Hello, My name's Jim Byrd. I'm the head of Rates Trading at RBC Capital Markets. Today, we're going to discuss the topic of LIBOR transition, and I'm very lucky to be joined by Harri Vikstedt, senior policy director in the financial markets department at the Bank of Canada. In his current role, Harri is focused on financial market related issues, including global and domestic benchmark reform. He's a member of the Financial Stability Board, Official Sector Steering Group, and co-chair of the Canadian Alternative Reference Rate working group, or CARR as its known. CARR is responsible for helping to transition the Canadian financial system from the Canadian Dollar Offered Rate, CDOR, to the Canadian Overnight Repo Rate Average, CORRA. Harri, I want to thank you for joining me today.
Before we get started, I just wanted to clarify that the comments and views are my own and do not necessarily represent those of the Bank of Canada or the FSB’s Official Sector Steering Group, which I'm a member of.
Noted. With over $400 trillion of financial products linked to IBORs globally, the transition to risk-free rates is a broad and impactful change for the financial markets. While every jurisdiction is at a different pace in the transition to RFRs, per today's discussion, we would like to focus more specifically on how the transition may impact the Canadian market. There's a lot to discuss, so why don't we get started? So, Harri, why is there a move away from LIBOR?
This applies to other interbank offered rates as well, so not just LIBOR. But in a nutshell, there's basically four drivers. The first is that there was some manipulation of some of these rates during the global financial crisis in 2008, 2009. Secondly, the reality is that derivatives in general do not need IBORs or LIBORs as the floating rate benchmark. Thirdly, there's been a reduction in the short-term interbank funding due to regulations that have been introduced since the crisis. And fourth, which is very important is that there is a desire by many of the banks on these panels to leave them.
So, I'd like to expand on this point by providing a quick history, if you don't mind. So, it started in 2012 with the Wheatley report. Basically Wheatley recommended that LIBOR should go down from 10 currencies to five, and some of the tenors to be discontinued. The reasons being that there was no underlying market and they weren't being used. In 2013, IOSCO, which is the umbrella organization for the global securities regulators, introduced their principles for financial benchmarks.
These set out what a robust benchmark should be. And basically it should be based on transactions from a liquid underlying market. Also in 2013, the FSB created the Official Sector Steering Group to review financial benchmarks and the focus there being on LIBOR, Euribor and TIBOR. The FSB also formed the market practitioners group, which was composed of roughly 40 plus, large global players, including RBC as the subject matter experts on benchmarks and derivatives. In 2014, the MPG and the OSSG released their report with three key recommendations. Firstly that these IBORs were to be made more transaction based, i.e. they were to be reformed. Secondly, that jurisdictions should create risk-free rates and that these should really be the basis for derivatives. This was coming from the market practitioners, not from the official sector. And thirdly that the fallbacks that many products relied on should be made much more robust.
But overall, the view was that most jurisdictions would remain multi rate, i.e. that you would have an IBOR and a risk-free rate. One of the other things that happened as a result of the global financial crisis was that there were new banking regulations that were introduced. This basically meant that the interbank lending market begun to dry up, so there weren't very many transactions. And as a result, many of these panel member banks were interested in leaving these panels. Remember that they're doing this as a public good, they don't get paid for it and some of them had also paid large fines.
So, in 2017, Andrew Bailey, who was the CEO of the FCA, the FCA is the regulator that regulates the IBA, the administrator of LIBOR, as well as LIBOR itself, gave his famous speech about the end of LIBOR. Basically he said that the FCA would not use its power to compel banks, panel member banks, to remain on the LIBOR panels past the end of 2021. And it’s clear from the recent announcements at the end of last year from the IBA and the FCA, that these panel member banks do not want to be on these panels. As a result, four of the LIBOR currencies will cease at the end of this year. And five out of the seven US dollar LIBOR tenors will continue to be published for another 18 months. So that's towards the end of June of 2023.
Okay, thanks for the background. So, what can firms do to prepare for transition? How can they get plugged in?
There're many important components, but I'll highlight the few that I think are the most important. Firstly, you need to understand your exposure, both on the asset and liability side. And it's not just the securities exposure, it could potentially be related to leases, oil contracts, sales contracts, et cetera. So, the key there is what is your exposure? You also need to understand what happens to those contracts once LIBOR is stopped, i.e. what are the fallbacks? And you specifically want to focus on those fallbacks that are not robust, in other words, is there a fallback?
There could be many implications from implementing those fallbacks. It could be accounting, relate to hedge effectiveness, systems. I think a lot of people don't focus a lot on systems, but the systems component is a very critical component of this transition. So, can your systems handle fallbacks, or can your systems handle new products? One of the things that people need to remember is that there's a fundamental shift happening in the plumbing of the financial system. IBORs, this includes LIBOR, are a forward-looking rate. We are moving towards risk-free rates, which are overnight rates and are calculated in arrears. So, it's important to understand that.
You should obviously allocate, i.e. have the resources to look at all these issues. For many of the large global players, the large money center banks, I mean, this can run into hundreds of millions of dollars. So, this is not an insignificant effort. One of the things that you should obviously be doing is making sure that you don't increase your exposure to LIBOR, and if you do, just make sure that any contracts that you do going forward have robust fallbacks. And then the last point is, that you really need to start transacting in new products or in these new benchmarks. In the case of the US, it's SOFR.
With respect to, how can you be plugged in? There are many good sources of information, and I would start with ISDA, or ISDA's website. It has extensive information, not only on the derivative fallbacks, but in general on the transition efforts globally. The Official Sector Steering Group also has materials. For example, we released a roadmap in October of 2020, i.e. last year. We also do an annual update, which was released in November. If you're focused on LIBOR specifically, then obviously the IBA as the administrator and the FCA as the regulator, are important sources to follow.
Each of the currency groups, LIBOR currency groups, has the national working group, in the case of the US it's the ARRC, and there's extensive material on the transitioning there. For the non-LIBOR currencies, they also have national working groups. As you mentioned, I'm the co-chair of CARR. So, it's important to follow what's happening in those jurisdictions. And then obviously you should be talking to your dealers like RBC. The one advantage that the dealers or the banks have is that they themselves are going through a transition effort, and to a large extent, it's a huge effort because these benchmarks are really the cornerstone of the bank plumbing.
And then lastly, you should really be talking to your system providers to make sure that you will have the systems ready when these benchmarks end.
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