TMS providers need to change gear to prepare for IBOR Reform
The discontinuation of the IBOR rates promises to be one of the most significant changes to the financial markets in decades. Some people argue that it will impact the financial industry even more than Brexit does.
Treasurers should, as mentioned in our previous article on the IBOR transition, prepare themselves for the changes that undeniably will occur.
Most IBOR rates will lose their regulatory support by the end of 2021. Regulators around the globe are therefore attempting to steer markets away from the self-disclosed IBOR rates towards benchmark rates based on actual market transactions. Central banks and regulators have been sending letters to financial institutions listed in their countries requesting them and their clients to move on to the replacement benchmark rates, once they are available. The letters also state that market participants should asses the risks of the transition and act on those risks to be prepared on the coming transition.
There are, however, many complications in replacing the current IBOR rates with the new reference rates. One of these complications is that the replacement rates, such as SONIA1, are based on overnight lending rates. The derivative market for SONIA, for example, is underdeveloped with regards to depth and breadth compared to LIBOR. Currently, SONIA is only published as an overnight rate, instead of a term structure of borrowing periods (e.g. 1, 3 and 6 months) as LIBOR is. This is not just the case for SONIA in the UK, but also for the other new benchmark rates in other countries.
The letters from the regulators and central banks urge market participants to use the new rates to develop the connected markets, such as the derivative market of the reference rates. They require from these markets to be as much developed as possible before the end of 2021, when the IBOR rates lose their regulatory support.
Besides the need of full functioning markets connected to the new rates, another critical complication is that of a valuation impact due to the transition. It seems very likely that changing the reference rate under a derivative or loan would cause a change in valuation, as the new and old rates are on a different level. This arises the question who should reimburse this valuation change. Moreover, how can this realistically be accomplished with regards to the extensive number of contracts that will be affected?
Next to the valuation impact, the wording in a contract’s fallback provision is another complication. All the contracts that do not contain specific fallback provisions, in case the old benchmark rate ceases to exist, will have to be renegotiated before the transition.
Treasury management system providers
For corporate treasuries there is another complication: the amendments of the new yield curves and related underlying contracts in their treasury management system (TMS). It seems that the TMS providers will have their hands full with all the complications of the IBOR reform. Zanders has contacted some of the main TMS providers to hear their views on the transition and to find out how the systems can cope with all the changes, as entire administrations ought to be adjusted.
The responses and actions taken differ per TMS provider. Some told us that they are somewhat skeptical on the transition, due to the opinions of their clients. Some of these clients do not want to push the transition, while regulators and central banks are delicately trying to accomplish that for the development of the new markets.
Even though their clients are not anxious on the replacement of the rates, TMS providers are preparing themselves for the transition. For most of the providers, however, the changes that need to be made are in some way already possible in the current system set-up but will be very time-consuming and costly to do all at once. Imagine having to replace all existing legal contracts or the old benchmark rates of the financial products recorded in a TMS. One of the providers mentioned that they are figuring out how to automate the transition process in their systems and to make bulk processing possible for contracts.
Regarding to the upcoming replacements, other providers informed us that they are currently still in the middle of the evaluation phase. They are exploring the requirements given by the market and the expectations of their clients. At this stage, it is too early for them to provide concrete feedback about this topic, but we will be following their evaluations.
As it will affect many of our clients, we will closely follow the approaches of TMS providers. In September, we will publish a new article on this subject and further inform treasurers on how to properly prepare for the transition.
 The Sterling Overnight Index Average (SONIA) will be the new near risk-free interest rate benchmark in the UK. It is calculated by the weighted average rate of unsecured overnight sterling transactions with minimum deal size of £25 million.