Ibor – the law of unintended consequences

London 2nd June - Originally published by Reuters Regulatory Intelligence on 24th May Delta Capita’s Philip Freeborn discusses the major challenges and opportunities of Ibor.

New regulations or market mechanisms are usually introduced in response to a specific problem that has caught the attention of regulators or legislators. By 2007/2008, cracks had appeared in the worldwide financial system and banks were beginning to struggle to fund themselves. The traditional mechanism used by UK banking regulators to determine the rate at which banks could borrow had been based on a trust system, with banks submitting their rates and an average determined. It had worked well for a long period but in 2007/2008, the opacity of the process meant there was a perceived conflict between the London Interbank Offered Rate (Libor) submissions and the interests of the banks themselves.

In 2012 this cost a number of chief executive officers and senior traders their jobs, and in the second half of the last decade a new way of determining interbank offered rates (Ibors) was proposed. This makes the rate more deterministic and deals with the inherent conflict of interest, but also creates a number of different challenges and problems, albeit alongside some new opportunities. These issues affect banks, financial institutions and end consumers.

The major challenges

There are five major challenges with the proposed replacement mechanism for interbank offered rates:

1. There is no like-for-like replacement for Ibors. The new proposed rates behave differently and will alter the risk profile of both the market participant and the counterparty. The counterparty can be a market professional but also a retail consumer who is used to having a mortgage that references, for example, Libor.
2. The market has been slow to adopt the new mechanisms following the first issue, hence liquidity is scarce.
3. The available fallback clauses designed to work for different products introduce optionality and basis risk within portfolios that were otherwise assumed to be hedged.
4. The design of the fallback language — which includes the introduction of an adjustment term to the replacement interest rate — introduces wealth transfer between counterparties. This is a classic example of the law of unintended consequences.
5. Finally, due to the potential for wealth transfer, there are major new conduct and reputational risks for banks and professional counterparties to consider. These risks are difficult to eliminate completely because of the way in which the new rates are being introduced.

Further consequential issues

There are several more mechanical, but nonetheless challenging, issues posed by the introduction of Ibors:

• New products will have to be devised to ensure the needs of all client types are met. Within banks and other financial institutions, systems need to be changed and processes modified; all of this clogs up the "new product approval" process. For example, new operating models and workflows must be orchestrated to account for the adoption of new or amended products, new curves, differences in payment instructions, etc.

• Modelling of specific products and market rates must adjust, and validation needs to take place. For banks and regulators, this follows a backlog of changes resulting from Brexit and other developments. It means there is limited capacity for other product innovation.

• Contract repapering will have to take place to ensure the legacy portfolio is compliant with the proposed changes. Again, this follows a period of extensive communication in relation to other changes, both regulatory and legal, following on from Brexit. Client communications and new legal agreements will take significantly longer than anticipated, as clients need to be given plenty of time to decide how to adopt these new rates and fully understand how the rates affect them.

• Millions of contracts reference these rates, and the sheer scale of change is massive. It will keep banks and other financial organisations busy for several years. None of this is made any easier by the continuing effects of the pandemic.

The opportunities

Many challenges have been highlighted, but there are also some significant opportunities that should benefit banks, other financial institutions and end clients.

• These new rates require a fundamental redesign of financial products. The author believes this will drive innovation to new highs as market participants find alternative ways to meet client demand. The move to new rates seems so small but, if handled well, offers a once-in-several-generations opportunity to rethink and optimise the way in which business is conducted. For example, the required changes should lead to contract digitalisation and this facilitates support of future growth, at a lower marginal cost and with better control over the population of contracts.

• Secondly, there is a gap between the regulatory intention and the practical issues that needs to be addressed, and market infrastructure companies will step in to fill this gap. This will not only reduce the individual risk of banks and other financial institutions becoming outliers on any matters requiring interpretation but will also allow them to reassess which parts of their value chain truly differentiate them.

In summary, the change in Ibors resulting from events just more than a decade ago is having, and will continue to have, a profound impact on the way financial products are designed, sold, papered and risk-managed. Banks and financial institutions need to adopt a holistic approach to this change and ensure they take advantage of the opportunities, rather than thinking about the minimum that can be done to ensure compliance.

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