The IBOR interest rate benchmark is a fundamental quantity required in asset management, where the primary markets for investing and hedging interest rate risks are linked to IBOR. However, there is already a well-known tale about the dark cloud hanging over IBOR, with the central theme of systemic risks in rate-polling on thin inter-bank loan markets. These concerns are serious enough to prompt recent waves to remove IBOR from the global financial system and establish continuity plans.
But the largest volumes in the swaps markets are currently for IBOR - with about $100T outstanding notional, it is clear IBOR is a well-established benchmark rate. Primarily, IBOR swaps markets have passed the requirement of market depth, liquidity, and transparency (DLT) that are all key measures for regulatory approval in insurance and other investment industries. But the suitability of IBOR markets for asset management appears much different when looking deeper into the IBOR benchmark, which is tied to the inter-bank loans market, with a recently estimated cap of around $500M. We should expect a decision in the coming days that the depth of IBOR is insufficient for approved use in the asset management industry.
In the wake of the revelations about IBOR's seeming demise, the search for new benchmarks is already underway. In order to avoid the problems inherent in IBOR, industry bodies have pushed towards benchmarks which represent loans with large volumes of transactions, and this has led to overnight rates. The front-runner candidates for replacing IBOR come either from existing markets like SONIA, or newly formed ones like ESTER and SOFR. So far, the developments in the adoption of overnight rate benchmarks have mostly taken two forms:
- Encouraging the rapid growth of derivative markets linked to candidate overnight rates
- Establishing robust contractual definitions in legacy contracts which currently reference IBOR
The decision of regulators to opine against IBOR due to lack of depth will need to be closely accompanied by identification of an alternative DLT benchmark in each currency. The important point is that the search is underway, and once IBOR is deemed unsuitable an unstoppable fuse will be lit for the demolition of IBOR. For example EIOPA annually revisits the current DLT assessments, and procedures will only allow up to three months of warning about changes to the DLT qualification of IBOR swaps.
Asset managers will need to start planning as soon as possible to tackle anticipated challenges of the IBOR transition. These include the possibility of mismatch of existing liability hedges, strategies for managing legacy IBOR positions or unwinding these positions at high cost. Despite the removal of IBOR and associated curves and modeling from the asset universe, the current challenges in planning for these changes will quickly reveal the growing, not shrinking, complexity that must be managed for the IBOR transition.
It is also important to recognise that in insurance, the asset side is not in a vacuum, and the liability business can have a strong influencing role in the composition of the asset book. One of the reasons for this is the solvency regulation that can provide significant balance sheet benefits to business lines that are able to closely match asset and liability exposures. In Solvency ii (S-ii), the DLT assessment is used to determine the appropriate risk-free rate for discounting liabilities, and this currently comes down again to the IBOR swap market. A shift to OIS discounting would naturally reduce discounting rates and worsen liability exposure unless a spread adjustment is instituted to compensate for this. The current credit risk adjustment in S-ii for liability discounting is directly calculated as 50% of the IBOR-OIS spread to account for a significant component of the spread being due to liquidity premium rather than just credit default risk. But as the global markets move away from IBOR, the current regulatory framework for the credit risk adjustment calculation will not be sustainable. This points to the potentially significant impact also for regulators, in losing the best existing benchmark for systemic credit risk in the financial sector.
Given all the challenges, uncertainty and open questions right now, it might seem prudent to wait for regulators to clarify all the details before taking action. But it is clear that by the time the details are actually finalized there may not be much time left. The best thing to do now is start preparing for the IBOR transition by getting an early start on the necessary upgrades to your pricing and risk analytics and IT infrastructure to cope with these challenges. The search for the next DLT benchmarks is already underway, and asset managers should be as ready as possible to stay ahead of the reassessment of depth of IBOR.