Financial firms pressed to prepare for LIBOR transition

In a letter to the CEOs of some financial institutions, the Australian Securities and Investments Commission (ASIC) has called for assurance that the senior management of financial institutions are cognisant of the impact and risks of the transition away from the London Interbank Offered Rate (LIBOR) to other benchmarks and has an action plan in place.

LIBOR, which is used by financial firms in their contracts and business processes, is set to become unusable beyond 2021, following an announcement from the UK Financial Conduct Authority (FCA) that it would stop using its powers to sustain the rate beyond the year.

The letter, penned by ASIC commissioner Cathie Armour and executive director of markets Greg Yanco, explains that the transition could be “complex” given how “embedded” LIBOR may be in financial firms’ business practices.

“The transition away from LIBOR may have significant implications on the entities’ risk management, operational processes and IT infrastructure. Insufficient preparations for the transition could have a negative impact on the entities’ business, clients and the markets in which they operate,” the letter states.

Speaking about the end of LIBOR, an initiative that has been supported by the Australian Prudential Regulation Authority and the Reserve Bank of Australia (RBA), RBA deputy governor Guy Debelle said in April: “The fundamental problem is that there are not enough transactions in the short-term interbank market to underpin LIBOR. The banks that make the submissions that are used to calculate these benchmarks are uncomfortable about continuing to do this, as they have to mainly rely on their ‘expert judgement’ rather than actual transactions.”

ASIC’s letter to CEOs also suggests specific actions that senior management should take in preparation for the shift, including:

• being aware of the size and nature of the financial institution’s exposures to LIBOR
• adding fallback provisions in contracts referencing LIBOR
• taking action to transition to alternative rates  

The FCA believes the best approach to take would be to replace or amend contracts that are based on LIBOR before fallback provisions are triggered. It suggested that contracts be based on alternative risk-free rates (RFRs).

Mr Debelle noted that the shift to alternative RFRs is “accelerating” internationally.

“RFRs have been identified for all the LIBOR currencies by national working groups involving the private sector and regulators. The rates chosen are overnight RFRs, either measured from transactions in interbank unsecured lending markets or repo markets,” the deputy governor said in April.

However, he acknowledged the concerns that have been raised around the use of overnight RFRs.

“LIBOR was originally set up to cater for the syndicated loan market. Participants in this market want to know the interest payments on loans in advance. This is possible with a forward-looking rate such as LIBOR, which is set at the beginning of the interest period,” Mr Debelle said.

“But it is not possible when compounding an overnight RFR, which can only be calculated at the end of the period.”

As such, the deputy governor said national working groups have been working on developing “term RFRs”.

“These forward-looking rates could potentially be constructed from derivatives referencing the overnight RFRs. However, for such term RFRs to be considered robust, there would need to be sufficient liquidity and transparency in the underlying derivatives markets,” he said.  

“The [Alternative Reference Rates Committee] is aiming for a term rate based on [Secured Overnight Financing Rate] derivatives to be developed by [the] end [of] 2021, once there is sufficient liquidity to produce a robust rate.”

[Related: APRA revises ADI credit risk management standard]