LIBOR Reform

The London Interbank Offered Rate (LIBOR) is the benchmark rate produced for CHF, EUR, GBP, JPY and USD and has seven maturities quoted for each ranging from overnight to 12 months. It is arguably one of the most important numbers to the financial markets due to the fact that they are extensively referenced in derivative, bond and loan documentation. It is reported that there are over $350 trillion worth of LIBOR referencing financial products.

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Latest News and Important updates

The latest updates and news regarding the IBOR Reform

10-Dec-2018 - ISDA Publishes 2018 Benchmarks Supplement Protocol

On 10th December 2018, the International Swaps and Derivatives Association, Inc. (ISDA) published the ISDA 2018 Benchmarks Supplement Protocol, intended to help market participants incorporate the ISDA Benchmarks Supplement into their interest rate, FX, equity and commodity derivatives transactions.

Click here to read the protocol

7-Dec-2018 - Draft Libor Transition Language Released for Business Loans, Securitizations

On 7th December 2018, the Alternative Reference Rates Committee  issued consultations on draft fallback language for bilateral business loans and securitizations that reference the U.S. dollar London Interbank Offer Rate. With Libor’s future beyond 2021 uncertain, the ARRC — a group of private-sector market participants and public agencies convened by the Federal Reserve — is developing plans to facilitate the transition to its recommended alternative rate, the Secured Overnight Financing Rate.

Nov-2018 - Consultation on Term SONIA Reference Rates – Summary of Responses

The Working Group on Sterling Risk-Free Reference Rates (RFRWG) issued a consultation on forward-looking Term Sonia Reference Rates (TSRR) on 17 July 2018. The consultation ran until 26 October 2018 and attracted 45 responses from a wide variety of market participants.

To view the entire results, click here

27-Nov-2018 ISDA Published Preliminary Results of Benchmark Consultation

The International Swaps and Derivatives Association, Inc. (ISDA) has today published a statement summarizing the preliminary results of a consultation on technical issues related to new benchmark fallbacks for derivatives contracts that reference certain interbank offered rates (IBORs).

To view more news and updates about the IBOR Reform

To view more updates from Working Groups and other relevant articles please click here...

What you need to know

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is a series of benchmark interest rates at which banks offer to lend funds to one another in the international interbank market. It reflects how much it costs banks to borrow from one another and is used as the reference rate for around $350 trillion in financial products.

Why is LIBOR being replaced?

LIBOR fixings are intended to represent the interest rate charged on short-term (unsecured) loans made between banks. Since the financial crisis, the volume of these transactions has dramatically diminished leading regulators to question their transaction-based definition. Historically, LIBOR has been used as a measure of trust within the financial system as it reflects the confidence banks have in each other's financial health. However, the recent manipulation scandal has led many to question the validity of these benchmarks and whether it truly serves the intended purpose. Furthermore, strict regulations, brought in since the GFC, have inadvertently reduced the liquidity within the interbank funding market further compounding the lack of transparency of the reported rates.

In the absence of robust transactional data to base LIBOR consensus on, individual submissions have become a subjective and unclear process requiring "expert" judgment by each contributing bank. Consequently, there has been an observable downwards trend in rate submitters willing to sustain the various benchmarks, due to their sensitivities towards perceived litigation risks.

Following the Wheatley review into LIBOR, the FSB and various other industry bodies have been spearheading collaborative initiatives to strengthen or reform the LIBOR processes.

When will the transition take place?

The transition to new RFRs is fluid and led by the market. In 2013, the FCA recommended the replacement of LIBOR with alternative RFRs. Subsequently, the FSB published its report on interest rate benchmark reform in July 2014 and concluded that an RFR is in many cases are more suitable than a LIBOR which is not supported by sufficient transactional data to make it robust. In July 2017, Andrew Bailey announced that the FCA had reached a voluntary agreement between current panel banks to sustain LIBOR in its current form until the end of 2021. As LIBOR will not be banned post-2021, it is possible that it will continue to be published, but in more recent speeches both ISDA and the FCA have been pushing the industry to migrate away from reliance upon the rate.

What is the industry doing to replace LIBOR?

Working groups have been set up, in multiple jurisdictions, to bring together representatives from both the public and private sectors to determine the most appropriate RFRs in the relevant jurisdictions. Four of the working groups, the UK, US, Switzerland and Japan have already identified their preferred RFRs, which are SONIA, SOFR, SARON and TONAR respectively. This represents four of the five currencies for which LIBOR is currently published. For EUR the decision on a preferred RFR has yet to be made.

ISDA is leading the work on implementing fallback rate documentation. In 2018, ISDA published a consultation seeking the views of participants on a number of possible adjusted RFRs and Spread Adjustments to ensure the least value transfer upon the event of LIBOR ceasing to exist.

Challenges to overcome for a successful transition

Challenges

Comments

Market Adoption of RFRs and Liquidity

It should be a prerequisite that the alternative RFR market is sufficiently liquid prior to adoption as a benchmark reference rate. This can be achieved by dedicating resources and educating all market participants about RFRs. Exchanges and Central Counterparties (CCPs) can also play their part by listing and clearing standardized products that reference alternative RFRs.

Selection of an overnight rate as an RFR would remove any IBOR-OIS basis risks currently seen in collateralized trades. It is unclear whether the collateral remuneration rates will be standardized to the jurisdiction’s chosen RFR.

Legal

Inconsistent approaches exist when it comes to fallback rates in the documentation of legacy transactions referencing IBORs. These documents need to be reviewed and segmented accordingly.

Other contractual amendments, which may lead to an increased upfront cost and increased operational risks must be considered when transitioning from IBORs to RFRs. This is will be made more difficult when counterparties have diverging incentives.

Valuation Risk and Management

Mechanisms need to be established to minimize value transfer between entities with respect to legacy transactions.

For less effective hedges, the transition to RFRs may not occur at the same time or on the same terms for both the underlying asset/liability and the corresponding hedge(s).

It is worth noting that IBORs provide market participants certainty because they are fixed in advance, meanwhile RFRs by design can only be determined at the end of the period (i.e., in arrears).

Infrastructure

Once definitive RFRs have been chosen and there is a clear jurisdictional transition plan, institutions must perform broad risk assessments to identify whether their infrastructure is adequate to support an RFR environment.

Market participants may have to make significant investments to meet these operational requirements.

Tax

Market participants must consider whether alternative RFR transition would result in an acceleration of payments on financial contracts or tax structures.

Accounting

A switch to alternative RFRs may lead financial instruments and their corresponding hedges to be booked separately in the event that IBOR and RFR are not effectively offset. This may result in net income volatility and growing balance sheets if not managed in proactively.

Institutions utilizing accrual accounting under International Financial Reporting Standards (IFRS) may crystallize profit or loss upon RFR conversion. Maintaining hedge accounting relationships would require significant work. Furthermore, an inconsistent adoption of a new RFR could cause an economic mismatch and a broken hedge.

Governance and Controls

Once definitive RFRs have been chosen and there is a clear jurisdictional transition plan, institutions must establish robust governance and controls when transitioning their contracts from IBORs to alternative RFRs.

Regulatory

Existing regulatory requirements may add unnecessary burdens to the alternative RFRs transitions. For example, existing margining rules may be triggered for existing derivative transactions if they are transitioned to an alternative RFR.

Regulators need to explore the possibility of implementing exemptions to the clearing mandate for legacy contracts.

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Our Publications

Solum Financial’s IBOR Reform Whitepaper

Since its first official publication in 1986, the BBA LIBOR fixing and other related IBORs have helped contribute to the exponential growth of the derivatives market. Alongside cash-based products that also reference IBORs, the total outstanding is estimated to run in hundreds of trillions of dollars. IBORs are therefore pervasive in financial markets and their replacement with new regulatory approved reference rates is a monumental undertaking.

Solum Financial formulates this white paper to provide the reader with an overview of key developments that have shaped the IBOR reform debate; current collaborative initiatives being undertaken by industry bodies, regulators and key market participants; the challenges they face and the current status of these reforms.