Preparing Your Treasury Management System for the IBOR Replacement

Preparing Your Treasury Management System for the IBOR Replacement

Instruments including bonds, loans, derivatives, leases, and the construction of discount curves, could all be affected by the new reference rates. The required repapering and repricing of affected financial instruments will challenge Treasury Management Systems (TMS) providers in how they will support treasurers with the IBOR transition.

Corporate treasuries should be prepared for numerous financial instruments to be affected by the upcoming IBOR replacement. The different financial instruments that benchmark the IBOR interest rates will have to be reviewed when the underlying interest rates are transitioned to a new reference rate. Instruments including bonds, loans, derivatives, leases, and the construction of discount curves, could all be affected by the new reference rates. The required repapering and repricing of affected financial instruments will challenge Treasury Management Systems (TMS) providers in how they will support treasurers with the IBOR transition.

Background

The Interbank Offered Rate (IBOR) consists of a series of benchmark rates based on values submitted by a panel of banks. For example, LIBOR is based on data submitted by banks in London and EURIBOR is the benchmark based on data from Eurozone banks. It represents the average interest rate at which a panel of banks claim they borrow funds from one another.

The IBOR scandal, which triggered the replacement, occurred from 2005 (if not even earlier) to 2008 when the scandal was exposed. The scandal involved banks understating the interest rate, which once aggregated could keep the IBOR artificially low.

The scandal resulted in the benchmark interest rates used to calculate the rate becoming no longer compliant with regulations and the market is therefore in transition to a transaction-based reference interest rate. Ever since the scandal, there have been requests to adapt or replace the benchmark interest rate. These rates are based on professional judgement instead of transactional data and therefore can be manipulated, as seen in the scandal.

To respond to the concerns about the reliability and robustness of the IBOR benchmarks, a Financial Stability Board (FSB) report in July 2014 recommended the development of an alternative risk-free reference rate (RFR). This RFR should be transaction-based. Central Banks and advisory bodies have responded to the recommendations of the FSB and the first plans to develop replacements for the benchmark interest rates are being worked out.

Since then, financial authorities have been either selecting or constructing a new reference rate for their currency. For the UK, US and Switzerland, these will be respectively the SONIA, SOFR and SARON with the transition planned on 1 January 2022. For the EU, the ESTER appears to be the new rate. The initial transition date to ESTER was set on 1 January 2020, but as such a transition comes with a multitude of complications the transition date has been postponed two weeks ago to 1 January 2022.

Financial institutions ahead of the curve

Compared to the high priority of this topic within financial institutions, the current approach of many corporate treasuries towards the IBOR replacement is somewhat hesitant. This cautious reaction from treasurers could be due to the still pending uncertainty on what the final outcome on the IBOR replacements will be, or perhaps due to corporate treasuries thinking this is more a problem for the banks. However, corporate treasurers need to be prepared for what will happen over the coming months, as it will have a direct impact on various financial instruments they use.

Because of the importance of this topic, Zanders will publish a series of articles on the subject. In these articles, we want to give a general overview on the IBOR replacement for corporate treasurers, but also provide hands-on tips and tricks for both the preparation as well as the transition phase. We will be working together with the TMS providers to understand their approach and help our clients with the adjustments that need to be made.

Some of the challenges that TMS providers and corporate treasurers could have to face include:

  • Set-up of new multiple yield curves per currencies, with the derivation of their new risk premiums
  • Definition of an IBOR contract master with reference rate details and fall-back provisions
  • Definition of portfolios in which legacy contracts with similar fall back language are grouped
  • Calculation of the impact of IBOR replacement repricing on MTM of individual contracts
  • Adjustment options as described by the ISDA consultation paper (July 2018)
  • Potential approaches towards creating a term floating rate
  • Hedge effectiveness calculation and potential mismatch using alternative RFR’s

Zanders will be publishing a series of articles covering the variety of challenges the IBOR replacement could create, and the approaches that corporates can take to properly prepare for the transition.