Move to risk free rates
Even before the FCA announcement, the financial services industries in the major international finance centres began work on new near risk free reference rates, known as RFRs, which are expected to replace IBORs in the majority of transactions.
RFRs are backward-looking rates calculated by reference to historical transaction data, are less susceptible to manipulation and reflect actual market funding costs. Despite the obvious benefits of benchmarking against RFRs, the move away from IBORs to RFRs presents a number of issues, chief among them that they are not economically equivalent.
As a result, the amendments required to existing documentation to implement the change of benchmark are not trivial.
Practical challenges and where Appleby can help
From a practical and operational perspective, IBORs are forward-looking rates that are ascertained at the beginning of an interest period giving certainty both to lenders and borrowers. RFRs on the other hand are backward-looking and could result in borrowers not knowing how much interest they are required to pay until it is due. RFRs are also overnight rates rather than term rates quoted for a range of maturities (for example, three and six months). In most scenarios it would be impractical to calculate interest on financial products using a rate that varies daily and the introduction of compounded backward looking term rates, such as compounded SONIA, should be of assistance here.
As we have seen it is not simply a case of all markets and jurisdictions transferring from LIBOR to a new favoured rate. Financial firms will need to carefully navigate not only how they wish to approach new business but also how they transition their existing portfolio of contracts and agreements away from LIBOR.
With no single replacement to LIBOR available, financial firms risk opening themselves to complaints or legal action if they do not select and recommend the “correct” replacement option in any given circumstance. In a retail banking setting, if the change in rate results in an improved outcome for the financial firm, it could be accused of profiteering at the expense of its customer.
Even if all parties to a contract agree on how to transition away from LIBOR, renegotiating such large numbers of contracts at the same time across a financial firm’s customer base is likely to be costly, administratively burdensome and complicated. Financial firms will also face a serious communication challenge engaging with their retail customers.
A number of financial institutions and market participants are looking to Fintech solutions to assist with this exercise. A range of data aggregation and AI based systems are available which connect into the vast amount of financial data already stored in structured, accessible format as well using optical character recognition and natural language processing to review thousands of contracts for key terms, LIBOR exposures and exit options. These systems can quickly model the adoption of new benchmarks on a per contract or contract type basis and can offer a quick, scalable and cost effective solution to help mitigate risk.
Regardless of the systems used, transitioning away from LIBOR is likely to create considerable operational, reputational and legal risk.
The Appleby team
The Corporate, Technology and Innovation and Dispute Resolution teams at Appleby have a wide ranging experience in advising leading financial institutions on large reform projects, new product offerings, supplier contracts, regulatory compliance and litigation risk, including the impact of benchmark changes. We are also able to deploy AI Solutions for large scale due diligence solutions.
If you would like to discuss any of the issues raised, please reach out to one of our experts below.