Risk management

Operational readiness and compliance requirements not appropriately identified

The wider impact of the transition, including operational issues and existing regulatory rules, can lead to delays

Changes to a corporation’s operating model are expected to be significant given the extent to which existing benchmark rates are likely to already be embedded in systems and processes. Corporations should identify and evaluate sectors where there are IBOR dependencies and likely complications when meeting regulatory changes, such as a lack of liquidity in new RFR or legacy IBOR benchmarks that may have an impact on the use of internal models to calculate regulatory capital requirements.

Ineffective industry action

Ineffective industry action that results from the lack of a regulatory or legislative mandate for the transition may lead to delays and possibly even sanctions

With a lack of regulatory or legislative mandates in place to support the transition, the responsibility for proactive engagement has been placed on the shoulders of market participants. Should corporations fail to engage, they may miss important market opportunities or face regulatory intervention, including sanctions, if authorities deem that they have failed to manage risks effectively or act in the best interests of their clients.

Hedging

Should the new RFR not be co-opted across all financial contract types, a mismatch may arise between a derivative and the underlying hedged exposure: for example, should a corporation issue variable rate debts linked to GBP LIBOR, which is then hedged using GBP LIBOR IRS. Where hedge accounting is adopted by corporations, this mismatch may also lead to a broken hedge and the requirement to make a variety of accounting entities, thus increasing volatility in the P&L as a result of interest basis differences.

It is imperative that companies undertake an impact assessment of their current economic and accounting hedges to better comprehend their potential exposure, raise awareness of the impact of the transition, and prioritise their next steps.

Systems, processes, and controls

Frontline employees lack training and awareness

Poor client service and unknown, unintended internal consequences may well result from a lack of employee awareness of the issues

Uncoordinated and ineffective training regarding new RFR products are likely to lead to conflicting messages from the differing business departments. Front line employees may furthermore promote products in a way that is not aligned to corporate strategy, or one business area may switch to an RFR without considering the implications for the wider corporation.

Debt finance

The raising of finance through the loan and bond markets is expected to be hugely impacted by the transition from the benchmark rate. Whilst the impact of the transition on these markets will be the same, the measures to address them may well differ.

Insufficient liquidity of RFR products

Insufficient RFR liquidity makes it difficult to build a yield curve and price products.

Companies may be unable to build a curve and price products effectively due to a lack of liquidity, giving rise to customer as well as counterparty complaints in the future and, in addition, to issues for the corporation itself in regards to appropriate hedging.

Conduct risks inappropriately managed

Information asymmetries, inadequate disclosures, and conflicts of interest give rise to conduct risk

Transitioning the reference rates for products may potentially lead to some losing out, with one party paying or receiving more or less than the other. Should the process not be managed appropriately, complaints by customers of unfair treatment will inevitably rise. This risk will only be heightened as corporations are likely to have a more in-depth insight than clients into the advantages and disadvantages of the transition.

Contractual language insufficiently vigorous

Reliance on existing fallback language gives rise to legal risk.

As the methodologies for calculating IBORs and RFRs differ, modifying legacy contracts in reference to RFRs could result in one party being financially advantaged over another. This will lead to a risk of contract frustration should provisions in standard-term legacy contracts, which will become unsuitable following the RFR adoption, not be updated to provide robust protection.

Tax issues arising from contract modifications

The transition of contracts to alternative RFRs may have tax ramifications should the implications of the amendments not be given due consideration

If considered of material importance, changes to existing contracts could constitute a disposal of the existing contract and an entrance into a new contract for corporate tax purposes in certain jurisdictions.