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By Chia Tan, Director, Counterparty Model Risk Management, Bank of America
What were some of the main challenges with the transition away from LIBOR?
LIBOR was the index to which the vast majority of interest rates instruments reference for determination of the floating coupon payments in all major markets outside EUR (which uses EURIBOR). This meant that even if all details were ironed out, a transition involved significant infrastructure implications in terms of piping the new contractual terms (e.g. implementing the LIBOR fallback mechanism of Risk-Free-Rate (RFR) plus spread) through to the underlying trades. There were further the related issues of curve construction and appropriate discounting (e.g. switch from Overnight Interest Swap discounting to RFR discounting). And there were modelling enhancements needed too (e.g. in relation to pricing normal caplets whose fixings are known only at period end, and additionally regarding term structure modelling of exotics).
However, the real world is rarely as simple. Specifically, there was the issue of negotiating the replacement of legacy contracts with thousands of clients, some of whom really had little interest in modifying one-off deals done years back. And there was naturally the issue of the development of an orderly liquid market for RFR securities to replace LIBOR, before the market participants were willing to move away from LIBOR. In a sense, this was a circular issue – a liquid market was needed to motivate clients to transition away from LIBOR, but enough clients must switch to RFR-based instruments for a liquid market to develop.
From the client perspective, there was also perhaps an infrastructure challenge for some corporations of having to deal with rates that are daily compounded (rather than based on a single fixing at the start of the period), and some corporate treasuries would find it unhelpful to only know the fixing for RFR a few business days (as opposed to a few months) before the floating coupon payment is due (and so having little time to organise the exact coupon payment).