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The coronavirus pandemic and related economic downturn have brought unforeseen challenges to the global financial infrastructure. Financial entities of all types must continue their day-to-day operations, maintain sufficient capital, comply with regulations, serve their clients—and prepare for the much-anticipated London Inter-Bank Offered Rate transition.
On March 25, 2020, the U.K.’s Financial Conduct Authority reaffirmed that the target cessation date for all firms remains the end of 2021. According to the FCA, the “central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.” The transition “remains an essential task that will strengthen the global financial system.”
The FCA's statement maintains a stance held by global regulators and central banks that a transition away from LIBOR is necessary. The 2008 financial crisis and growing scarcity of transactions in unsecured markets brought additional scrutiny associated with post-crisis manipulation scandals. In addition, LIBOR panel banks, i.e., the banks responsible for submitting daily input data to the Intercontinental Exchange to support the calculation of LIBOR, were reluctant to provide necessary quotes, calling into question LIBOR's status as a global benchmark rate.
The LIBOR transition followed the Financial Stability Board's review of major interest rate benchmarks, coupled with the FSB's 2014 recommendation for many financial products to reference a “risk-free” rate (that is, an interest rate that does not include credit risk). It has been on the horizon for financial institutions with embedded LIBOR contracts and exposures. These includes banks, insurance companies, and asset managers, as well as broader financial market participants, such as institutional investors, corporate and middle-market end users, and retail customers that borrow or invest using LIBOR-tied cash and/or derivative products.
Beginning as early as 2014, financial institutions as originators to nearly $400 trillion of financial contracts referencing LIBOR, e.g., derivatives, loans, floating rate notes, securitized products, started to establish LIBOR transition teams to support and execute the regulatory mandated transition. Those activities including beginning the impact and exposure assessments, selection of alternative reference rates, contract analysis and remediation, client communication and negotiation, and system and operational updates.
Through the first quarter of 2020, impacted institutions with identified LIBOR exposure worked on comprehensive, enterprise-wide transition plans and activities. Financial institutions and other impacted organizations, e.g., banks, investment managers and corporations, continued to manage detailed lines of business or product timelines, enhance governance frameworks, and integrated second lines of defense. These efforts are advancing in 2020 as liquidity in key financial markets is slowly building across the majority of global alternative reference rates.
According to Mark Chorazak, a partner at the New York law firm of Cadwalader, Wickersham & Taft LLP, “There was a steady increase in preparation throughout 2019, especially by the largest banking organizations.” Preparation has centered on several areas, he said, “from analyzing fallback language in legacy contracts to developing transition budgets needed to support execution of transition activities and strategy for contract remediation.”
There were defined “leaders,” notably global systemically important banks (GSIBs), large insurance firms, and other asset managers. In addition, “fast-followers” included large U.S. regional banks, mid-size insurance firms, and asset managers, and other institutions that had not yet initiated those efforts. However, most institutions were progressing at a steady pace and the transition emerged as a key theme for financial institutions in the first quarter of 2020.
Market Conditions. The immediacy and severity of the financial market and economic disruption caused by the pandemic has been felt globally. Pressure has mounted quickly in many key functions of the financial markets, volatility has persisted across interest rates, equity, oil, and almost all underlying markets and economic indicators. As a result, the Federal Reserve and other central banks have deployed aggressive responses to support the financial system and markets.
Even with those efforts and additional direct steps to alleviate pressure on key components of normally thriving financial markets—open-ended quantitative easing of debt securities, re-launching the Money Market Mutual Fund Facility (MMLF), and vast expansion of repo market operations—the impact of market disruption and illiquidity in these markets will be substantial.
In addition, the aggressive action by the Federal Reserve and other central banks has driven major RFRs globally to or below zero percent. The downward movement of RFRs since the onset of market pressures and liquidity challenges caused by the pandemic highlights the greater sensitivity RFRs have to monetary policy and short-term liquidity shifts in the market. Conversely, LIBOR, as a rate constructed based on daily quotes from panel banks versus based on underlying transactions, has remained elevated despite the aggressive actions of the Federal Reserve and other global central banks.
The combination of these shifts in market conditions coupled with the widening spread between RFRs and LIBOR is introducing uncertainty, at least in the near-term, about the ability and willingness of some institutions to begin earnest shifts toward other agreed-upon reference rates.
Clients and Counterparties. Through the first quarter, client communication and enhancement of outreach and remediation strategies emerged as the key focus for transition teams at impacted financial institutions. Financial institutions engaged clients through varying levels of outreach. The largest banking institutions directly engaged clients while enhancing their internal approaches to managing risks associated with client communication at scale: conduct, litigation, regulatory, financial and operational. Most other participants had not taken similarly aggressive steps with the majority of their clients.
“Education and outreach is the key to a smooth transition,” says Lary Stromfeld, head of Cadwalader's LIBOR preparedness team. “However, the unprecedented volatility of the markets has brought added scrutiny to LIBOR as a measure of market conditions and made discussion of the transition to new rates more challenging.”
The current economic downturn will affect clients and counterparties beyond the resourcing and organizational elements described below. From an economic perspective, client positioning and associated contracts will change. Further, the potential of forbearances, defaults, or restructurings complicates how financial institutions should assess or redefine legacy LIBOR contract remediation and communications strategies at an organization and line of business level.
Finally, of particular relevance for corporate or institutional clients, counterparties, or investors, it is unclear how public health restrictions will affect the ability for effective communication and renegotiation of documents (delayed in-person meetings, etc.).
Operations and Resourcing. With the widespread implementation of business continuity plans, institutions have quickly shifted to a new operational and resourcing model to support and protect the safety of personnel and continued essential operations. All the institutions are now relying on a remote working arrangement for a substantial portion of their workforce. In addition, institutions are currently shifting the activities and allocations of resources and personnel to meet the new demands on “business as usual” processes due to the increased volume of transactions resulting from market disruption.
There has also been disruption in onboarding and hiring capabilities. These disruptions are, in the short term, impacting the ability of firms to ramp up their support teams and fully engage software or other third-party vendors. In addition, institutions have described pressure around maintaining historical manual documentation processes under business continuity plans and remote work arrangements.
These operational disruptions, as well as market and client effects, will impact the prioritization of transition tasks and near-term milestones as institutions grapple with the fallout from the pandemic. The re-prioritization of needs and resources is likely to only heighten challenges for certain institutions to meet near-term industry milestones.
As the FCA acknowledged, the disruptions are likely to impact institutions on a product by product basis, interim industry-driven transition milestones, and forthcoming regulatory efforts. “The impact will also be more pronounced for smaller financial institutions, as staffing and resources are understandably directed to other crisis-related work,” Chorazak said.
While there is the possibility of near-term relief for certain industry milestones on a regulator-by-regulator basis, transition teams should not depend on general regulatory statements in determining next steps. Regulators have differed on the approaches, timing of delays were they to occur, and implementation for the handling of non-LIBOR related initiatives during the pandemic on other fronts.
Phasing-out of European Securities Financing Transactions Regulation rules, requests for delays on Securities Financing Transactions Regulation among European banks, and requests from U.S. banks on further guidance on running down their liquidity buffers are but three examples of clarity that will be required in the industry, and have knock on effects for the modeling issues in the LIBOR transition.
“There was already a general perception that completing the transition by the end of 2021 was going to be a significant challenge,” Stromfeld said, “so even if the deadlines are relaxed, financial institutions would be wise to remain focused on their transition plans and make adjustments for post-crisis conditions.”
Stay Current on Developments. In line with Alternative Reference Rate Committee's (i.e. the group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar LIBOR) recommended guidelines, institutions should continue to proactively monitor evolving and shifting external industry and regulatory developments. The scope, length, and severity of the economic and market disruption are unknown.
Industry participants will be impacted to varying degrees. The responses from regulators and policymakers as well as priorities will evolve, including other existing regulatory initiatives (Comprehensive Capital Analysis and Review, Current Expected Credit Losses, Fundamental Review Trading Book, etc.) as well as global efforts that will require their immediate attention before the LIBOR transition.
Remain Engaged. Transition teams should, given the circumstances and extenuating developments, remain engaged and committed to defined project plans and key transition activities/milestones. Where practical and within a balance of their own firms’ capacities, organization leadership and transition teams should avoid pausing their efforts or enacting major transition changes such as budgetary pullbacks or significant resource reductions, unless necessary or after reassessment.
Review and Reassess. As clarity begins to emerge surrounding the impact of the economic downturn and market volatility, transition teams should engage in a detailed reassessment of their transition effort strategies (new product, customer communication, legacy product remediation, etc.), timelines and milestones, internal and external dependencies, and resource allocation to ensure the transition effort is still aligned with organizational, industry, regulatory and client needs and demands.
For example, transition teams may need to revisit pre-pandemic assessments of documentation inventory/analysis exercises and risk assessments to better understand product portfolios impacted by the economic and market disruption to confirm documentation changes specific to applicable triggers, client positions, etc.
Rethink and Reallocate. Where necessary, based on the findings of the reassessment, transition teams may need to redefine certain activities or workstreams within their transition plan and approach. For example, transition teams may need to redefine segments of customer communication. remediation priorities, or strategies as the result of evolving regulatory changes and requirements. This should happen while policymakers work to mitigate the fallout from the pandemic by, for example, encouraging or, in some cases, requiring forbearance relief.
Where necessary and based on the findings of the reassessment, transition teams should reallocate or redefine resourcing strategies (capital, budgetary, and personnel) to meet new strategies, timelines or prioritizations, including giving consideration to supplementing hard-hit transition activities with variable or flexible workforces.
The transition away from LIBOR remains an extremely complex market challenge on a unique scale that affects the complete spectrum of financial market participants, which makes the industry transition off LIBOR by the end of 2021 a continued challenge. “The coronavirus pandemic has made a complex transition even more complicated,” Stromfeld said. “Nothing about that situation should make market participants believe they can take their eyes off the ball.”