What does replacing LIBOR mean for financial services firms?

The London Interbank Offered Rate (LIBOR) is a series of benchmark interest rates and has been called the “world’s most important number”. It is a globally recognized base rate for pricing loans, debt, and derivatives. As a key part of the financial services infrastructure, more than $240 trillion in products reference LIBOR.

As its underlying transactions have diminished, regulators have announced a target date to replace LIBOR and begun the process of identifying and creating alternative rates. However, these rates are structurally different from LIBOR, and it is unclear how existing products referencing it will change, and what new products will emerge. There is the possibility of significant customer and economic impact and uncertainty over how this will develop.

It may not be the ultimate goal, but in 2021 the global financial markets will experience a major transition. For APAC's financial markets, 2021 may still seem a long way off, but given the magnitude of the transition and its impact on financial markets, the timing is right for financial institutions to start mobilizing everything they need to do to prepare for it already.

Initiatives for interest rate benchmark reform in Japan
The first reform implemented in Japan was the reform of the Tokyo Interbank Offered Rate (TIBOR), which was widely used as the interest rate benchmark for domestic loan transactions and other transactions. TIBOR used to be published by the Japanese Bankers Association (JBA), but the JBA TIBOR Administration was established in April 2014 to develop a more independent and neutral administration framework for TIBOR and it took over the calculation and publication of TIBOR. Moreover, in May 2015 it became apparent that TIBOR was subject to regulations of the Japan Financial Services Agency (JFSA) as a Specified Financial Benchmark under the Financial Instruments and Exchange Act. In July 2017, the rates to be submitted started to be calculated in accordance with a standardized and clarified calculation and determination process.

At the same time, discussions on the JPY risk-free rate were held by the Study Group on Risk-Free Reference Rates, which was launched in April 2015. In December 2016, the study group identified the “uncollateralized overnight call rate” which is calculated and published by the Bank of Japan, as the JPY risk-free rate.

Even if LIBOR is discontinued, TIBOR and Euro Interbank Offered Rate (EURIBOR) will continue to be published for JPY and EUR, respectively, resulting in the coexistence of those benchmarks and risk-free rates. However, for the USD and other currencies, there will be no comparable benchmarks once LIBOR ceases to exist, and the only option will be to transition to risk-free rates.

The first step in that phase is to examine alternative benchmarks to replace LIBOR. It is also necessary to modify the language in existing contracts that refer to LIBOR well in advance to ensure smooth transactions after the discontinuation of LIBOR.

These activities are being examined by applying different approaches according to the type of financial product or transaction. First, for derivative transactions, the International Swaps and Derivatives Association (ISDA), which develops a standard contract for such transactions, is promoting global efforts to modify the standard contract for derivatives while consulting with market participants.

On the other hand, for “cash products” such as loans and bonds, unlike derivative transactions, there is no standard contract that is widely used internationally. Accordingly, each jurisdiction needs to take measures to deal with the discontinuation of LIBOR in those transactions.

In Japan, the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks consisting of financial institutions, institutional investors, and non-financial corporations was established in August 2018, with the Bank of Japan acting as the secretariat, and it has been conducting deliberations. As a key milestone in the committee's work, a public consultation was held on the appropriate choice of alternative benchmarks to JPY LIBOR. During that consultation, many comments were provided on the issues presented by the committee from a wide range of relevant parties, including non-financial services corporations.

As a result of that public consultation, a “term reference rate,” which would be calculated based on future expectations of the Japanese risk-free rate (uncollateralized overnight call rate), received the most support as an alternative benchmark to JPY LIBOR for both loans and bonds.

There are several reasons for the strong support for the term reference rate: It is not affected by bank credit risk; it would be “fixing in advance” like LIBOR, which would allow users to determine the base rate before entering transactions; and it is highly compatible with current conventions and operations. It is expected that the initiatives toward a transition to the term reference rate will be promoted for transactions that currently use JPY LIBOR.

Leveraging LIBOR transitions into new technologies
Of the considerable efforts required, the technology, system, and infrastructure challenge will be the bulk of the effort for most firms. Celent expects that technology will be 35% of the overall spending by firms, which skews toward capital markets-focused firms. A large part of the overall technology spending will be in upgrading, replacing, or rearchitecting existing systems to work in today’s rate regime, the long tail transition away from LIBOR, and in a future state of AFRs.

We further reduced the categories and look at the technology spending in three buckets across functional areas of an investment bank or institutional-focused financial institution in this figure.

The LIBOR transition process should manage the temporary transition process and the final steady state.

The cost and resources for this should be considered an investment in the future of the marketplace as well as an adaptation to the new normal. It is an opportunity to optimize enterprise architecture through a review of enterprise-wide data and workflows across system infrastructure and core business systems.

For each area of the solution, it is essential to distinguish between generic data and processes and specific technologies that depend on specific asset classes, lending products, and customers, and to define milestones for overall optimization.