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.
Latest News and Important updates
The latest updates and news regarding the IBOR Reform
June-2019 - Feedback on the Dear CEO letter on LIBOR Reform
In September 2018, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) wrote to CEOs of major banks and insurers supervised in the UK asking for details of the preparations and actions they are taking to manage the transition from LIBOR to alternative interest rate benchmarks.
This document covers 8 key findings along with Further Supporting Information from the responses on each finding.
16-May-2019 - ISDA Publishes two Consultations on Benchmark Fallbacks
The International Swaps and Derivatives Association, Inc. (ISDA) has launched two new consultations on benchmark fallbacks – one covering adjustments that would apply to fallback rates in the event certain interbank offered rates (IBORs) are permanently discontinued, and another relating to pre-cessation issues for LIBOR and certain other IBORs.
25-April-2019 - ARRC Releases Recommended Fallback Language for FRNs and Syndicated Loans
11 April 2019 - ISDA Letter to the FSB OSSG - Update on Fallbacks for Derivatives
This week, ISDA wrote a letter to the co-chairs of the FSB Official Sector Steering Group (OSSG) to update them on ISDA’s work to implement fallbacks for derivative contracts referencing key interest rate benchmarks. ISDA undertook this work in 2016 at the request of the FSB OSSG and expects the fallbacks to take effect in early 2020.
The letter is available on the ISDA website.
10 April 2019 - Randal K Quarles: Progress on the transition to risk-free rates
Speech by Mr Randal K Quarles, Vice Chairman for SUpervision of the Board of Governors of the Federal Reserve System, at the Financial Stability Board Roundtable on Reforming Major Interest Rate Benchmarks, Washington DC.
Read the speech here.
March 19 - The Sterling RFR Working Group has published a discussion paper on Conventions for Referencing SONIA in New Contracts
To view more news and updates about the IBOR Reform
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
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.
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).
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.
Market participants must consider whether alternative RFR transition would result in an acceleration of payments on financial contracts or tax structures.
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.
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.
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.