 transition timeline without
size that institutions should not enter below. flexibility. Most of the participants
new US Dollar LIBOR contracts after were surprised by the November 30/
end-2021. Subject to the responses to MIXED REACTIONS December 4 announcements, but not
the IBA consultation, which is open for disappointed. Here is our thinking why
comment until January 25, 2021, lega- First, participants noted that the an- that is the case.
cy contracts referencing certain tenors nouncements have in some meaningful
of US Dollar LIBOR could continue to fashion for some, and far less for others, • Postponement would provide some
mature through June 2023. IBA has affected the broader thinking relating helpful time to implement certain
stated that it intends to publish feed- to the progress of the transition. Insti- operational/vendor upgrades. Larger
back summarizing responses from the tutions noted that the transition was at firms noted that considerable amount
consultation shortly after the consul- an “inflection point” with a broad set of of progress had been made since
tation deadline and regulators are issues ranging from clients’ willingness vendor work was nearing completion;
expected to further consider to what to transition; liquidity growth in SOFR, • Some hesitance on success until ele-
extent they should limit new uses of avoidance of delays in passage of le- ments of SOFR (or another ARR) are
USD LIBOR. gislation to provide legal certainty on finalized that some of those steps
contracts among the topics that nee- likely will be delayed.
Recognizing the impact of these an- ded redress. Others noted that there • S maller and mid-size firms whose
nouncements, we reached out to a has been solid progress on operational systems were internally based would
number of our project participants and topics but reiterated the need for more potentially lag and drag out the pro-
asked them for their input. specificity on the SOFR product roll cess; Firms separately identified the
out (term rate for most, credit spread value of this delay value in the run-off
Over the past two weeks, we have overlay for a smaller group) and most of their agreements and set out their
had several dozen exchanges on the importantly some teeth behind the thinking around these theses:
issues raised in the November 30 and safety and soundness approaches that • Unrelated to the percentage of agree-
December 4 announcements from the banking regulators have identified to ments that firms identified were per-
IBA and the official sector. We also encourage transition progress. tinent to their business lines (40% or
requested input on a year-end as- A significant percentage of the firms we higher) that would get additional time
sessment on the progress on contract spoke with noted that while they were to run-off; the concept of the heighte-
review, operational and vendor efforts ready to meet the original transition ned time was seen as a positive for
to close gaps identified earlier in our deadlines, the delay envisioned would the industry.
studies as well as current challenges be useful. Indeed, our data reflected • For the tougher legacy agreements,
surrounding client outreach and com- mid-year a growing number of firms additional time was helpful to avoid
munications and their transition initia- that wanted additional time for varied negotiation with clients;0
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• certain clients or business lines with a have been vocal advocates of including the maturity of product growth. Stu-
higher preponderance of (ABS/CMBS, a dynamic credit spread to SOFR. As dy participants shared the view that
etc.,) the deadline loomed, the Credit Sensi- time should provide additional time to
• Easing the negotiations related to tivity Group, sponsored by the Federal build-out growth in cash and derivative
“tough legacy” contracts especially Reserve, considered some alternatives instruments and hopefully a ramp up
as firms articulated the timing asso- but chose not to recommend any of
in issuance as product clarity and legal
ciated with the legislation from either them specifically during the summer.
certainty are enhanced in 2021.Study
the NY State Legislature or Congress Separately, some firms have advocated
participants agreed the additional time
to provide legal clarity and hence the consideration to other approaches in-
should help those in the market that
longer runoff time was seen as an cluding the Bank Yield Index, Ameribor,
asset. had yet to invest or stand up a program.
several under sponsorship by third par-
ties and recommendations put forth by This would include those that were:
IMPACT ON SOFR LIQUIDITY academicians. Individual firms noted • Global but had not invested in their US
that for all the dialogue, the demand Dollar LIBOR efforts;
Not surprisingly, an additional benefit for individual reference rates will be • Firms both financials and corporates
of the extended time from our parti- market driven and liquidity for both the who were aware of the transition but
cipants was the build-out of SOFR to derivatives, cash and lending markets not yet heavily invested;
ensure a higher level of robustness are months off. • M id-size & smaller companies who
and potentially other reference We will address the broader liquidity required additional education and
rates. We have addressed this issue and product issues below. However, persuasion about the necessity for
throughout our papers the past two a majority of our participants agreed
meaningful transition progress.
years and the interest in some alterna- that the additional timing would allow
Institutions noted that the delay would
tive approaches has stayed reasonably a broader liquidity pool to be built for
provide additional time for the legal
consistent among the participants in SOFR emphasizing this was a critical in-
remedies to be passed globally, inclu-
our projects. To be clear, we are not gredient for success. Institutions noted
suggesting that this reflects the broa- ding legislation which would provide
that to date, the SOFR liquidity results
der banking or end user universe, but have been mixed—a pick up after needed clarity that sits before the
rather our research group across those SOFR Discounting but somewhat of a • NY State Legislature
categories. There has been a select flattening thereafter. A few institutions • Congress
group of respondents from the banking felt that derivatives growth was rising • UK/EC equivalents
community---mostly US based—who but most admitted disappointment in
Our initial reaction is that this does not
change what we need to accomplish in 2021.
We still need to complete our application,
model and contract remediation as originally
planned. We plan to be ready to meet the
dates in the ARRC recommendation that were
published in May 2020. U.S. Banking Participant0
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CONCERNS IDENTIFIED TO DATE so broadly no impact; king groups, timing and best practice
• Many firms noted that “our planned guidelines. A group of firms vocally
Our participants identified some core actions for the transition and timing raised the concern what would be the
concerns about the delay that they stay the same”; outcome of those approaches—would
felt might not be easily calculable im- • They were expecting some relief and those dates be retained/rescued or lost
mediately. These included those that our product enablement, model and to the process?
invested—spent time—to build up their technology work is unchanged; We discussed briefly above the impact
efforts and now were being penalized • Accomplishment benchmarks for 2021 of the announcement on the ability to
by pushing back pieces of the ces- remain unchanged for most firms; and create some global consistency with
sation date, and those firms that saw • Some enhanced thought on client en- regard to the transition. Firms generally
value in their significant organizational gagements and execution times but believed the challenges included:
approaches for contract review, ope- planning unchanged. • a general recognition from the global
rations, and product management and banks that they have been planning on
did not want to surrender that margin. What will be the Impact of a cross currency overlay with different
Second, there was broad concern ex- the Official Sector in Im- implementation dates for a long while.
pressed about the risks of magnifying This did not meaningful change their
global fragmentation. Firms noted that
plementing the Goal of the approach;
this has been a consistent concern gi- Consultative Documents? • an agreement that UK regulators have
ven the earlier start in the UK-EC and been more rigorous in their approach;
The second issue that emerged from
what both banks and buy side firms • other IBORs are further progressed
Sia’s discussions was the role of the
believe has been a more rigorous regu- both for banks and end-users and ins-
“official sector”—regulators—in imple-
latory approach which enhanced pro- titutions believe that this would not be
menting the consultative approaches.
gress. Firms noted that this delay could altered by the announcements;
The views varied and often depended
• participants questioned the impact
upon the intensity of interaction with
• Complicate management of multi-cur- of the announcement affecting the
regulators as part of their LIBOR tran-
rency tenor pairs; and timing related to any fixed dates for
sition. Some firms had begun those
• Lead to inevitable rolling off separate FCA pre-cessation triggers or spread
dialogues at least a year ago and were
currencies in ’21 vs. ’22 and risk ma- rate adjustments or other planned cla-
in contact on a formal, quarterly ba-
naging around that. rifications for the industry.
sis with their supervisors. Others had
dialogues on an informal basis more
Firms also noted a concern about inter- There was extensive dialogue from a
often. Other firms identified a far less
nal progress: group of firms about the ability to align
frequent interaction and did not have
• Loss for client outreach momentum the safety and soundness approaches
a view on the depth of understanding
some pauses until we know the im- for banks with a more robust effort for
on the transition for those who had
pact of the official sector guidelines; less regulated end-users. Participants
oversight. There was some agreement
• Loss of budget commitments and identified a series of challenges:
that the announcements were vague in
risks of re-allocation; • foremost, the structure for the SEC,
what precisely implementation of en-
• Management of whether there is a re- CFTC and others that have oversight
hanced “safety and soundness” efforts
turn to “business as usual” and have responsibilities for corporates, financial
would mean although some felt that
the central program re-focused; end users is meaningfully different and
was transparent and part of the day
• Keeping a team afloat for up to 18 efforts to persuade those they have
to day banking regulator approaches.
more months—funding/resources oversight for quicker action could be
There were some institutions who
• Losing overall management focus— problematic;
clearly wanted greater clarity and a
attention to the transition-some re- • a view that asset managers and some
stronger approach from the regulato-
ferenced seeing this with MiFid and in the ‘alternative space’ could step in
ry sector. These firms have generally
other policy initiatives in the past; and and provide the liquidity for the bank
held similar views throughout our study
• Risk of lowering commitment to risk loan and middle market space is quite
process and have asked for a sturdier
management/model projects and plausible and needs redress if the goal
response from U.S. parties.
digitizing contracts built off the back is to ensure a timely transition away
A number of firms made a separate
of this transition effort at some larger from LIBOR product;
argument—which was embracing the
firms. • a requirement for an FSOC or equi-
ARRC Best Practices as part of the
valent effort across regulators for uni-
“teeth” in the next set of regulatory
Our assessment included a group of formity on goals—standing behind the
commentary. Institutions noted that
clients that did not see at least some hardwire language (as an example) and
for the past several years firms glo-
aspects of this as moving the needle ensuring a clear vocal direction for all
bally (if not primarily in the U.S.) have
in a meaningful way. Clients noted that market participants.
been reliant on ARRC direction, wor-
• There is still no new LIBOR post 20210
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How has the Release of the were long-discussed challenges of (for example trade financing or any
utilizing SOFR in arrears for a group business that offers discounting).
Consultative Documents Im-
of banks and some end users. Institu- Throughout our summer-fall discus-
pacted the Development of tions identified challenges on the cash sions, a term structure was seen as
SOFR and other Alternative side (vs. derivatives) for using the mul- significantly desirable. The support
Reference Rate Products? ti-step process as well as the timing for for that as we enter 2021 has grown
amendments for options and picking among the firms who did not have
Our third client feedback section fo- conventions for which additional time strong views earlier and certainly in
cuses on the views of the participants would be useful. the strength of that conviction among
related to the consultative paper’s im- those firms who have favored term
pact on SOFR’s maturity as well as the A separate stream of dialogue sur- from the beginning.
creation of other reference rates. Alike rounded the value of giving a dynamic
other themes, this topic arose in every credit solution a chance for fruition. A In summary there was a broad consen-
topical segment we raised related to number of respondents noted that they sus that the growth of SOFR products
the consultative papers role in shaping felt that this option had been more than has been slow and, in many ways, di-
the transition deadlines (section one) sufficiently vetted and that any version sappointing. Institutions agreed that
as well as how SOFR’s development is of either market or operational success discounting provided a short, “large
linked to the official sectors pressure was not likely. However, others (as they boost” but that liquidity was tempo-
on regulated entities to commit to the have throughout our projects) differed. rary. Firms noted that traders did not
transition in a timely manner. The argument from those firms was believe that the discounting switch did
Our participants throughout our stu- built centrally around the market ab- not produce what was hoped for or in-
dies the past several years have voiced sorbing the risk; taking advantage of tended and other mechanisms we have
opinions regarding the value of encou- the “extended runway” and make ad- already discussed above need serious
raging the adoption of alternative refe- ditional attempts to build some support consideration. Several institutions
rence rates to SOFR. Data from our ex- for the credit overlay concept. Some re-emphasized that the liquidity issue
changes have consistently suggested firms noted that building a consensus for SOFR was up to the client demand
that there was limited momentum for around SOFR supplementations (cre- and their appetite and less about the
any one particular alternative—howe- dit, term curve, etc.) would take time actual structure of the product itself.
ver crossing a few alternatives—the and might end up being prioritized as This requires the market and the of-
potential support grew. There was a industry participants choose which ficial sector separately delivering a
broad consensus that the additional aspect is most important to them to strong message both for derivatives
time would provide support for the launch SOFR. Others commented and for syndicated transactions. There
growth for a few alternative rates. A that the challenges of less centralized is a need for strong fallback language
smaller but vocal group of firms have, conventions and greater underlying and hardwire requirements as well as
from the outset been support of consi- data issues made a credit overlay more strong actions by the official sector that
deration of a credit overlay. In our most complex to construct vs. term rates. we have discussed previously. Firms
recent discussions, those firms conti- There was unanimous view on the va- agreed that this was a combined col-
nued to articulate the value of building lue of adding a term rate to the SOFR lective action to achieve the desired
out that choice but also consider for structure. There was a small number of results in building out liquidity in the
their middle market clients additional individuals who felt that a credit overlay SOFR product and other alternative
reference options including Ameribor, was of great comparative importance, reference rates.
Bank Yield index and others being de- but the significant majority did not
veloped. Other firms noted that unless share that view. In no particular order,
there was a meaningful uptick in SOFR firms identified a series of reasons that
post the final release of the consulta- this was valuable:
tive paper in late January/early Februa- • a number of firms generally argued
ry, then the dialogue surrounding op- that a term structure was a pre-re-
tions would build out. And there were quisite for the success of SOFR by
strong views relayed by others that January 2022. The publisher of this
they have been trading and issuing in structure cannot be synthetic; me-
SOFR for a while—they are comfortable thodology preferable ICE driven and
with the progress at multiple tenors of meet pricing and valuation processes
the product build. for accrual calculation;
In the discussions, clients identified • there needs to be a definition end
a variety of reasons that timing could date for issuing to ensure liquidity in
impact SOFR product maturity in va- other products;
rious meaningful ways. First, there • t he value for specific businesses1
1
How has the Consultative by the pandemic. Second, there is a re- to be part of a transition good citizenry.
cognition that simplicity for many of the Finally, we have seen the pace of client
Announcements Impacted
middle market clients will eventually be outreach has increased from our ear-
Client Transition Progress? determinative. Our study participants lier pieces in the spring and summer/
believe that at year end their clients fall of this year. The implications of the
Our last client interview discussant
are either confused by the consultative pandemic on corporate entities was
section will briefly focus on the impact
papers and what the implications are meaningful and clearly impacted their
on end users and clients from the an-
or curious if this allows a time break for progress. Less on financial end users.
nouncements on November 30th and
their own efforts. This feedback com- Client outreach was frozen for the
December 4th. We have in other por-
ports with our own individual client spring for many or limited. That picked
tions of this document addressed what
exchanges the past few weeks. up in the late spring and seemingly
the banks believe will be the impact
Third, there was a broad consensus was a pace through year end until the
on their timeline for implementation,
that there has been close to no engage- issuance of the consultative papers. A
SOFR product development, the role
ment by the official sector with clients. combination of year end activities and
of regulatory bodies in furthering tran-
Larger clients confirmed exchanges the lack of full clarity from the consul-
sition progress and numerous opera-
with some parts of the official sector, tative documents could make further
tional and contractual related topics.
but most had not and were not aware of progress difficult until mid-Q1. Global
The progress of clients in meeting the
particular forthcoming oversight pres- firms could continue to have mixed res-
transition deadlines is tied to every one
sure. Fourth, few buyside institutions ponses—more vigorous commitments
of these topics among others. Separa-
acknowledged what was expressed in their European/APAC offices and
tely, in our policy section, we address
by their dealer peers about the critical less convicted on investment in the US
issues related to client communications
role that end user entities played in the until their US Dollar LIBOR approaches
and outreach. One of the larger provi-
transition. There continued, at year-end are validated by both counterparties
ders in the automation and NLP space
2020 to be a belief that non dealer en- and the official sector. Indeed, some
suggested:
tities were going to be “takers” on ne- financial counterparts in the alternative
Study respondents identified a few
gotiations with their bank counterparts sector will likely await the final outco-
challenges for the end-user commu-
and with few exceptions, did not see me and identify market opportunities
nity. First, participants believed that
themselves as core to the policy dia- that will arise as the transition is fina-
the end user market was bifurcated
logues or negotiations. The potential lized which will enable them portfolio
in their commitment to the transition.
“educational” or “communication” gap enhancements as mismatches occur
Larger financial end users and larger
could be at two levels: the acknowled- across currencies and jurisdictional
corporates appreciate the timeline,
gement of the timing of the transition timings are put in place. In sum, there
have initiated governance and made
and the commitment to complete the is no monolith on the end user side. We
in many cases substantially larger
tasks but also the recognition of the would expect differences in responses
investments. But smaller-mid-size
need for the engagement on the macro across geographies and entity types as
entities have expressed either disin-
side—commitment to trade, willingness the transition progresses through 2021
terest—lack of awareness or focus—or
to partake in risk taking, advance broa- and beyond.
a greater need to focus on clients and
der policy initiatives and best practices
businesses that have been damaged1
1
2. The LIBOR Transi-
tion: End of the Year
Update on Industry
Progress and Recent
Developments.
Background on Research critical steps. In its prior report from and associated costs. Firms with in-
June 2020, Sia Partners had identified house AI/NLP development and delive-
Sia Partners’ research comprised a some sluggishness in progress among ry teams encountered challenges rela-
benchmarking study of over 70 market sections of the industry. While G-SIBs ting to the size and scope of the effort
participants on the progress of their and large non-US financial institutions for LIBOR. For example, the sheer vo-
transition from LIBOR to alternative had made substantial progress across lume of different document types and
overnight risk-free reference rates. the areas of contract review and ex- the variances within required substan-
Representatives from Sia Partners traction and initial remediation, other tial development work, increased mo-
conducted virtual interviews of sub- institutions were at the time, procee- del training time and longer lead times
ject-matter experts from a variety of ding on a markedly slower pace. Based to achieve the necessary data and
functions, including legal, risk ma- on Sia Partners’ most recent set of dis- accuracy rates. Discussions with our
nagement, compliance, operations, cussions with market participants over partner firms and material we separa-
finance and information technology, the course of this fall, a significant up- tely identify in our accompanying docu-
along with those charged with direc- tick among US regional banks and lar- ments highlight both those challenges
ting LIBOR transition efforts at a wide ger financial end-users was identified and how firms have more successfully
range of financial institutions and other with respect to their contract review utilized the technologies. The more
market participants. This report, com- initiatives. Progress entailed a range recent feedback that Sia Partners
pleted in conjunction with Shearman & of steps, from the extraction of key gathered on implementation of key
Sterling, builds upon that research and contractual terms to internal dialogues provisions on the cash and derivatives
supplemental work completed during on fallback terms of criticality. side reflects progress in the industry.
the fall and winter focusing on those The complexity and depth of legacy Many firms have been taking remedial
firms challenges in meeting the requi- contract analysis and remediation re- steps that they had not initiated three-
rements for the global IBOR transition. mains one, if not the most, challenging to-six months earlier. Those that had
Contract Review and Remediation activities firms are facing in completing initiated their efforts earlier—many of
GENERAL OBSERVATIONS a successful and timely LIBOR transi- which had used some form of NLP/AI
Sia Partners’ discussions with financial tion. The use of artificial intelligence solution to expedite that review and
institutions over the past two years in (AI), natural language processing extraction process—have moved on
various studies have highlighted the (NLP) and machine learning (ML) can to recognize that a portion of their
interlinking steps of contract review streamline and speed-up the time as- contracts will not work with conven-
and remediation, as well as the use of sociated with contract analysis, while tional fallback language and will need
automation and natural language pro- increasing efficiency and data quality customized remediation. Some portion
cessing (NLP) to help implement those and reducing resource requirements of those contracts could be beneficia-1
1
ries of the most recent consultative clarity. And indeed, there are still some (ARRC) has published recommended
announcement from the official sector. that would prefer a different reference fallback language for adjustable rate
Among the initial challenges that had rate (outside of SOFR). All these steps mortgages, bilateral business loans,
affected progress on contracts was the impact the core challenges every firm floating rate notes, securitizations,
need for a firm cessation date as well faces: operationalizing the transition, syndicated loans and variable rate pri-
as a determination of a clearer version communicating those changes to vate student loans. The extent to which
of the Secured Overnight Financing clients and helping them effectuate any market participant implements or
Rate (SOFR). Recognition of simple the transition, setting up the appro- adopts any suggested contract lan-
SOFR for some products and more priate risk management tools for new guage is completely voluntary. Each
complex SOFR in arrears for others, reference rates, and ensuring buy-in market participant will make an inde-
such as floating rate notes, continue to from business units to be confident that pendent decision about whether or to
challenge many including some of the the transition will be near flawless. We what extent any suggested contract
most advanced in the industry. address some of those operational and language is adopted.
Some specific lending language on risk issues separately in this document.
CLOs has advanced segments of the Within the cash space, the Alter-
market that had been awaiting industry native Reference Rates Committee
The table below highlights the ARRC’s recommended best practices for newly issued loans.
Notably, ARRC’s set of recommended COORDINATED AND CONSEQUEN- On November 30, 2020, IBA an-
best practices identified June 30, 2021 TIAL NOVEMBER ANNOUNCEMENTS nounced a proposal to extend the pu-
as the target cessation date for new blication of the most commonly used
business loans, derivatives, and non- In November, the industry saw highly USD LIBOR settings (overnight and
CLO securitizations. As discussed coordinated and consequential an- one-, three-, six- and 12-month) until
below, this is six months in advance nouncements from the ICE Benchmark June 30, 2023, with the other settings
of the date—December 31, 2021—by Administration (IBA) (the administrator (one-week and two-month) ceasing af-
which the US banking agencies have of LIBOR) and UK and US banking regu- ter December 31, 2021. IBA’s announ-
encouraged banks to stop entering into lators, which, taken together, provide cement followed an earlier statement
new USD LIBOR contracts. the clearest, most practical framework in which it announced plans to cease
to date on the end of LIBOR. publication of all GBP, EUR, CHF, and1
1
JPY LIBOR setting after December for feedback closes in January 2021. vatives market participants with new
31, 2021. In connection with IBA’s an- • New contracts and instruments that fallbacks, respectively, for legacy deri-
nouncement on November 30, the UK reference USD LIBOR should include vative contracts and for new derivative
Financial Conduct Authority (FCA) and hardwired fallbacks now. contracts. As derivatives represent the
the US Federal Reserve issued state- vast majority of the outstanding LIBOR
ments welcoming IBA’s announcement, The recent announcements, which exposure, ISDA’s announcement was
which the FCA described as “incenti- have been received positively by fi- much-awaited by the industry. It will
vis[ing] swift transition, while allowing nancial and banking trade associations, be an efficient mechanism to amend
time to address a significant proportion signify an important shift from what had derivatives contracts with many coun-
of the legacy contracts that reference been viewed as an inflexible deadline terparties. Broad adherence to the
[USD LIBOR].”1 Concurrently with IBA’s of year-end 2021. With the extra time Protocol is, therefore, important for
latest announcement, the US banking to prepare, market participants should mitigating the financial stability risks
agencies issued a joint statement en- continue taking actionable steps to associated with LIBOR becoming
couraging banks to cease entering into operationalize remediation processes unusable. According to the ARRC’s
new contracts that use USD LIBOR as a in a thoughtful and thorough manner. recommended best practices, market
reference rate “as soon as practicable participants are encouraged to adhere
and in any event by December 31, PROSPECTS FOR A LEGISLATIVE to the Protocol before it takes effect on
2021.” The agencies described this as SOLUTION January 25, 2021.
necessary to facilitate an orderly—and
safe and sound—LIBOR transition. In In March 2020, the ARRC proposed Technology and Operational
particular, “[g]iven consumer protec- legislation for New York that would, Readiness
tion, litigation, and reputation risks, among other things, protect parties
the agencies believe entering into new that adopt SOFR as a replacement Firms have generally identified several
contracts that use USD LIBOR as a re- for LIBOR under financial contracts operational hurdles to the LIBOR tran-
ference rate after December 31, 2021, governed by New York law. ARRC’s sition, including system updates and
would create safety and soundness legislation solution, which specifically product and model construction, based
risks and will examine bank practices addresses LIBOR fallback language, on Sia Partners’ most recent set of
accordingly.”2 was formally introduced in the New interviews. Delays with vendor selec-
York State Senate and is expected to tion have improved in our most recent
In a newly issued guide, ARRC has des- be considered next year. Following the discussions with the industry, with the
cribed these recent announcements as November announcements, the ARRC most progress among the larger firms
being fully aligned with its own work reiterated its support for it. who had begun vendor outreach prior
to date. It has also noted that the time- The New York legislative solution, to the pandemic. Smaller and midsize
lines contained in its recommended together with the November announ- firms have continued some struggles. It
best practices (referenced in the chart cements discussed above, are an es- is evident that firms are either contem-
above) were designed on the basis of sential part of an orderly transition from plating vendor implementation or are
what it considered to be practicable. LIBOR. The additional 18-month time- in the process of testing their own sys-
Therefore, the following take-aways frame during which a substantial por- tems against ARRC guidelines, with the
should be considered by market tion of LIBOR-linked legacy contracts achievement of industry milestones
participants: can run-off will give greater clarity, expected to occur throughout Q1 and
and perhaps urgency, for legislation Q2 of 2021.
• N ew contracts and instruments to address, what Federal Reserve Vice
should stop referencing USD LIBOR Chair Randal Quarles recently descri- We believe firms will need to focus on
by December 31, 2021, but earlier if bed as, the “hard tail.” the following technology and operatio-
practicable. Otherwise, examiners nal areas for 2021:
may determine that a bank is enga- ANNOUNCEMENT OF ISDA
ging in unsafe and unsound banking PROTOCOL Governance
practices.
• Legacy contracts (i.e., those that ma- Finally, a highly positive development • Implement centralized project mana-
ture beyond December 31, 2021) that for contract remediation occurred gement office (PMO) governance to
reference USD LIBOR may have an earlier this fall. On October 23, 2020, oversee all LIBOR Transition Office
additional 18 months—until June 30, ISDA announced its IBOR Fallback (LTO) project timelines and budgets
2023—to mature, be refinanced, or Protocol and IBOR Fallback Supple- • Align PMO timelines to specific LTO
otherwise be remediated, including ment (collectively, the “Protocol”). The vendor solution transition efforts
through a legislative fix, if one were to Protocol, which received widespread • Develop work plans for contract re-
be enacted. For planning purposes, it support from official sector institutions view and remediation
should be assumed that IBA’s propo- worldwide, facilitates the transition Systems
sal is adopted after the consultation away from LIBOR by providing deri- • E nsure technology teams are on
According to recent comments by an FCA official, the FCA believes it is possible to maintain a representative USD LIBOR until June 30, 2023, and it would not be welcoming
1
and supporting IBA’s proposed extension unless it was confident that representativeness thresholds could be maintained in terms of the number of panel banks. Therefore,
the FCA regards an extension as effectively eliminating the risk of so-called “zombie LIBOR” in any currency.
The joint statement clarified that is not to be read as announcing that the LIBOR benchmark has ceased, or will cease, to be provided permanently or indefinitely or that it is
2
not, or no longer will be, representative for the purposes of language adopted by ISDA. For its part, ISDA similarly clarified that it does not view the statements as constituting
an “index cessation event” or triggering fallbacks.1
1
board with end-to-end UAT as aligned MBS, corporate bonds, leveraged as critical both for product develop-
to ARRC recommendations and end- loans for extraction of qualitative and ment and pricing frameworks as well
user requirements quantitative information needed for LI- as emerging regulatory requirements
• P arallel-test beta systems while BOR evaluation on definitions, fallback from examination guidelines by the
running legacy systems to validate provisions, cost of funds, and consent SEC and the banking agencies. Model
readiness for contract parsing and requirements. Furthermore, classifying development is more advanced for
review across in-scope products language for agent determination, some Syndicated Loan or Cash pro-
• Approve new vendor solutions as they arithmetic means and averages tied to ducts, but less so for Derivatives or
pass each phase of UAT towards go- tough legacy contracts are also driving complex structured products. Sensiti-
live dates per PMO action plan and streamlined vendor implementation. vities in hedging ratios with short-term
steering committee Loan accounting systems are pre- vs. long-term RFR instruments are an
Contracts senting some of the most significant ongoing development challenge.
• Perform contract repository scope challenges, (i.e., a legacy loan accoun-
analysis for all in-scope products ting platform) and separate pricing/de- Model Risk Management
• Map gap analysis findings on legacy rivative product transition issues. Such and Validation Issues
contracts vs. revised contracts long-time technology and infrastruc-
ture tools within many impacted organi- The Technology and Operational Rea-
Both EU and US regulatory bodies have zations continue to create obstacles to diness section above identifies key
reiterated the importance of additional a successful transition when updating issues related to execution against es-
focus to these areas for several years to new and different ARR functionality. tablished project plans for performing
or more. To assist in bridging the gap Based on industry feedback, some analyses on how the new alternative
between firms’ current progress and banks are ahead of the curve in certain reference rates will likely impact inco-
regulatory expectations, the following upgrades for particular technologies/ me, funding, liquidity, and capital le-
actions are recommended: systems while others have lagged vels. The PMO must ensure timelines
behind the LIBOR transition timeline in are met, while also being adaptive to
• A s various ARR / LIBOR models affect terms of legacy system upgrades. The possible changes being communicated
different trading scenarios, the LTO need here is to incorporate current from regulators and market activity.
team must be prepared to implement loan accounting calculator modules And critically, those firms without that
dynamic rate-sensitive systems that that can perform simple, term, arrears, governance and infrastructure in place
adjust to market making decisions in compounded, and weighted-average must also diligently implement the es-
real time calculations that match to vanilla, to sential transition steps.
• Business and technology subject mat- complex, to synthetic IBOR, LIBOR,
ter experts should consider all cost SOFR loan structures. On November 20, 2020, the Alternative
and process dependencies along the Reference Rates Committee (ARRC)
design roadmap, which also includes While many loan term variants will go- published its findings and recommen-
clear milestones for each change du- live before the cessation deadline, dations in a memorandum based on
ring the transition from requirements timelines for upgrades are still not in the view that the post-LIBOR cessation
gathering, to beta, to go-live place from a system implementation will cause major sweeping changes to
• B usiness Requirement Documents perspective. Overall, loan accounting stress forecasting scenarios, PPNR,
(BRD), wireframes, and process flows vendors, large and small, are playing ALM, CCAR, RWA, FRTB and other
should be drafted and finalized accor- catch-up, or are in a “wait and see,” applicable treatments to regulatory
ding to the PMO governance model, modality. The continued regulatory capital and control. The ARRC noted
where approved versions clearly guidance should assist in building out that if the transition were to lead to
support all regulatory mandates the number of firms that can transition unintended increases in capital and
pertaining to LTO operational rea- their systems in 2021.In considering liquidity requirements, this would be
diness. Such documentation should the newest upgrades from loan sys- at cross-purposes with the macropru-
be reviewed by IT Audit and Internal tem vendors, some have expressed dential goal of mitigating risk of the fi-
Audit and stored in a user accessible the view that certain rule require- nancial system as a whole. Prior to the
central repository ments are progressing faster than the ARRC release, in June 2020, the Basel
actual development time needed to Committee on Banking Supervision is-
From conversations with vendors of install and test new modules. This is sued its guidance to clarify ES (Expec-
third-party solutions, success is mea- a difficult problem for firms to solve, ted Shortfall) and IMA (Internal Models
sured by the level of effectiveness in and different sectors have expressed Approach) calculations, along with
quantifying basis risk and market risk individual concerns related to Capital FRTB implementation and Counter-
on the portfolio for selected trading Markets, Asset Management, Lending, party Credit Risk Exposure Estimation
dates. Therefore, delays can be expe- Insurance, and Corporates alike. as per international capital and liquidity
rienced by firms gearing up functio- standards in light of the transitions in
nality to identify contracts for CLOs, Model development has been cited different jurisdictions.1
1
From a risk and valuation perspective, Analytic systems and risk processes certain instruments then many insti-
several other areas will also require that do not support negative rates can- tutions will also be required to adjust
attention of market practitioners. Both not effectively analyze SOFR backed complex frameworks around TLAC (To-
VAR (Value-at-Risk) and LCR (Liqui- floaters in mortgage-backed securi- tal Loss-Absorbing Capacity). As SOFR
dity Coverage Ratio) on the whole are tizations. Applying a floor of zero to may become an increasingly important
potentially at stake, or become dys- floating rates causes systems to com- factor for these models, performance
functional, when there is no historical pute a longer duration for such floaters. modelling will be challenging without
pricing for legacy contract fallbacks A proposed GSE transaction included historical proxy data released by the
(e.g., SOFR / LIBOR credit spread, a floating rate bond with a margin of Fed towards MRM application.
SOFR “term” structure, hedged cash / 330 bps and a floor of zero, indicating
derivatives). Another downside risk will that even with a negative SOFR rate the As RiskSpan has noted in a prior blog,
include legacy / fallback assets, which bond would receive interest. This bond, there is multi-layered risk with the
could result in illiquid assets as they be- if run with SOFR floored to zero, would transition away from LIBOR – market,
come too cumbersome to handle ope- effectively behave like a fixed rate se- operational, strategic, reputational,
rationally, or if trading all moves over curity from a duration perspective. compliance, model risk – which im-
to SOFR based assets. Finally, certain pacts any models that are tasked with
contracts will become non-observable A key data vendor in the structured mitigating or assessing these risks.
in terms of their pricing structure, spe- products space has added a feature Model validators will be focused on
cifically, contracts that are locked in to allow end users to define fallback testing of model inputs, benchmarking
legacy LIBOR, interpolated LIBOR, or approaches for legacy securities. Risk performance relative to the inputs, and
synthetic LIBOR credit spreads and systems would have to maintain a da- assessing the selection process across
term. tabase of fallback methods adapted for alternatives. Validators will also need to
each legacy transaction. Inconsisten- be keenly aware of fallback language,
As of November, daily trading volumes cies across systems and vendors can its interpretation and its application
for SOFR futures have now surpassed lead to discrepancies in pricing and to data and model estimation. Docu-
Fed fund futures and are at about 20% affect secondary trading. Banks and mentation and supporting evidence
of euro dollar. SOFR interest curves other regulated institutions would also from the model developers, whether
now have the beginning of sufficient have to validate their approach on a proprietary or vendor created, will
data points to bootstrap a forward deal-by-deal basis for existing holdings be paramount to meeting the typical
curve to calculate floating rate cou- and any future acquisitions. regulatory and model validation best
pons and discount factors. Interest rate practices required for production mo-
derivative trading is still in its infancy. All these factors combined will have dels. Scheduling of model reviews by
Interest rate models used for risk and material impacts on a variant of regu- MRM teams in 2021, if not completed
valuation are calibrated using volatili- latory reporting requirements, such as already with providers should become
ties from the derivatives market. Lack VAR and RWA (Risk-Weighted Assets), a top priority as we close out 2020 and
of SOFR swaption volatility data will FRTB (Fundamental Review of the move into Q1 of 2021.
prevent analytic systems to calibrate Trading Book) capital charges due to
models using SOFR swaptions and NMRF (Non-Modellable Risk Factors).
use LIBOR swaptions as a proxy. Hed-
ging SOFR backed MBS will remain a Additionally, as we interacted with
challenge until the SOFR swaption mar- the Model Risk Management (MRM)
ket is established. leadership at several participants,
the need to review and analyze the
Agency and corporate bond issuers changes being implemented to mo-
have yet to settle on a standard method dels is on their radar, but still requires
for compounding in arrears for SOFR focus as we move into 2021. With in-
backed floating rate notes. Analytic and ternal system/model and vendor sys-
risk systems must provide the flexibility tem/model implementation timelines
for investors to analyze instruments with extending, and a seemingly uncertain
varying compounding methodologies. LIBOR transition date, MRM teams will
Issuers need similar flexibility to be able be squeezed for time to conduct their
to evaluate an optimal approach before risk assessments across a potentially
issuance. Data vendors need to provi- numerous sets of models, depending
de the ability to maintain arrears calcu- on the portfolio composition of the
lations for SOFR floaters. Investment institution. As a specific example, if
firms also need daily accruals and the fallback amendments or replacement
ability to run scenarios to calculate and rate amendments cause future unin-
monitor exposures. tended negative capital treatment to1
1
Client Outreach and nerally found it challenging to engage tion. This is true even at some of the
certain clients on what the LIBOR tran- largest firms and global banks. A lack
Communication
sition means for them until there was of cohesion among different areas of
more specific detail on SOFR and other the business has the potential to sow
Communication, both internal and
reference rates which are being built doubt internally and with clients alike.
external, is integral to a successful
out. Consistency and efficiency should be
LIBOR transition effort. A robust client
Considering the literature from the prime goals for institutions. Having
communication plan requires appro-
ARRC, the current regulatory lands- clear, concrete answers to common
priate diligence and strategy before
cape surrounding the transition and questions will lower the risk of provi-
being properly executed. As contract
what has been learned from Sia ding employees and clients with incor-
remediation ramps up, client com-
Partners’ research, several best prac- rect information.
munication goes hand-in-hand with
tices have emerged as markers of pro- A third significant marker of progress
contract remediation. Pursuant to the
gress among the most well-prepared has been where an institution has used
ARRC’s recommended best practices,
institutions. The first is the develop- client-based focus groups and/or sur-
for contracts specifying that a party will
ment of business and philosophical veys to establish a baseline understan-
select a replacement rate at its discre-
processes to reach out to clients to ding of where client exposures lie. This
tion following a LIBOR transition event,
demonstrate their commitment to has enabled firms to develop more ac-
there will need to be disclosures of the
completing the transition. This more curate approaches for different types
planned selection to the counterparty
specifically includes early reach-outs of clients and prevent the unnecessary
at least six months prior to the date
to targets in individual business units dedication of resources to clients that
that a replacement rate would become
to establish a remediation timeline. The do not require further elaboration on
effective.
development of these processes is a a particular facet of the transition. We
hugely important first step. As men- found additional firms embracing these
Sia Partners has had a series of ex-
tioned, institutions are continuing to approaches in late 2020 as part of their
changes with industry participants
operate with unanswered questions, transition communication efforts.
and, based on interviews conducted
which if full outreach efforts were to These points and others have been dis-
over the summer and fall, found that
begin, would be passed onto clients. cussed by various regulators. For exa-
nearly half of those financial institutions
The biggest advantage institutions can mple, the comprehension of client ex-
interviewed had reached out to their
gain now is to ensure that their inter- posures and risks (and the prioritization
work streams, organized internally and
nal processes are developed and as of certain segments) was discussed by
started high-level client communica-
clear as possible. The establishment of the Financial Stability Board (FSB) in
tions for a single business unit. When
what an institution wants to gain from its “Global Transition Map,” released
asked about the extent of contract re-
discussions with a client, what types of last October. The FSB asserted that to
mediation conducted, less than a third
clients require what level of education remove remaining dependencies on
of that group were actually remediating
and commitment of time, and how and LIBOR come end-2021, firms should
with client segments. Approximately
when these efforts will be implemented fully understand which LIBOR settings
20% of the overall G-SIB group had
across various internal business lines they have a continuing reliance on af-
engaged across all workstreams with
will offer advantages down the line. ter end-2021 (by currency and tenor)
client segments or had been limited to
Many of the largest institutions, both and what fallback arrangements those
due diligence and planning only. The
foreign and domestic, have developed contracts currently have in place. There
follow-up discussions in December of
those approaches through Q4 of 2020 is an added layer of complexity here, as
2020 suggest progress had been made
and are prepared for a more vigorous there is the reliance on the clients to
across most banking groups in rea-
outreach effort leading to remediation understand their risks themselves. The
ching out to their clients. These efforts
in 2021. When the window of oppor- lack of a strong pattern in responses
included a build-out of their internal
tunity opens to have more informa- among various participant segments is
communication capabilities to educate
tive and educative discussions with an indication that there are questions
their relationship managers and others
clients, those that have not begun and as to who internally will lead the charge
with client responsibilities. Clearly,
completed this preparation phase will (relationship managers, internal legal,
the consultative announcements (as
find themselves having to develop and sales etc.) and how to keep messa-
we note above) will likely affect some
implement a plan concurrently. This is ging and education consistent across
of those efforts while clarity is sought
a theme seen in other aspects of tran- the organization. As noted in the FSB
from the official sector in early 2021.
sition efforts. checklist, the biggest concerns are
Based on Sia Partners’ interviews, the
A second closely related marker of legal, conduct and reputational risks;
preponderance of participants indi-
transition-related progress is ongoing each of which will need to be miti-
cated that efforts through the spring
internal educational efforts for sales, gated by a particular workstream. With
into the summer had focused mostly on
traders and relationship managers. the many unanswered questions that
internal communications. For external
A common observation is the lack of remain for participants, it is clear that
communications, institutions have ge-
coherent messaging across an institu- the majority of participants have notYou can also read
