In our second in a new series of blog posts on the LIBOR transition, we discuss how the market is dealing with the uncertainty around forward looking term rates and what we are doing at Finastra to help our clients manage the transition as effectively as possible.
Dealing with complexity
Most institutions have become very accustomed to the certainty and simplicity that LIBOR provides. Initially, many hoped that the transition would merely involve replacing LIBOR with something else – which it would have, if forward looking term rates for the alternative reference rate options existed, but they don't yet.
Given the lack of clarity around forward looking term rates, a lot of market participants have spent considerable time and effort establishing how to proceed without them. This includes working through some of the more complex options that may be a better fit for sophisticated borrowers and financial institutions.
Whether we’ll see mass migration to forward looking term rates is one of the biggest questions around the transition. Alternatively, we may end up with more of a ‘mixed bag’, with certain parts of the market adopting forward looking term rates, others staying with simpler daily rates, while some larger, more sophisticated institutions recognize the benefits afforded through more complex calculations.
Irrespective of which options institutions choose, the transition process has highlighted the pressing need for the industry to digitize. While LIBOR is a fairly simple rate, it still involves large volumes of time-consuming reconciliation between various entities. It’s becoming increasingly evident that the post-LIBOR world is going to involve significantly more complex calculations – and if market participants don’t find ways to digitize and automate their systems and processes, these reconciliation issues will be amplified and may become untenable.
Finastra has been very involved in various transition working groups and committees, with both our clients and the regulators. These groups provide an invaluable forum for institutions to engage with each other, to discuss how they are tackling similar issues, and to work through some of the transition challenges together.
They are proving particularly helpful for market participants looking at the transition from a global perspective, and those involved in complex cross-border deals. We are now encouraging our clients to take back some of the challenges highlighted to their various jurisdictional working groups. This should hopefully allow for more convergence in the global discussions taking place.
Following the publication of the SOFR and SONIA conventions, we have increased the frequency of our working groups to help our clients work through the intricacies and nuances of the published conventions.
Calculating the impact
Through various conversations with market institutions, clients and our engineering team, we’ve realized there is a need for many market participants to have access to complex calculations similar to those available in Fusion Loan IQ. To address this need, we have developed the Fusion LIBOR Transition Calculator.
The Calculator mimics Fusion Loan IQ’s complex calculations for either the interest rate itself or for the complex compounding in arrears calculations (the average compounded in arrears rate or the daily non-cumulative compounding rates).
Institutions can use the Calculator to determine the complex calculated rate by entering the start and end dates, as well as any look back and other parameters. And if further details on the loan principal amount are entered, the Calculator can provide the necessary interest accruals for that loan.
The Calculator can also be used more broadly within an organization. Many institutions have very fragmented system landscapes, with lots of systems all housing LIBOR portfolios. Given the migration paths for all of those systems, meeting the tight deadlines may prove to be a challenge.
Our Calculator is designed to offer a tactical approach to enable institutions to be compliant and transition, while also giving them the space to work out how to best manage multiple systems with overlapping features and functions in the transition away from LIBOR.
Flexibility is key
We’re also keeping up to date with all of the changes to the conventions and standards and adjusting and developing our software solution as and when required.
For example, since the SONIA conventions were published in the summer we have been working through the nuances of the differences in the calculations with our clients to prioritize our development roadmap. These nuances include the different approaches to the NCCR calculation, along with the observation period shift, which is one of the alternate options.
There has also been lots of discussion around the concept of the spread adjustment, which was originally anticipated to be used only for legacy credit agreements. Essentially, the spread adjustment is meant to even out the alternative reference base rate with where LIBOR used to be, so there’s a level playing field for pricing credit agreements that pre-date the initial plans for the end of LIBOR.
However, it’s now become clear that the spread adjustments may have a longer life cycle than originally intended for new credit agreements. It’s likely there will be a dynamic period of early opt-in, after which they will either be fixed for a set period of time from the end of 2021 or subject to a new set of dynamic parameters.
This is understandably a cause of concern for institutions from an operational perspective as they need to manage the spread adjustments both during the initial interim, dynamic period and then post LIBOR cessation.
To help our clients achieve the necessary operational efficiencies, one of our major objectives is therefore to deliver a solution within Fusion Loan IQ that will be able to support both the interim and long-term elements of the spread adjustment. Watch this space.