Global regulators realized early on that the cessation of LIBOR benchmarks would have far reaching consequences for financial institutions under their supervision. In response, many regulatory agencies commenced working groups to facilitate the industry-wide transition to Alternative Reference Rates (ARR) in their respective jurisdictions, including the Alternative Reference Rate Committee (ARRC) in the U.S. Recently, many of these working groups published recommendations and objectives for transitioning from LIBOR to the new ARRs. Hundreds of market participants have contributed to consultative papers and publications to assist financial institutions in addressing complex scenarios encountered as part of their individual LIBOR transition journey. As the final cessation date nears, it is critical that banks leverage applicable recommendations, timelines, and checklists to benefit from the experiences of practitioners who have already made significant progress in their migration to ARRs. Operations and technology enhancements, remediating fallback language in agreements, and legal and compliance hurdles are some of the challenges that need to be addressed in advance of the final LIBOR cessation. In addition, introducing new ARR data sources for a wide range of currencies requires strong data controls and governance. To alleviate concerns and industry-wide pressures, Monticello has prepared this best practice insight paper to assist our clients in their preparation ahead of the anticipated January 1st, 2022 LIBOR end date (see Figure 1 below for the ARRC recommended timelines).
Figure 1: ARRC Recommended LIBOR Transition Suggested Timelines
Third-Party Vendor and Proprietary System Readiness
Technology and vendor readiness play an integral role in transitioning from LIBOR to ARRs. Financial institutions and third-party solution vendors should initiate joint workshops to ensure a consistent transition approach. Many banks rely on both proprietary and vendor-based systems (see Figure 2 below) that support critical front, middle, and back-office capabilities. Given the scope of LIBOR cessation work, many larger banks have started to prepare for enhancements well in advance of finalized working group and regulatory guidance. For example, while U.S. capital markets participants are still eagerly awaiting the launch of SOFR term rates (30, 90, 180 days), banks should take proactive implementation actions and not assume that forward-looking rates will be finalized ahead of the recommended ARRC cessation timeline. Although indicative U.K. SONIA term rates (published by FTSE Russell) have been available starting in July 2020, US banks should not assume that comparable U.S markets will develop along the same trajectory.
Data Remediation, Governance, and Controls
In many financial institutions, LIBOR transition efforts have reinvigorated efforts to improve data governance and control protocols. As organizations prepare to transition their LIBOR-referenced legacy portfolios, appointing dedicated data gatekeepers will enhance data consistency, data integrity and preserve data lineage.
Data quality should be a top priority when introducing new ARR benchmarks into existing BAU processes. For example, ISDA and Bloomberg started publishing indicative fallback rates across various tenors and currencies in July 2020. In addition to the newly published IBOR fallback rates, the need for a credit sensitive alternative benchmark (e.g. AMERIBOR) should be considered for new deals. Introducing a credit sensitive benchmark may significantly reduce some of the inherent challenges when transitioning from the LIBOR benchmark that include credit spreads to risk-free ARR benchmarks (i.e. SOFR in the U.S., SONIA in the U.K. etc.). Rigorous data control checks and testing procedures are key to a smooth transition from LIBOR to ARR benchmarks across the universe of in-scope systems (see Figure 2 below).
Figure 2: Operations and Technology Vendor Readiness Scope
Discounting Transition
Compounding interest in arrears requires changes to proprietary and vendor accounting accrual systems. Thorough regression testing by both accounting and technology IT teams is critical to a successful transition. All systems impacted by compounding changes need to be identified early on in the planning process to avoid code or maintenance freezes that may impact execution and system availability during critical switchover phases. Risk technology teams will need to implement backend enhancements to promote the new ARRs as the primary discount benchmarks in the relevant risk management systems
Establishing integration and impact testing processes for discounting changes will be crucial to validate business objectives and outcomes to the technology implementation. Sound data governance practices (discussed earlier) and a standardized Market Data API facilitate end-to-end testing and impact analysis that are critical to a successful discounting switch. Continuous integration testing will help ensure that all critical stakeholders are part of the validation and sign-off processes required to transition to ARR-based discounting. Providing time-zone technical and communication support during transition weekends will ensure reconciliations and final Risk and PnL numbers are available in a timely manner and Day 1 impacts are transparent to all critical stakeholders
Transitioning Legacy Transactions
Figure 3 below highlights the proposed category-by-category prioritizations for U.S institutions from 2018 to late 2021. Banks should consider deployment of third-party workflow tools to document the migration of legacy positions across the transaction lifecycle (e.g., pricing, negotiation, notification, execution, allocation, confirmation, settlement, etc.). Doing so will address potential audit concerns and assist in shaping a comprehensive client outreach and strategy (see figure 3). The volume of legacy transactions that require direct client communication can be in the millions for large financial institutions. As a result, client outreach will require appropriate governance, coordination and controls. Regardless of their respective size, all financial institutions should adhere to the recommended LIBOR transition timelines (Figure 1) to avoid a backlog of legacy transactions that need to be transitioned toward the end of the December 31st, 2021 end date.
Figure 3: Implementation Checklist for SOFR Adoption