David Kelly, Co-Founder and Managing Director
The most impressive aspect of the discourse around IBOR transition are the numbers – $260,000,000,000,000 of derivatives that need to migrate onto the world’s most important number. The big consultancies and technology firms are very excited as it is Y2K all over again, does that make it Y2k+21?
The answer is Yes and No. Yes as the impact of this transition impacts many players other than the big banks – asset manager, insurers, mortgage providers. No, because the shock-and-awe numbers are missing the point of the transition which is less about the size of interest rate swap market and more about the operational upgrade necessary to make wholesale changes to contracts outside of ISDA.
Derivative trading is well-organised in that the ISDA sets the legal framework for all players to trade existing LIBOR contracts and are doing the same for the Risk-Free Rate (RFR) contracts. The vast majority (>80%) of the $260tn expires before 2021. For long-dated contracts, all players trade out of their current positions and replace it with a new risk position. The transition should be completed several months before the deadline as it is in the interest of everyone to execute a smooth transition.
The risk quants in both the banks and those that use swaps as hedges (pensions being a key group) collectively need to focus on answering the question of effective risk hedge ratio. Moving from a contract that represented an inter-bank and unsecured loan to an overnight and collateralised is substantial. The basis between LIBOR and Risk-Free Rates (RFR) trades in the region of 25-30 bp, so what does that mean for a defined benefit pension fund that has to date used LIBOR to hedge their long-term liability?
While complex this is a problem that most quant teams can address. How they communicate their findings to their traders and clients is another matter and something we at the Quant Foundry have been exploring from both sides.
As is usual, some banks are ahead of others. What is clear is the priority – moving away from the past of LIBOR rigging and onto a new paradigm is in the court of public opinion, not an option. There is also a clear deadline of 2021 which focuses the mind. Compared to risk programs such as FRTB that focuses on 5% of the banking capital base, IBOR migration stands out as the number one program.
The two-year time horizon for ISDA swap trade migration is very much achievable with existing front office pricing, operations and risk capital. We expect some disruption of introducing a benchmark curve with limited history so quickly into a capital regime that requires ten years of data. Again, coming up with a proxy methodology to fill in the gaps is within the capabilities of the community of risk quants that do compare notes on methodology.
The challenge for banks is outside of the ISDA world and focuses on instruments such as bonds, loans, structured notes, project finance that reference LIBOR and include fall-back clauses in the (used to be unlikely) event that the reference benchmark is no longer available. Unlike ISDA, the language is specific to each instrument and is somewhere in the legal documentation.
The banks need to build a consistent and efficient way of getting a handle of all of these contracts and put them into a framework that can manage the transition from IBOR to RFR. Structuring teams that signed many of these contracts left a long time ago, so institutional knowledge is a problem.
Banks are considering using teams of paralegals to approach the effort of repapering and client engagement as a one-off manual exercise. The outsource manual approach might get banks over the finish line, but it misses an opportunity to address the need to capture institutional knowledge in the way such deals of originated and managed over their lifespan.
Loading all deals other than ISDA contracts onto a framework that manages not just the daily valuation and settlement processes, but also the contractual components now looks more sensible. It has always been a mystery why critical components of a transaction – legal, financial and risk – are separated at origination and managed in siloed systems.
One solution that banks should consider is to follow the path of ISDA and collaborate and define a common standard for all instruments that reference to the new RFR. A standard suite of legal definitions would future-proof these instruments for the next iteration of benchmarks as well as reduce the operational and legal cost of origination and ownership.
At the Quant Forge division of Quant Foundry, we are working with partners that are digitising the entire lifecycle of all securities that includes placing each prospectus on the secure blockchain alongside its daily valuation and risk disclosures. Banks face the challenge of moving onto such a paradigm so this type of blockchain is likely to be a step too far, but the concept is sound. Banks need to use a technology solution that holds the critical textual components of each contract in a digital form – not just as a pdf but in a database form that the migration team can use to effect a smooth transition.
As hinted before, the success of the migration depends on how the teams manage the basis between the old IBOR and new RFR. The banks have to bring their clients through the migration from IBOR to RFR+Basis smoothly and fairly. This should not be an opportunity to make a profit but to evidence probity and sufficient independent oversight. The regulators and their political paymasters demand it and will not forggive any transgression.
Banks and hedge funds are now active traders on the basis which is proving to be volatile. The banks need to develop strategies such as “Asian Out” to manage the volatility and communicate to each client on their intentions and course of action.
Bringing the clients through this process and doing the right thing needs to be the critical pillar for the transition. Taking the opportunity to reduce the cost of ownership of these instruments should be the second.