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5/13/19 - IBOR Transition: Managing Conduct Risks

Global financial markets face a major shift as alternative reference rates (ARRs) will replace today’s dominant interest rate benchmarks in 2022. As the transition moves ahead, managing the conduct risk, the risk that customers affected by the transition will be treated unfairly, is emerging as a major challenge for financial institutions.

The transition from interbank offered rates to ARRs is expected to affect an estimated $36 trillion1 worth of financial products maturing beyond 2021. These products, comprised mainly of derivatives, debt, and cash-instruments, will require transfer to alternative rates through changes to their contractual provisions, which can have significant impacts on customers. To date, most firms have been sizing up the scale and their exposures to the transition, including legacy contracts that are affected. Many firms are also working to understand the changes required to key internal processes and controls, such as product governance, pricing curves, risk models, and valuation tools.

Now, there is a noticeable industry shift that is recognising the need to manage conduct risks arising from the transition. Such risks will only partly be mitigated through the agreement of new ARRs and fall-back language in contracts; if not managed carefully, firms could be facing very substantial remediation costs.

Regulators and other authorities have a material role to play in enabling the global industry’s smooth transition. However, it is unlikely that they will allow the industry to simply take a wait and see approach given the systemic risks that are likely to arise if the transition proves to be a rough ride.

Firms can expect regulators to be judging whether they are taking the right steps on transition-related conduct risks. In the U.K., for example, the Financial Conduct Authority has highlighted the transition away from the London Interbank Offered Rate as a key priority area within its 2019/2020 business plan. As part of this, the FCA will likely be reviewing whether firms have developed their assessments and plans to manage conduct risks. This approach is consistent with last year’s “Dear CEO” letter requiring firms to undertake an assessment of key risks.

What Types of Conduct Risks Arise from the Transition, and Why Are They Challenging to Manage?

As firms transition from IBORs, their exposure to conduct risk will arise from the three major parts of the transition:

  1. Changes to existing/legacy contracts linked to IBORs
  2. Continued activity in IBOR-linked transactions during the transition
  3. Undertaking new transactions in ARR-linked products

The specific conduct risks differ considerably depending on the three factors above, the client type, and product type. In essence, however, the major risk that needs to be managed is that because the features, risk profiles, and payment profiles of transactions will change, there will likely be winners and losers as a result of transitioning IBOR-based transactions, if those transactions are live post-transition (known in technical terms as “value transfer”).

Despite this uncertainty, certain actions can be taken or planned to manage conduct risks. Regulators will expect firms to be taking reasonable steps. A transition conduct risk assessment, taking into account the different product types and customer segments the firm deals with, will allow firms to set out their policy to help address the risks and formalise their immediate and near-term actions.

The industry is working to agree on how best to tackle the contractual changes required during the transition and beyond, but this alone won’t mitigate the risk of customers’ substantial future claims and complaints if they feel they have experienced loss or misselling.

Managing this conduct risk is complex because it is difficult to assess at any point which party to a transaction will be better or worse off post-transition, as the way transactions will be priced at any point is likely to differ from an IBOR-based product, and further, could involve complex cross-currency challenges. The precise timing of the transition is not certain, the fall-back rates and contractual change processes haven’t been agreed to, and there are still some critical accounting, tax, and regulatory safe harbours that relevant authorities need to confirm before transition can occur. This is why a conduct risk management mechanism – which could be communicated with customers – is difficult to produce as it is not entirely clear what to communicate.

Changes to Existing/Legacy Contracts Linked to IBORs

For existing contracts that refer to any IBORs that mature beyond the transition date, the product features, risk profiles, and payment profiles will change. The contracts will need to be amended, and clients will need to be supported to understand what the change means for them. This effort involves adopting customised approaches to different client groups and product classes, and some client types and products will pose greater challenges than others.

Identifying Affected Clients and Products

Within the transition conduct risk assessment, it is critical to identify potentially affected customers and products. Classification of customers into groups will assist in developing an appropriate approach for different cohorts of affected customer segments. Some higher-risk or challenging customer groups will include vulnerable customers, trusts, and small corporates.  Complex transactions will include mortgages, syndicated loans, derivatives that potentially become imperfect hedges, and transactions where floating payments potentially become fixed.

Leading industry bodies are offering guidance related to impacted product classes, which firms should consider. For derivatives, the International Swaps and Derivatives Association (ISDA) is set to issue transition guidance, as well as the Loans Market Association (LMA) and the International Capital Market Association (ICMA) on debt and cash products respectively.

Negotiating Contractual Fall-Back Covenants

Some key conduct risks will arise when negotiating the fall-back provisions within legacy contracts. Shifting to ARRs will likely result in valuation changes that may pose material risk to consumers whose future payment projections would have to be recalculated. This may have adverse effects on clients’ future cashflows and violate their expectations of the products they were sold. There is an open question as to who will foot the bill when a payment is less than it was expected under the IBOR (the value transfer).  

Some firms have thus far held the view that amending or adding to legacy derivatives contracts will not be much of an issue, and that contracts in bonds and loans will pose the highest operational, legal, and conduct risks. Yet even derivative contract changes, as they are likely to be performed through the agreement of additional ISDA protocols, will be a mammoth task. It will lead to bilateral negotiations and considerations of related products held by clients that may have different future fall-back arrangements (e.g. a derivative being used to hedge a loan).

Dealing with Complex Cases

Firms should be prepared for cases in which changes to contracts are resisted or where clients choose to break their contract.

In the wholesale market, counterparties may opt for, or be required to, terminate existing derivatives contracts. Clients that have existing swaps positions with a significant remaining term until they expire may determine that a change in benchmark will reduce their future cashflows from the swap and no longer provide a suitable hedge. They may therefore seek to break the contract rather than accept an amendment. The fairness of the costs to break a contract in such a scenario, and which party would absorb said costs, are likely to be debated.

In cases where instruments are held by trustees, say of a pension fund, complications may arise where the entities have limited ability to change contract provisions. In other scenarios, firms may have to renegotiate contracts that require the consent of a majority of investors, which depending on the size and complexity of the instrument may prove to be an extensive task.

Continued Activity in IBOR-Linked Transactions During the Transition

ARRs such as the U.K.’s Sterling Overnight Interbank Average Rate (SONIA) or the U.S. Secured Overnight Financing Rate (SOFR) are gradually replacing IBOR instruments in financial markets. Firms, however, continue to issue IBOR-linked instruments, giving rise to conduct risks associated with existing/legacy contracts described above if the transactions mature post-2021.

Firms will need to consider when they can begin to add appropriate fall-back language. Existing standard provisions do not account for a permanent benchmark rate’s unavailability, instead referring to a temporary fixed rate. Yet as IBORs are set to be discontinued indefinitely, floating rate instruments could effectively revert to a fixed rate, changing their expected value and return. Failure to deal with such a scenario increases the risk that clients claim to have been mis-sold products given firms were aware that IBOR transition will take place.

The transition conduct risk assessment should also take into account the risk that where legacy or new transactions linked to an IBOR extend beyond the transition date, valuation disputes could arise if calculation models are not updated and aligned post transition.

Undertaking New Transactions in ARR-linked Products

The features, risk profile, payment profile, and pricing of products will change post transition. From a conduct risk perspective this will drive the need to make changes to sales and marketing materials, and product governance and new product controls will need to be applied to the revised product suite.

Given that the ARR market is in the process of growth and that trading in related instruments is not yet established with significant volume, clients may consider the financial reality of these instruments to be incompatible with their cashflow forecasts and price expectations. Volatile rates and/or financial detriment from basis risk is likely.

Different firms have considered the risks noted above to varying degrees, and in terms of new business, some are giving serious consideration to halting any new lending business where the maturity extends beyond 2021.

How Firms Should Approach Conduct Risk in IBOR Transitioning

The Transition Conduct Risk Assessment

Firms’ plans to manage the conduct risks should be based on an initial assessment of the risks specifically related to the transition. This should take into account different client segments and product types, as they will all carry different conduct risks, and consider the different potential outcomes for firms and customers during the transition period and beyond. Firms operating in various currencies and across different jurisdictions likely will need to incorporate l future plans for different IBORs in different currencies and customer/jurisdiction risks.

As IBOR discontinuation nears, firms’ exposures to conduct risks will increase. Despite lack of further regulatory guidance or safe harbours, firms should be undertaking this detailed risk assessment now. Proper mitigation of conduct risk remains high on regulators’ priorities for this year, and firms need to be ready to show evidence of action.

Transition Policy

From the transition conduct risk assessment, firms will be able to identify key areas where they need to agree on a policy relating to the transition, and specify areas where they need to take a wait and see stance with clear and appropriate justification. A number of complex scenarios are likely to be considered as firms approach their conduct risk policy. This policy will continue to develop over the course of the transition period as industry practices and guidance emerge. It will be important to use this process to manage expected regulatory scrutiny.

Some key areas and scenarios to be considered in the policy formation will include:

  • How should the differences and impacts of the transition from IBORs to ARRs as well as fall-back provisions be explained to different types of customers?
  • How can risks, features, payment and price changes be communicated transparently without it appearing to be advice?
  • What actions should be taken if a customer wishes to roll over an existing contract, which will extend the maturity past the expected IBOR discontinuation date?
  • What is the firm’s policy where customers require a change in product as a result of the transition?
  • How will customer complaints be handled and appropriately addressed?
  • How will the firm handle non-responsive clients to contract negotiations?
  • What should/can be communicated to different stakeholders at different periods of time during the transition?

Communicating with Customers

One of the key transition conduct risks is information asymmetry – firms possessing greater knowledge on the nature and effects of the transition vis-à-vis their customers. Retail and smaller corporate customers in particular will require attention, and they are less likely to understand financial products and how benchmarks impact price. Geographical location and language comprehension will also affect the level of information asymmetry.
Firms will need to develop a communications strategy that is applied across the transition period. The transition conduct risk assessment will help firms devise such a communications strategy that is aligned to policy decisions being made. It should include a proactive outreach strategy for clients, external and internal stakeholders, as well as a comprehensive approach to reacting to questions and challenges.

Ensuring the content is both clear and factual will be complicated but critical to reducing the conduct risk of providing clients with vague, misleading, or false information. Although the industry is moving toward consistent fall-back language for different types of contracts, unsophisticated clients require far simpler explanations of legalese.

Firms should be thinking about how to prepare their sales and other client relationship teams for discussions with clients. Adequate staffing will also need to be in place for teams dedicated to customer contact or client management. Not surprisingly, leading firms have engaged their communications departments already.

How We Can Help

Given the size of the existing global book of business that will still be based on IBORs post-2021, the key emerging concern is how to manage the related conduct risks. Promontory is uniquely placed to perform transition conduct risk assessments that will inform the ongoing development of a firm’s policy and actions needed to manage this risk over the transition’s course.

Contact Us

Munib Ali
Managing Director
+44 203 900 9803

Anthony Murphy
Managing Director
+1 212 542 6713

Gregory Rossi
+44 203 900 9893

Winn Faria
Senior Principal
+44 203 900 9889


  1. U.S. Department of the Treasury, pg. 3, (Oct. 22, 2018).
  2. FCA sets out its priorities for 2019/20,” Financial Conduct Authority, (April 17, 2019).
  3. David Rule, Megan Butler, and Jonathan Davidson, “Dear CEO,” Bank of England, Prudential Regulation Authority (Sept. 19, 2018).