7 minute read 23 Apr. 2019

Five insights for Canadian executives on IBOR reform

EY Canada
By EY Canada

Multidisciplinary professional services organization

7 minute read 23 Apr. 2019
Related topics IBOR Insurance
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The future of IBORs is in doubt, but reform efforts are underway globally and in Canada.

Interbank Offered Rates (IBORs) is the global benchmark for variable rate financial instruments. However, there has been concern about systemic risk and decline in interbank liquidity, as well as manipulation scandals and the reluctance of panel banks to submit quotes. The result is a coordinated approach to reform IBOR and reinstate confidence in the reliability and robustness of system rates by transitioning to Alternative Reference Rates (ARRs) by the end of 2021.

Regulators and industry groups have undertaken an intense, carefully coordinated global push for firms to recognize the pressing circumstances surrounding IBORs, and to speed up efforts to phase out products referencing IBORs.

Current progress made in the development of fallback provisions and market efforts to build liquidity for products referencing the ARRs are good examples of the pace in preparation for the transition.

Here are five insights for Canadian finance executives about IBOR reform in Canada.
 

1. Developing the Canadian Alternative Reference Rate

The Canadian Alternative Reference Rate Working Group (CARR) has collaborated with various global IBOR transition working groups, while focusing on the unique aspects of the Canadian market. The CARR was established to identify and develop a Canadian dollar term risk-free rate benchmark. In 2018, the working group finalized its recommendation to propose an enhanced Canadian overnight repo rate average (CORRA) as the Canadian overnight risk-free rate benchmark.

Like other jurisdictions, Canada is working to develop ARRs, including both overnight and term. As a multi-rate jurisdiction; the new term ARR would act as a complementary reference rate for the Canadian market and would operate alongside the Canadian dollar offered rate (CDOR).

2. Enhancing overnight repo rate average

Enhanced CORRA is similar to current CORRA in that it’s an overnight rate for repo transactions secured with Government of Canada securities. Enhanced CORRA will include transactions beyond just the inter-dealer market, which significantly increases the volume of transactions and makes the rate more robust.

In the expanded market, there are certain transactions, known as “specials,” where a lender tries to source a specific security and offers lending rates below typical funding rates. Since these transactions do not meet the general collateral funding criterion, the enhanced CORRA calculation methodology attempts to exclude them. The methodology to exclude these specials is similar to the approach used by the US Federal Reserve’s secured overnight financing rate (SOFR), whereby it removes transactions with rates below the 25th volume-weighted percentile rate.

3. Focusing on term structure, liquidity and credit spread

The Canadian market continues to closely follow the IBOR transition developments globally, especially in the US and UK as they are much further along. In those markets, the focus is on developing the required term structure, liquidity surrounding ARRs and related credit spread, as well as minimizing the potential value transfer on transition.

Term structure: Though there has been no final decision on the methodology in the Canadian market as of the time of writing, there are two common methods for developing the term structure: compounded setting in arrears rate and forward-looking term rate. Both methods require a robust governance framework and transparency on its generation, a high enough volume and liquidity to promote reliability, and an ongoing ability to meet these conditions.

Liquidity: To develop the new term ARR, the volume of transactions referencing the enhanced CORRA must be large enough to be a truly liquid market. The scope of products referring to enhanced CORRA should expand to include futures markets, derivatives, clearing house settlements, debt issuances, and other cash products. This will require industry-wide collaboration.

Credit spread: The existing IBORs have an inherent credit component, while the ARRs are nearly risk-free. For smooth transition from IBORs to the ARRs, it’s necessary to develop and apply a credit spread adjustment to the ARR to keep a level of consistency upon transition. In Canada, there is no plan in place at this time to decommission CDOR, resulting in uncertainty as to how much focus the credit spread will receive.

Value transfer: If CDOR is no longer published, depending on which methods are employed for the term rates and credit spreads, there will inevitably be asymmetry between the fair value of the product under the existing and new rates. As a result, there will be a certain amount of value transfer on transition to the new ARR between the counterparties. It will be important for the market to understand what is driving this value transfer, how to price the new instrument to minimize this amount, and what tax implications for any cash payments could arise.

How EY can help

IBOR transition services

EY helps global institutions prepare for the imminent transition away from Interbank Offered Rates (IBORs) to Alternate Reference Rates (ARRs). We also play a leading role in supporting regulators, trade associations and others to increase awareness and education.

Read more

4. Current status in Canada

The current focus in the Canadian market is to establish enhanced CORRA as the preferred benchmark. The CARR is delaying further consultations pending the results of the consultations on enhanced CORRA currently underway.

A second step for the Canadian market is the development of fallback language. In January 2019, CARR published its Principles for Enhancements to Fallback Language for cash products. These

principles focused on the need for fairness and consistency across the market as well as transparency in any calculations or triggers.

A third step for the Canadian market is the development of term and alignment on how they should be calculated. There are different possible calculation approaches, but there has been no market consensus so far. This is a key area for CARR in its 2019 work plan.
 

5. Preparing financial institutions for the transition

Canadian participants will most likely be impacted by the IBOR transition areas where they currently have the largest exposures, such as USD LIBOR, GBP LIBOR and CDOR. Financial institutions should start developing a view of where the major IBORs are used or referenced in their organizations.

An impact assessment should include the following are four key areas:

  • Products: Complete assessment of product inventory and the impact of IBOR transition on this inventory by exposure type, maturity profile and product features.
  • Contracts: Identify impact on legal contracts to assess the potential need for base rate and fallback language amendment, re-pricing, re-papering and client outreach.
  • Valuation models: The impact of transition on enterprise‑wide valuation model inventory for both quantitative and qualitative impact, and how to leverage existing first- and second-line inventories and model evaluation criteria.
  • Operating model: Assessment of the impact of transition on core business line and enterprise-level processes, making use of existing process catalogue and defined impact assessment criteria. It should also include an adaptation of treasury-related systems, capturing market data and financial products.

Summary

The global regulatory community initiated IBOR reform to reinstate confidence in the reliability and robustness of benchmark rates by transitioning to alternative reference rates by the end of 2021. Global and Canadian efforts are aiming for a smooth transition, but there’s still much work to be done. 

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EY Canada
By EY Canada

Multidisciplinary professional services organization

Related topics IBOR Insurance
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