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Transitioning from LIBOR: understanding the modalities

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Ajay Bhargava
Khaitan & Co, New Delhi
ajay.bhargava@khaitanco.com

Shivank Diddi
Khaitan & Co, New Delhi
shivank.diddi@khaitanco.com

 

Introduction

The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow from other banks’ wholesale unsecured funds. It is administered by ICE Benchmark Administration. LIBOR is currently produced in seven different maturities (or ‘tenors’): overnight/spot next, one week, one month, two months, three months, six months and 12 months. It operates across five currencies: pound sterling, US dollar, Swiss franc, yen, and euro. It is based on submissions provided by a panel of 20 banks. These submissions are intended to reflect the interest rate at which banks could borrow money on unsecured terms in wholesale markets. In 2017, both the Financial Conduct Authority (FCA) and the Bank of England’s Financial Policy Committee (FPC) noted that it had become increasingly apparent that the absence of active underlying markets and the scarcity of term unsecured deposit transactions raised serious questions about the future sustainability of the LIBOR benchmarks.

The end of 2021 will mark a milestone in global financial markets when regulators phase out the LIBOR benchmark which underpins much of the global financial system. With LIBOR being widely used in banking, capital markets, derivatives, asset finance, project development and finance contracts – and in many other contracts – its discontinuation is considered one of the biggest challenges ever to affect global financial markets.

What is the problem with LIBOR and why is transition difficult?

The reliability of LIBOR was doubted during the peak of the Global Financial Crisis when several banks participating in its calculation were blamed for manipulating the rate. This was followed by a withdrawal in the unsecured interbank lending market as a result of which the fate of LIBOR was put in question.

In 2014, the Financial Stability Board issued a report clarifying that benchmarks, for example, LIBOR, ought to be founded on actual transactions to the maximum possible extent. Consequently, certain amendments were made in the manner in which LIBOR was calculated in an attempt to recognise it on the basis of the transactions. However, owing to the fact that fewer banks are now lending to each other on an unsecured basis, LIBOR is usually determined by drawing an inference from ‘expert judgement’ by panel banks.

LIBOR is extensively used, of as a result of which there is a large outstanding value of the subsisting contracts. It is projected, for instance, that the contracts making reference to LIBOR (in US dollars) are valued at over US$200tn, with respect to derivatives while in relation to retail mortgage contracts they are valued at US$1.2tn. The majority of these are due to mature by the end of 2021. Contracts due to mature beyond 2021 would require to be revised by incorporating fallback provisions or transitioning to a new risk-free reference rate (RFR).

LIBOR submissions, in the absence of sufficient data, tend to rely on expert judgement, which increases the risk of benchmark manipulation. The panel banks have expressed uneasiness about presenting submissions dependent on judgements with minimal genuine borrowing activity against which to authenticate them and, as a result, the FCA has invested a great deal of energy in convincing panel banks to continue submitting to LIBOR.

Market-wide and cross-jurisdictional coordination may be restricted. Regulators desire the transition to be a market-motivated result. Consequently, differing market approaches could arise. For example, for progress to work, the ensuing (in addition to other things) ought to be set up: fallback language; a term structure for specific items; and answers for any hedging effects and hedge bookkeeping concerns. To achieve this, support and coordination are required between sector members, lawyers and accountants. Without coordination, the perils of change may increase.

RFRs are developed in a different way to LIBOR. They are potentially risk free, while LIBOR reflects apparent credit risk. Fixings for RFRs accordingly will in general be lower. This could imply that a market which transitions from LIBOR to an RFR has a varying market incentive/index over time than it would have otherwise had. As such, there may be gainers and losers. Valuation procedures ought to be re-examined. Liquidity in the market for RFRs is also likely to be a controlling element, from an early stage.

The new alternatives

Regulatory reform in relation to benchmarks has been ongoing for many years. Following the Wheatley Review of LIBOR in 2012 and the Financial Stability Board (FSB) 2014 report on Reforming Major Interest Rate Benchmarks, benchmark administrators (including ICE Benchmark Administration Ltd) have been working on strengthening existing benchmarks. Work has also been ongoing in the derivatives market as to the development of alternative rates.

The FSB’s Official Sector Steering Group (OSSG) coordinates international efforts on benchmark reform and the transition from LIBOR. The OSSG is co-chaired by the Governor of the Bank of England and the President and CEO of the Federal Reserve Bank of New York. In July 2016, the OSSG asked the International Swaps and Derivatives Association (ISDA) to lead work to enhance the robustness of derivatives contracts referencing widely-used benchmarks, such as LIBOR. ISDA has consulted on how best to calculate fair replacement rates for LIBOR in sterling, Swiss franc, yen and US dollar. These replacement rates are based on the RFRs recommended as alternatives to LIBOR by the relevant market-led working group for each jurisdiction, as follows:

 

Jurisdiction

Working group

Alternate reference rate

Administrator

United Kingdom

Working Group on Sterling Risk-Free Reference Rates

Sterling Overnight Index Average (SONIA)

Bank of England

United States

Alternative Reference Rates Committee

Secured Overnight Financing Rate (SOFR)

Federal Reserve Bank of New York

European Union

Working Group on Risk-Free Reference Rates for the Euro Area

Euro short-term rate

(€STR)

European Central Bank

Switzerland

The National Working Group on CHF Reference Rates

Swiss Average Rate Overnight (SARON

SIX Exchange

Japan

Study Group on Risk-Free Reference Rates

Tokyo Overnight Average Rate (TONAR)

Bank of Japan

 

In the sterling market, LIBOR-based products issued after the FCA’s announcement tend to contain more sophisticated fallback provisions. For such products, there has been a proliferation of risk factors in related prospectuses and other disclosure documents addressing uncertainty relating to various issues. These include: the consequence of failure to select an alternative rate; the ability of alternative rates to produce a comparable result; and whether the general increased regulatory scrutiny of LIBOR could increase the costs and risks of administering or otherwise participating in the setting of a LIBOR rate. The Sterling RFR Working Group recommended that legacy bonds be amended or replaced before the fallback provisions are triggered, in order to allow for an orderly transition from LIBOR to SONIA.

In the US, there is still much work to be done to develop liquidity in SOFR. There are critical differences between LIBOR and SOFR that complicate the transition from one rate to another in affected contracts. LIBOR is an estimated unsecured interbank lending rate published for different interest periods. It is a forward-looking rate, meaning the borrower knows the interest rate on the loan at the beginning of the interest period. SOFR, on the other hand, is a secured, nearly risk-free rate, and there are several variants of SOFR that can be used. SOFR is also an overnight rate which is backward-looking and, therefore, lacks term rates and a yield curve.

The Working Group on Risk-Free Reference Rates for the Euro Area is chiefly concerned with the transition from EONIA to €STR. It is also looking at identifying fallbacks for the EURIBOR based on €STR. Both backward- and forward-looking options are being considered. Since there is no immediate decision on discontinuing the EURIBOR, the needs to consider fallback options therefrom are less urgent.

LIBOR v RFRs

The main ways in which alternative RFRs differ from LIBOR are:

  • Alternative RFRs are overnight rates which are published at the end of the overnight borrowing period. This means they are ‘backward-looking’. In contrast, LIBOR is a term rate (ie, it is a rate to borrow for a period of time such as three or six months) and it is published at the beginning of the borrowing period. This means LIBOR is ‘forward-looking’.
  • LIBOR also includes a premium for interbank credit risk (ie, an additional amount to account for the risk that the borrowing bank may not be able to repay the interbank borrowing). RFRs, which are overnight rates and, in some cases, secured do not include this premium or include a reduced premium.
  • LIBOR also measures the same market in all currencies (ie, the unsecured interbank lending market). The RFRs measure different markets. For example, the RFRs for sterling, yen and euro are based on unsecured markets, whereas the RFRs for the US dollar and Swiss franc are based on secured markets. This means that different RFRs are likely to behave slightly differently.

How this could affect consumer borrowers

When a loan or line of credit is taken out, the amount borrowed is called the principal. Interest is an amount to be paid over a certain period of time for borrowing the money. The interest rate is the interest being charged, expressed as a percentage of the principal. The amount of interest to be paid over the life of the loan and in the monthly loan payments is determined by the interest rate (and other loan terms).

For adjustable rate loans and lines of credit, lenders typically calculate the interest rate using two figures: the index and the margin.

The index is a benchmark interest rate which reflects market conditions, and changes based on the market. There are many indexes in the marketplace. Common indexes currently include LIBOR, the US Prime Rate, and the Constant Maturity Treasury Index (CMT).

The margin is the number of percentage points added to the index by the lender to achieve the total interest rate, that is, index + margin = interest rate.

The transition could also pose challenges for how lenders communicate rate changes to borrowers. Because RFRs are overnight rate (versus the varying terms for LIBOR), banks will need to estimate interest rates for consumers using a prior compounding period. For those who hold individual floating-rate notes, the impact may depend on the notes’ reference rate, and whether there is stated fallback language for when LIBOR is no longer available. While for legacy floaters tied to LIBOR without explicit language as to what happens once LIBOR has been superseded, there is risk involved as there could be increased price volatility as liquidity decreases.

Conclusion

The future of LIBOR is uncertain. It is unclear whether or not LIBOR will be permanently discontinued by the end of 2021. Firms should plan for cessation, but they should also consider a scenario where LIBOR continues in some form after 2021.

LIBOR transition is a complicated undertaking. Its success will depend on active collaboration between a range of different market participants and the official sector: regulator, trade associations, buyside firms, banks and market infrastructures. Gearing up for LIBOR transition will require banks to conduct a meticulous due diligence exercise to understand their current portfolio of LIBOR-linked products, exposures, services, operations and strategies. Banks would do well to start early and draw up a detailed strategy to transition to the new benchmark.

 

References

• Transition from LIBOR, Financial Conduct Authority, available at www.fca.org.uk/markets/libor

• Staff Statement on LIBOR Transition, Public Statement, US Securities and Exchange Commission, available at www.sec.gov/news/public-statement/libor-transition

• Factbox: The global benchmarks replacing Libor, Business News, Reuters, available at www.reuters.com/Article/us-britain-libor-transition-factbox/factbox-the-global-benchmarks-replacing-libor-idUSKBN1WN0HN

• The world needs a new workhorse interest rate. Finding one isn't easy, Anneken Tappe, CNN Business, available at https://edition.cnn.com/2020/02/19/economy/libor-replacement-sofr/index.html

• Transitioning LIBOR: What It Means for Investors, Morgan Stanley, available at www.morganstanley.com/ideas/libor-its-end-transition-to-sofr#:~:text=First%20of%20all%2C%20SOFR%20relies,called%20an%20overnight%20rate%E2%80%94vs.&text=Finally%2C%20LIBOR%20incorporates%20a%20built,of%20borrowing%20by%20a%20bank.