The time has finally come, as of midnight December 31, 2021, LIBOR quotes ceased for GBP, EUR, CHR, JPY and 1-week and 2-month USD (quotes for remaining tenors for USD LIBOR will cease as of July 1, 2023). This is an exceptional financial event, which inevitably has significant implications for capital markets globally. While this milestone has long been anticipated by the market, and marks a huge step in the journey to transition off of all IBORs, not everyone is as prepared as one would expect to fully implement this change.
Aware does not mean ready
In December, just weeks before the LIBOR transition, The Global Association of Risk Professionals (GARP) published a survey of nearly 600 Certified Financial Risk Managers (FRM®) around the world. The result was astonishing, fewer than 50% of respondents believe the financial services industry is “completely” or “mostly” ready for the transition to a post-LIBOR benchmark. The respondents also believe that less than half of the relevant people in their organization understand the mechanism for setting the new RFR (Risk Free Rate) most relevant to their firm.
At TS Imagine we assessed the wider implications of this transition at an early stage and had solutions ready ahead of the final deadline. We spent significant time and resources, working with our clients to ensure their readiness to continue to price, trade, manage and evaluate risk.
As of the 11th of December, TS Imagine clients have been able to transition those instruments and portfolios that have to move off of LIBOR-based calculations and “go live” with the Alternative Reference Rates (ARRs) replacing them.
In this blog post, we share insight into the basic requirements, key challenges, our approach for a smooth transition from IBORs to ARRs and an outlook for what’s next in the multi-year journey to move away from IBORs.
Differences and challenges
The initial transition that took place at the end of 2021 was focused on replacing LIBORs for the following major currencies, by ARRs:
- CHF LIBOR– SARON (Swiss Average Rate Overnight)
- EURIBOR/EONIA – €STR (Euro Short-Term Rate)
- GBP LIBOR – SONIA (Reformed Sterling Overnight Index Average)
- USD LIBOR – SOFR (Secured Overnight Financing Rate; 12/31/2021 for 1-week and 2-month tenors; 6/30/2023 for overnight, 1-month, 3-month, 6-month, 12-month tenors)
- JPY LIBOR – TONAR – Tokyo Overnight Average Rate
There are important differences between the old and new rates. As a result, some of the ARRs differ from the LIBOR rates they are replacing by 10 to 20 basis points or more, creating the potential for a non-trivial economic impact due to the switchover. This impact should not be understated, any active position that requires a risk-free interest rate in the calculation of a theoretical price, market value, profit/loss or risk metric is impacted – everything from bonds and rates contracts to swaps and equity options.
This main difference lies in LIBOR including a component of bank credit risk whereas ARRs are considered near-risk-free rates. Also, LIBOR is published over various tenors – overnight, 1-month, 3-month, 6-month, and 12-month, whereas ARRs are generally overnight rates.
The GARP survey found that over 33% of respondents said the lack of a robust term-structure is a significant short-coming of the new ARRs, and around 60% said the lack of historical data to be the most pressing issue. In switching to overnight rates (€STR, SOFR, SONIA, SARON, and TONAR) it is critical to consider the impact on historical time series used in valuations and risk calculations such as VaR.
Constructing term rates (forward looking) is another challenge. Due to the vast range of instruments that used LIBOR as the underlying rate, constructing LIBOR rate curves extending to 30 years has historically been relatively straightforward. But at present, a lack of liquidity in some instruments tied to term ARRs, means such rates are likely to be volatile and unreliable until a deeper ARR market develops. The construction of forward-looking curves for the ARRs requires an adjusted method to cope with current market conditions and a process to monitor and adjust the methodology as markets develop in the future.
As a vendor providing risk management solutions, one has to confront this to prevent a discrete “jump” in a time series. Simply using a LIBOR value as of a cut-off date and then an overnight ARR the following day, is not acceptable. The Federal Reserve Bank of New York began publishing SOFR rate in April 2018, but to support scenario analytics of events prior to that, the full time series is required. At TS Imagine, we have built historical time series for ARRs using algorithms developed by our modeling team. Our historical time series stretch as far back as 2008, and to ensure that our model meets market requirements we closely collaborated with our client community in the development process.
We have developed a proprietary method for constructing ARR term structures and historical time series using a variety of inputs for valuations and other modeling purposes. In advance of the transition date, we’ve engaged with our clients and provided them with comparisons between term structures and time series generated for the ARRs, and the term structures and time series for the equivalent to-be-retired LIBORs. As the market adopt these new reference rates, we will continue to adjust our methodology accordingly. For example, as liquidity improves for the instruments used as inputs, we will adjust our methodology to construct term rates.
Ahead of the curve – live since 11th of December 2021
In collaboration with our clients, we decided not to wait until the 31st December deadline to go-live with the new ARRs. This decision ensured clients had ample time to prepare their LIBOR transition without impacting year-end or month-end processes. When we went live with the new approach in early December, before the official switchover, and our solution was well received and worked smoothly. During this period, our clients chose between using LIBOR rates or ARRs, however since the switchover the default for all of our clients is to use the ARRs.
Looking forward – all IBORs will be changed
IBORs beyond the five major LIBORs discussed here are in the process of transitioning to ARRs or transforming the calculation methodology of the IBOR itself. Hence trading desks and portfolios with exposure to other currencies will have to follow suit. TS Imagine is monitoring the entire IBOR universe for all affected currencies, including the Australian Dollar, Canadian Dollar and Singaporean Dollar. We will continue to release new ARR-based curves (term rates and historical time series) and improve methodologies for our existing data as time goes on.
As there is no standardized approach or method for how to handle the LIBOR transition and as the target state will be achieved in phases over years, we’ve taken a consultative approach, partnering with our clients to provide the best solution. Members from our data management, quantitative analytics, software engineering, professional services, account management, data sourcing, procurement and subject matter experts from our clients will continue to collaborate and rollout the adjustments in phases.
This is not a one-off solution, but rather a process of supporting and working with our clients. TS Imagine has a dedicated team managing this – it is part of our global data office and has one core objective: to help our clients achieve a smooth transition to the target state over the coming years.
