Swapping notes: Dealing with the move away from LIBOR

Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA) has signalled a move away from supporting LIBOR, a widely used interest rate benchmark, from 2021 With both LIBOR and whatever replaces it having an important influence on insurers’ asset and liability valuations, what are the key considerations for managing the transition?

The London Interbank Offered Rate (LIBOR) is the average of the interest rates that leading banks would be charged if they borrowed from each other. The benchmark is widely used as a reference for mortgage, credit card rates and interest rate swap contracts, both in the UK and other countries (LIBOR is calculated in a number of currencies). LIBOR underpins an estimated $350 trillion worth of financial contracts worldwide.

What are the key considerations for managing the transition away from LIBOR?

For insurers, LIBOR has a particular significance on the asset side as movements are reflected in the swaps used to manage and hedge interest rate risk, which are especially important within life insurance business. On the liability side, LIBOR is used by the European Insurance and Occupational Pensions Authority (EIOPA) to derive the risk free interest term structure for best estimate liabilities (BEL) and solvency capital ratio (SCR) calculations.

Following a series of manipulation scandals, the FCA has strengthened governance procedures for LIBOR submissions in recent years. However, the greatly reduced liquidity within the interbank lending market has raised questions over the validity of LIBOR as a viable benchmark. Drawing on recommendations from the Financial Stability Board (FSB), the FCA wants to move to a benchmark based on a larger volume of transactions performed at observable rates.

Main alternatives

So what’s likely to replace LIBOR for sterling transactions? The Bank of England’s working party has recommended a reformed version of the Sterling Overnight Index Average (SONIA). The Federal Reserve Bank of New York favours a broad treasury repo rate. Conceivably, LIBOR may still be used even if it isn’t supported by the FCA. However, both repo rates and a reformed SONIA have the advantage of being anchored in significantly more active markets than LIBOR.

Pros and cons: Asset implications

Depending how the swap contracts are worded and how the process of moving away from LIBOR is implemented, there may be winners and losers among existing holders of swaps. If the new swap rate is based on a reformed SONIA (which is typically lower than LIBOR), this could be beneficial to floating rate payers. Swaps could be consistently valued and priced if cash is posted as collateral. However, if Gilts are eligible as collateral, a mismatch would still exist unless the repo rates are adopted for the swap benchmark. However, we would eventually expect the reformed SONIA to be the basis used for the swap benchmark based on the recommendation of the Bank of England’s working party.

A key question is whether to move to a new benchmark ahead of 2021. Some swap agreements would need to be unwound before being replaced. Any benefits from moving to a new benchmark would therefore be offset by the transaction costs of setting up a new swap.

BEL adjustment: Liability implications

It’s important to assess how moving the risk free interest term structure could affect liabilities, though EIOPA hasn’t yet said when it will move away from using LIBOR, what will replace it or what kind of transitional arrangements it will adopt.

For liabilities covered by the matching adjustment, there would actually be little impact as the spread above the risk-free rate would be expected to adjust accordingly. However, for with-profits and non-life liabilities, where the matching adjustment can’t be applied, the liabilities are likely to rise if reformed SONIA is adopted, although this depends on EIOPA’s allowance for the LIBOR-SONIA basis and spread levels in the market. A lower discount rate would also lead to an increase in the risk margin.

Way forward

We expect most market participants to wait for more information from the FCA and EIOPA before responding. However, it’s important to keep a close eye on the changes and their implications and consider what actions you should take once the road ahead is clearer, rather than waiting until LIBOR is no longer supported.

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