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Alternative Risk-Free-Rates are Coming. Are you Ready?

Tushar Chitra
Vice President, Product Strategy & Marketing, Oracle Financial Services

By Tushar Chitra, Vice President – Product Strategy & Marketing, Oracle Financial Services and, Venkatramana Bhat  Senior  Principal Product Manager, Oracle Financial Services

Since 1986, the London Interbank Offered Rate (LIBOR) has been the most widely used interest rate benchmark across many loans, derivatives, deposits, bonds, securitizations, and other financial transactions, as well as for banks’ funding and capital needs. LIBOR is published across a range of currencies (GBP, USD, EUR, JPY, and CHF) and underpins contracts worth over $350 trillion across the globe.

It’s been discussed, deliberated, and debated; however, the future of LIBOR is not guaranteed. The UK Financial Conduct Authority (FCA) has no plans to compel banks to submit the rates required to calculate LIBOR after the end of 2021. Are you ready to start transitioning away from LIBOR to new alternative risk-free rates (RFRs)?  Regulators have not come up with a checklist of actions banks must take, nor prescribed specific measures or technologies that banks must have in place. It is up to banks to decide how they want to move forward.

Transitioning Away from LIBOR – the Impact          

The transition from LIBOR will not be simple.  It’s not just swapping one interest rate for another. It creates significant operational, accounting, and pricing implications, and will involve updating IT systems/operational processes and changes to contractual documentation.

Here is a view of the impact the LIBOR transition could have:

1. Increased need to include fall-back provisions in contractual documentation: As many LIBOR-based contracts extend beyond 2021, banks should move to use fall-back language that explicitly considers the permanent cessation of LIBOR and contractual provisions that specify the replacement rate, trigger events for a transition to a replacement rate, and the spread adjustment

2. Dealing with time zone challenges: Risk-free rates are published at different times around the globe, whereas LIBOR publishes at 11:00 GMT across five currencies.

3. The crossover between different calculation methodologies: LIBOR is a forward-looking term rate (usually T-2 basis) which comes in various maturities, including overnight, 1-week, 1-month, 2-months, 3-months, 6-months, and 12-months whereas the proposed alternative rates are mostly backward-looking overnight rates (T+1 basis). Besides, some of the alternative risk-free rates are secure and do not bear a credit spread. Hence, the need to add a Credit Spread Adjustment to the risk-free rate and margin.

4. Addition of new IT capabilities not found in existing systems: There will be a need for IT systems that can manage compounding calculation, credit spread adjustment, suspension/lockout period and, day lookback, amongst others.

The New Benchmark

It is clear. There will no longer be a global benchmark rate after LIBOR.  With no obvious alternative, there is considerable work being done across countries to develop their benchmarks. International alternatives to LIBOR across major currencies are:

  1. Sterling Overnight Indexed Average rate (SONIA), a backward-looking overnight rate based on actual transactions that have taken place the day before, is already widely used in the UK.
  1. The US is likely to use the Secured Overnight Financing Rate (SOFR), which is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight.
  1. The EU has set out its plans for the adoption of the Euro Short-Term rate (€STR) that reflects the wholesale euro unsecured overnight borrowing costs of banks located in the euro area
  1. The Swiss market has introduced (Swiss Average Rate Overnight (SARON), an overnight reference rate based on data from the Swiss franc repo market.
  1. Japan is expected to move towards Tokyo Overnight Average Rate (TONAR), a transaction-based overnight interest rate that is unsecured.

Be Future-Ready and Outpace Change

As a leading provider of loan and lending solutions, Oracle is committed to not only facilitate a smooth transition but also turn it into an opportunity for our customers and prospects.

Oracle solutions come packaged with a robust set of built-in rate pick up methods and approaches to compounding to ensure your bank is future-ready for multiple risk-free rates, once they come into effect. We have invested significant research and development efforts in configurability and parameterization options, including flexible interest rule definition and back value dated computation.

Oracle has developed a flexible interest calculation engine that offers a great variety of interest calculation methods across various product processors.  If any product processor requires interest rate or computed interest amount, it is provided by this interest calculation engine on receipt of appropriate parameters. These capabilities span the broader module portfolio, including Corporate Deposits, Money Market, Lending, and Syndication.

With a centralized engine, you can maintain various interest rates, set parameters around holiday handling, choose the rate to pick up the method you need, and calculate interest amount for several different scenarios. The advanced interest calculation engine supports compounded-in-arrears term rate based on rate pick up using look back and payment delay methods, with the option of using the last reset and last recent value. Besides, you can set up a lockout/ suspension period along with interest rollover/principal adjustment.

Accelerate your Path to Alternative Risk-Free-Rates with Oracle

With the deadline for transition closing in, it might be tempting to implement a short-term measure quickly. While the sense of urgency is warranted, a measured and strategic action with long term focus is the best course to take. The path towards new risk-free rates requires a coordinated strategy that engages different organizational entities (including legal to create new contracts, relationship managers to oversee the new agreements, IT for the migration to the new rates, and others).  Organizations should therefore have a clear strategy and action plan to address the transition requirements with the end of the 2021 deadline in mind.

So that’s a lot to do. But let’s look on the bright side. Some banks view this as a once-in-a-generation chance to truly take a look at their loans and lending software applications and transform it according to best practices. So if there’s any application you’ve had your eye on previously, now’s your chance to kick start your move into the next- generation digital-native lending platform. 

Based on vast experience and technological capabilities, Oracle is committed to providing customers with a strategy designed to help them make a smooth transition away from LIBOR. To learn more about how Oracle can help, please contact your local sales representative and visit oracle.com/banking.            

My colleague Venkat and I co-authored this blog. We would love to hear your views. You can reach out to us via our emails at venkat.bhat@oracle.com or tushar.chitra@oracle.com.   

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Contact us:
Email: financialservices_ww@oracle.com    
Email: Tushar Chitra: tushar.chitra@oracle.com
Email: Venkatramana Bhat: venkat.bhat@oracle.com

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