The move from LIBOR to Alternative Reference Rates (ARRs) likely will change the pricing of newly issued products. Firms should assess potential impacts to the makeup of their Funds Transfer Pricing (FTP) curves and methodology.
As firms develop their LIBOR remediation plans surrounding their products, contracts, systems and processes, FTP—the function that allows financial services firms to measure their profitability—needs to be reviewed and analyzed for impact.
Firms should take this opportunity ahead of cessation to begin building out capabilities to baseline their FTP curves to new ARRs.
By its very nature, LIBOR is different in composition to many of the ARRs being proposed around the world as replacements. For many FTP professionals, LIBOR has served as the base rate when building out transfer pricing curves. LIBOR includes an inherent interbank credit premium, as well as an established and widely published term structure of rates set daily. The challenge of cessation is answering the questions on how ARRs can replicate these features to baseline new pricing and measures of profitability.
Take the Federal Reserve Bank’s proposed LIBOR replacement for U.S. dollar products, the Secured Overnight Funding Rate (SOFR). SOFR is calculated as a volume-weighted median of transaction level repurchase agreement (repo) data cleared through the Fixed Income Clearing Corporation.1 SOFR is published each business day on the New York Fed’s website.
Because it is based on overnight repo, SOFR has some unique features not found in LIBOR. It is a risk-free rate (no credit risk), a backward-looking overnight rate and has no term structure. More importantly, in historical times of stress such as the 2007-2008 crisis, simulated SOFR rates have decreased, a pattern that is counter to LIBOR, which has increased in times of stress as a result of the interbank credit premium that is baked in (see Figure 1). This presents some clear issues for developing future FTP curves for pricing and profitability measurement in a post LIBOR world.
Figure 1. Comparison of Primary Dealer Survey Rate vs 1-Month Daily LIBOR
Financial services firms should be planning for changes to FTP throughout the transition period, where LIBOR can still be referenced as a benchmark, and during the post cessation period and beyond. Key issues to consider are:
- How new base curves are constructed
- What new curve considerations should emerge due to the properties and behavior of ARRs
- How Treasury departments are expected to communicate these changes to FTP functions so key stakeholders across front office, risk and finance are aware of impact
Considerations for assessing the impact to FTP in a post LIBOR world
Transition to ARR base curves: One of the largest impacts of LIBOR is the transition of existing LIBOR-linked products and contracts over to new ARRs. This means taking existing products maturing after 2021 and updating financial contracts to reflect new rates once LIBOR is no longer published.
Some cessation events should occur earlier depending on the product. For example, Federal Government Sponsored Enterprises (GSEs) are to stop accepting LIBOR-linked mortgages for pooling as early as January 1, 2021.2
Many firms are expected to kick off the process of issuing new, non-LIBOR products to the market for the first time and starting the process of phasing out new LIBOR issuances from their portfolio entirely. These transitioned and newly issued products would all be required to be transfer priced by Treasury to monitor the profitability of these instruments.
Firms should take this opportunity ahead of cessation to begin building out capabilities to baseline their FTP curves to new ARRs. This includes deciding what this rate should be, often times limited by the ARR available by currency. An assessment of a firm’s current technology capabilities and FTP methodology should be conducted to understand any capability gaps.
Guidance from local working groups, such as the Alternative Reference Rates Committee (ARRC), should be taken into consideration when developing transition strategies. For instance, the ARRC has suggested firms use the International Swaps and Derivatives Association (ISDA) methodology of a 5-year median of the historical difference between LIBOR and SOFR curves for cash products.3
Curve construction in a post LIBOR world: Some of the biggest questions raised in the financial industry about FTP concern the curve construction to be used in a post LIBOR world. As mentioned, key features of LIBOR such as the implicit credit premium and term structure are not present for most of the existing ARRs. Many ARRs are based on secured transactions, backed by collateral, resulting in what is considered a risk-free rate.
In addition, illiquid forward-looking swap markets do not provide reliable term structures for pricing, currently. Firms should be thinking about the following when creating a framework for future curve construction:
- Dynamic credit spread: The lack of a credit premium in ARRs raises a fundamental issue. Issuers used to pass on this credit risk, as agreed upon, to their clients in the form of a dynamically moving LIBOR base rate. To recoup that spread, firms would now have to price this into their margin. Unfortunately, development of this credit premium across the industry has yet to be agreed upon at time of this writing. If the industry cannot agree on a common, published approach, development of these premiums could vary from bank to bank, impacting pricing and profitability.
- Term liquidity premium: As cessation approaches, more firms are expected to issue and hedge their alternative rate exposures in the form of the developing swap markets. It is uncertain if these swap markets remain liquid enough to provide a stable term structure for ARRs at the time of LIBOR cessation. FTP professionals should consider proxies and methodologies to build this term liquidity premium into their curve construction and methodology.
- Contingent liquidity factors: Firms should be considering how their customers’ behavior might be altered or changed as a result of swapping out LIBOR for ARRs. The volatility profile and behavior of ARRs tend to differ from LIBOR which can cause changes in client borrowing and investment behavior. On the asset side, there may be a change in the assumptions used for prepayments of amortized products. On the liability side, shifts in ARRs may shift break-funding costs for products with buyback optionality. History has shown that corporations pull on their LIBOR based lines of credit during times of financial stress. As financial stress in the markets increases, LIBOR and lending rates have historically increased. ARRs that behave like risk-free rates have moved in the opposite direction, providing further incentive for increased borrowing by stressed companies. Creating a robust list of potential factors across product and jurisdiction allows firms to react quickly to changes in a potentially volatile new rate regime.
Communication, communication, communication – All LIBOR transition programs require a robust communications plan for their customers and internal stakeholders. The same holds true for the fundamental changes to FTP:
- Finance should be notified of the potential impacts to profitability reporting as a result of changes to curve construction and contingent liquidity factors.
- Risk should understand the shift of credit risk from customer to the firm when moving from LIBOR to ARRs and assess the need for hedging and other monitoring.
- The front office, which actively leverages FTP curves, needs to understand the fundamental differences in reference rates and the implications on pricing transparency to customers as well as the factors that make up the cost of funding.
To find out more on the topic or how Accenture can help in your LIBOR transition, please contact the authors.
- “Secured Overnight Financing Rate Data,” Federal Reserve Bank of New York. Access at: https://apps.newyorkfed.org/markets/autorates/SOFR
- “GSEs Prepare for Losing LIBOR,” Bradley, February 10, 2020. Access at: https://www.financialservicesperspectives.com/2020/02/gses-prepare-for-losing-libor/. “LIBOR-based loans will not be eligible for Ginnie Mae pooling,” Buckley LLP, September 23, 2020. Access at: https://buckleyfirm.com/blog/2020-09-23/libor-based-loans-will-not-be-eligible-ginnie-mae-pooling
- “ARRC Announces Recommendation of a Spread Adjustment Methodology for Cash Products,” Alternative Reference Rates Committee, April 8, 2020. Access at: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Spread_Adjustment_Methodology.pdf