The whole financial system relies on reference interest rates, more precisely on InterBank Offered Rates (IBORs) whose integrity and reliability have raised some concerns since the 2008 financial crisis and the LIBOR manipulation scandal.
These IBORs are used to determine the unsecured short-term funding cost in the interbank market for a combination of currencies, tenors and maturities. Indeed, often without us realising, IBORs are used as an index for almost all financial instruments: Over-The-Counter (OTC) derivatives and Exchange-Traded Derivatives, syndicated loans, securitized products, business loans, retail loans, floating rate bonds and deposits.
Given the importance of these rates for the stability of the financial system and specific demands of the G20, the Financial Stability Board undertook a fundamental review of those major interest rate benchmarks which ended up in a recommendation to strengthen the existing IBORs and also to develop alternative, nearly risk-free reference rates (RFR).
That report was published 4 years ago and, since then, the European Union has developed new Benchmark Regulations which entered into force in January 2018. In addition, dedicated RFR working groups have been set up and alternatives to IBORs developed – the so called preferred alternative RFR – at least for most of them.
|GBP||GBH LIBOR||Reformed Sterling Overnight Index Average (SONIA)|
|USD||USD LIBOR||Secured Overnight Financing Rate (SOFR)|
|EUR||EUR LIBOR, EURIBOR||Expected by September 2018|
|CHF||CHF LIBOR||Swiss Average Rate Overnight (SARON)|
|JPY||JPY LIBOR, JPY TIBOR, Euroyen TIBOR||Tokyo Overnight Average Rate (TONA)|
Source: IBOR Global Benchmark Transition Report June 2018 – by International Trade Associations
In July last year, the FCA’s Chief Executive, Andrew Bailey, confirmed the death of the sacred London InterBank Offered Rate (“LIBOR”) by the end of 2021.
What does it mean? Basically, it means that financial institutions have now a bit less than three years to get prepared. At this point, it might be hard to assess the extent of the resulting impacts but we know for sure that the whole chain, from the legal contract to accounting, will be affected.
Financial contracts indexed to IBOR which mature after 2021 will have to be renegotiated and new ones should be revised so that institutions have a robust fallback when IBORs will not be an option anymore. On 10 July 2018, the Alternative Reference Rates Committee (ARRC) issued its “Principles for Fallback Contract Language”. These principles aim to deal with new cash product contracts that reference LIBOR; they provide guidance in addressing the issues of fallback language in financial contracts and events that could trigger the LIBOR-Alternative RFR switch.
Modifying the legal terms will cause the instrument’s valuation to change with expected direct consequences in Profit & Loss (P&L), Other Comprehensive Income (OCI) and on the effectiveness of Hedging Strategies. However, prior to these nonetheless key issues comes the modelling challenge.
Modelling teams and model risk management will, indeed, be put under pressure. New curves and thus forward-looking term structure models will have to be built for each of the alternative RFRs, without limited data. Basis curves between the still existing IBORs will have to be assessed and monitored, which will be challenging as it needs to be done for each currency and tenor. This issue will be all the more challenging as the Euro OverNightIndex Average EONIA used as a reference rate in contracts should also be replaced by 2020. These modelling and basis issues hide other challenges. In particular, from a regulatory point of view with revised framework for market risk requirements and the “punishing” treatment applied to non-modellable risk factors. Furthermore, managing multi-curves can prove to be quite burdensome and carries substantial operational risks.
The full extent of this reform is undisputedly broad and mainly unknown but, again, institutions need to initiate transition plans and start assessing the potential impacts. In June 2018, a combination of various Trade Associations issued the “IBOR Global Benchmark Transition Report”. The report presented the conclusions of a survey conducted with 150 market participants (commercial and investment banks, other banking and financial entities, financial end-users; corporates, infrastructure providers and law firms) in 24 countries. Whilst survey participants are mostly aware of the IBOR reform and its associated issues, it seems that they have not yet taken the necessary actions to transition. The more institutions wait in developing and deploying an IBOR programme, the more contracts indexed to IBOR they will have to deal with after 2021. Another consequence, but not the least, will be the lack of observability of the alternative reference rates and all the consequences this can trigger in terms of both capital requirements within the new market risk framework and accounting treatment.
The IBOR reform may seem very much like a revolution, even though it was both unavoidable and expected. Developing and implementing a comprehensive transition plan should now be the priority for financial institutions if they want to reduce costs, risks and identify opportunities.
 International Swaps and Derivatives Association, the Association for Financial Markets in Europe, the International Capital Market Association, the Securities Industry and Financial Market Association (SIFMA) and SIFMA’s Asset Management Group