Once known as the world’s most-important number, London Interbank-Offered Rate (LIBOR) has become something of a fading star in recent years. The impact of the high-profile rigging scandal of 2012 continues to resound, but it’s the lack of underlying activity in the wholesale funding market that’s proved to be the final death knell for LIBOR and other interbank-offered rates (IBORs).
Replacing LIBOR is an inherently complex task. Originally applied to the eurocurrency market, LIBOR’s remit has expanded significantly, and it has become a key factor in pricing across the derivatives market, among others. Replacing the benchmark requires a review of all exposures and contracts, a rethink around pricing and hedging, and operational changes to key processes and systems.
To highlight the scale of the issue, around USD 350 trillion in financial instruments use LIBOR as a reference rate and it has become so deeply ingrained in the financial system that just identifying the affected contracts and instruments is a challenge.
With the LIBOR end date looming, the transition process requires careful oversight, risk management and assurance to stay on track. As a key feature on many 2021 audit plans, let's look at some of the key areas for review:
For heads of internal audit, offering assurance over these activities is no mean feat.
LIBOR’s broad remit affects multiple business units, and the transition has risk implications for HM Treasury (HMT), finance function, operations and technology, to name a few.
Effective assurance over governance and risk management is key to achieving a smooth transition, within the relatively short timeframe remaining across the business. This includes assessing output from working committees, setting appropriate key performance indicators (KPIs) and reviewing ongoing progress against them.
Effective training at every level, combined with good governance can also help to mitigate potential conduct risks.
Conduct risk and the risk of mis-selling are most likely to materialise in the front office. Good training for all front-office teams and transparency over pricing practices will help to reduce the risks.
Reviewing the appropriateness of alternative rates, and how these to the client, is crucial for treating customers fairly.
Assessing product development, pricing and client services will support best practice and promote good conduct.
Reviewing existing systems and processes will make sure all reference data is up to date, that booking systems include the new reference rates, and key dates have been set to review the transaction lifecycle.
Effective assurance over development, monitoring and validation processes will reduce model risk.
Assessing how that risk-management data is captured will support regulatory compliance and improve reporting processes.
Reviewing position risk control and discounting processes will also help manage risk in the long term.
Monitoring the potential impact on HMT will include reviewing securities, hedging strategies and how the transition will affect liquidity.
Assessing funds-transfer pricing (FTP) will offer assurance over the profitability or viability of products.
The LIBOR transition will impact valuations, and hedging strategies and effectiveness, with the potential for greater profit and loss volatility.
Reviewing existing models with this in mind will offer greater peace of mind for the board and senior management.
Reducing legal and compliance risk relies on robust review at every stage in the process.
Contract repapering, including back-book products, is a big task that will require additional skilled resources. Overstretched resources could lead to heightened conduct risk, unfair treatment of customers and legal risk.
Machine learning and artificial intelligence can help to update contracts.
Gaining assurance over their usage is critical to appropriately identify and update all exposures.
Similarly, where firms introduce new systems for ongoing use, it's important to establish a smooth transition – and one that promotes operational resilience.
Internal audit has a crucial role to play and ongoing assurance can identify emerging risks and interdependencies, while driving the programme forward. The deep-rooted nature of LIBOR means it affects a wide range of business processes, making it complex to replace and requiring significant oversight from internal audit.
Contact Paul Young for further information on what the LIBOR transition means for internal audit.