The days of the benchmark interest rate LIBOR are numbered: According to the UK banking regulator, the London Interbank Offered Rate will be replaced by the end of 2021. A change that finance, investment and risk managers naturally follow closely. But it's not just for operations, CIOs also face the question of how to absorb the impact of a necessary system migration. In any case, the end of LIBOR will not be cheap – neither operationally nor technologically. This is precisely why some smart investment decisions from IT management are needed now.
By Christine Bazanowski Scaffidi, Senior Principal Product Manager at Finastra
T he crucial news right from the start: According to our research, we assume that the discontinuation of the British LIBOR and the accompanying switch to risk-free interest rates (RFR) will cost the financial industry more than 8 billion US dollars globally. A number that resonates – and describes losses that no one can use, especially in the current situation. It is therefore all the more important to approach the migration from LIBOR to alternative rating concepts both operationally and technically with system and expertise.
LIBOR – and what it stands for
LIBOR reflects the average interest rate at which renowned, internationally active banking houses on the London Stock Exchange are willing to borrow money from other banks. Established by the British Bankers' Association (BBA) in 1986, the standard is of global relevance and was intended primarily to facilitate the pricing of financial products – a concept that has long worked, but unfortunately now suffers from a loss of confidence.
The way LIBOR is calculated is no longer truly representative of transactions and activity in the markets where it is used. Regulators are demanding that industry benchmarks be based on and driven by actual market activity, not the views and input of a handful of institutions."
It is foreseeable that other interbank interest rates such as EURIBOR or TIBOR will also change. Regulators want it replaced or at least the methodology for determining reference rates changed. The fact that the nominal values of financial products with a total value of more than USD 400 trillion worldwide are based on IBOR rates illustrates the scope of the impending changes.
Replacement must come: risk-free interest rates as an alternative
The move away from LIBOR and other IBOR rates cannot, of course, be done without replacement; national and international regulators and central banks are therefore driving the shift to risk-free rates. However, there is little clear guidance from the authorities on how to make this change. The UK's FCA (Financial Conduct Authority) is the regulator in charge of LIBOR, but the exact date they will make the official statement that LIBOR will no longer exist after 2021 is not yet known.
In addition, the fact that LIBOR is calculated not only on an overnight basis, i.e., for one-day maturities, but in six other cycles: one week, one month, two months, three months, six months and twelve months, is particularly serious."
In contrast, the available risk-free rates are currently only available on a daily basis. Sooner or later, future forward rates are also expected, but not before the end of 2021. And yet – despite all the differences and regulatory divergences – the switch to RFRs is advisable, as the uncertainty surrounding the future of the UK benchmark rate alone represents a striking business risk for financial firms.
Migration will not be a walk in the park
A wide range of financial products are linked to LIBOR for pricing purposes. In securities trading, these are mainly interest rate swaps and interest rate options, floating-rate bonds, forward rate agreements (FRAs) or even foreign exchange transactions. On the banking side, almost all syndicated loans are referenced to the London benchmark rate. The situation is similar for residential mortgages, commercial mortgages, corporate loans, credit cards and similar consumer loans.
Due to the multifaceted nature of the underlying financial products, a switch from LIBOR to other rating systems is anything but a walk in the park."
Because unlike the euro changeover, for example, there is neither a binding date nor a fixed exchange rate in this case, which at the time was 1 Deutsche mark = 0.51 euros. Harmonization of a myriad of contracts, and therefore processes and applications, will be far more complex when moving from LIBOR to RFRs. The fact that risk-free interest rates are issued exclusively as overnight rates, in contrast to the often more long-term interbank rates, makes the migration of existing LIBOR contracts even more difficult, as some of the previously applicable calculation bases become completely obsolete.
Renegotiate old contracts
As Senior Principal Product Manager, Corporate & Syndicated Lending at Finastra(website ), Christine is responsible for Fusion Loan IQ's product strategy for the Americas. Their responsibilities currently include driving awareness, conversation and solutions to support the market transition from LIBOR to alternative reference rates. Prior to joining Finastra in 2012, Christine was with Commerzbank where she held various positions – most recently managing commercial lending in the Americas. Christine studied economics and European studies at the University of Freiburg and received her Bachelor of Science in economics and German from Albright College.
Compliance with legacy financial contracts entered into before the U.K. Financial Conduct Authority (FCA) announced the replacement of LIBOR will present some challenges. Most agreements do contain fall-back clauses, but only in the event that LIBOR is not available in the short term – the situation where LIBOR is completely discontinued is at best adequately addressed in more recent contracts. Regulators are in any case encouraging companies not to rely on fall-back clauses, but to completely renegotiate formerly LIBOR-linked contracts. This is exactly where we get to the point where operational and IT costs go through the roof: Changing a large number of contract documents simultaneously entails a large application-side effort. Not to mention the increased legal risk. Because with the large number of contracts and negotiating partners, it is difficult to imagine that every new agreement can be launched smoothly. Resource-consuming litigation is therefore to be expected. All of these factors necessitate restructuring of contract-related data and documents. In addition, it is possible to make predictions: Those who restructure their contract, document and booking management promptly and efficiently will be a decisive step closer to consolidating their rating processes more quickly – despite the elimination of LIBOR and regulatory uncertainties.
The need for additional, intelligent systems is great
In the course of the LIBOR conversion, every single application in the company that is in some way related to the London benchmark rate will require at least minor modifications. But before focusing on updating existing solutions, CIOs should also consider deploying completely new systems.
Restructuring document-based processes and applications to manage LIBOR migration presents unique challenges. Thus, it will be extremely helpful to be able to automatically identify LIBOR-based contracts and extract linguistic cues for fall-back clauses."
To do this, companies often have to consult original contracts – some of which go back decades, have been passed on several times in the course of acquisitions, and are only available as scans in the archives. As a result, key contract data is unstructured and in natural language – unlike more recent agreements that are recorded in a structured manner. How to master this massive information heterogeneity? The key lies in the use of artificial intelligence. Once the contracts have been identified and their contents analyzed, the migration gets down to the nitty-gritty: a new contract language has to be developed, customized modules have to be set up and implemented, new wording has to be agreed upon.
Slowing costs through targeted investment
With the ACTUAL analysis of the contract portfolio, the indispensable basis for a seamless LIBOR migration has been created. The subsequent bi- or multilateral negotiation and approval rounds also require stringent process and document management.
Workflow tools are useful in this phase to transparently map the progress of negotiations."
Once the contractual terms have been negotiated, new interest rates and the underlying calculation methods must be integrated into the accounting systems. With regard to existing IT assets, solutions that previously only had to manage a specific interest rate need to be examined to see to what extent they can be used to map multiple ratings and more complex conditions. Similarly, the software for pricing and risk management needs to be updated. All of these measures – both the development and commissioning of new system modules and the modification of existing IT building blocks – initially entail a significant investment requirement. Investments that will all pay off in the medium term.
This is because, to date, the necessary measures that will be required in the wake of the LIBOR migration have been significantly underestimated."
It's about much more than just replacing one rating system with another in a single step. The contractual framework for financial products will undergo lasting change in both securities trading and retail banking. Transparent and legally watertight workflows are essential here to ensure as seamless a transition as possible in operations – and to avoid unwanted costs, for example, from delays in contract negotiations and litigation. With this in mind, the investment in IT and intelligent systems will be worth every penny and will cushion the financial impact of the inevitable LIBOR migration.
Intelligent tools map processes seamlessly
There are now a number of renowned financial IT solutions that technology providers such as Finastra have enhanced specifically for efficient and cost-saving conversion from LIBOR to RFRs. Modern software products cover the entire lifecycle of a loan – which significantly simplifies complex processing steps such as just credit rating.
Customized solutions support specific processes and workflows that are adapted to current requirements and integrate changes such as the elimination of LIBOR and the inclusion of risk-free ratings in an automated way."
Financial institutions and companies would be well advised to take advantage of this support: The right solution offers seamless process management and has real-time monitoring that identifies outliers and fixes errors early on, helping to keep LIBOR migration costs down.