Tim Versteeg, Managing Director APAC at NeoXam
With approximately $370tn (£284tn) of financial contracts referencing Libor-based rates across the main currencies globally as of April 2019, on products ranging from OTC and exchange-traded derivatives to loans, adjustable-rates mortgages, floating rates notes and securitisations, the whole financial industry has been working around the clock to remove any remaining dependencies on the rate which was formally phased out at the end of last year. This has created numerous operational challenges for financial institutions.
Unlike legacy benchmarks which were based on good faith estimates and heavily reliant on expert judgement of contributing panel banks, the new Risk-Free Rates (or Alternative Reference Rates) are based on real transactions that have occurred either in the secured repo markets (for USD SOFR, CHF SARON, CAD SORA and THB THOR), in the unsecured wholesale inter-bank borrowing money market (for EUR €STER, GBP SONIA, HKD HONIA, SGD SORA, AUD AONIA) or on wholesale call rates (for JPY TONA). Banks source their rates for all currencies from the market data vendors. While getting hold of the data is one thing, capturing, storing, and validating all market and credit spread information that connects Libor-based rates and the new risk-free rates is the real challenge.
The market requires a specific solution to effectively generate all the risk-free rates required to replace Libor. The only way to overcome this challenge is to take the information from the various market data vendors before calculating all of the rates in a central hub. This way, banks will be able to compare the different rates so they can contrast them to the regulated risk-free rates to ensure they align. Banks can then use the calculated rates as the golden copy for their downstream processing. Our estimates show banks could save 30% – 35% on what it would cost them to source these computed rates from market data vendors.
On top of computing the rates for the standard tenors for the risk-free rates, banks also might need to calculate rates based on specific needs, such as a seven or eight-month rate – that needs to be interpolated, and combined with a lending rate based on calculated forecasts of the credit quality of the counterparty.
The consequential reputational damage the industry faced post-Libor means they can ill-afford not to address any post-transition operational teething problems. To be fully prepared for the US dollar switchover next year, the shift to other risk-free rates needs to be done in a fully transparent and auditable way. This means ensuring the most up-to-date technology is in place to easily be able to automatically transfer thousands of Libor linked contracts over to the new risk-free rates. Libor, ultimately, proved to be inherently flawed to the point where the regulators lost complete confidence in it. If risk-free rates prove to be a better alternative, banks have to get their operations in order so that the operational legacy of Libor doesn’t linger.
