The IBOR Transition – A Reference Rates Reform
The IBOR transition is a global reform with significant impact on the financial industry. Current expectations are that some IBORs will be replaced by new alternative reference rates (ARRs), while others may continue to exist but with a reformed methodology.
For various reasons, the interbank market has become less liquid since the financial crisis, especially in tenors longer than overnight. The rates are therefore no longer considered representative of an actual interbank market, and therefore global regulators are replacing certain IBORs with a new set of benchmark rates, also known as ARRs.
More specifically, concerns about LIBOR first became known well over a decade ago. LIBOR panel bank submissions were manipulated, which highlighted the secular decline in its underlying market. This triggered reform efforts worldwide, and global regulators and industry bodies like the ARRC, FSB, IOSCO, LMA, ISDA, FCA and many more have worked to coordinate these efforts. The purpose has been to address the unique needs of financial markets across countries and currencies, e.g. securing robust benchmark rates based on deep, liquid markets.
There are many attributes that can help make a reference rate robust, but to name a few it should:
- Have a reliable administrator with strong and resilient production and oversight processes
- Be clear what market the rate represents and how it measures that market
- Be based on transactions at a market that has high volumes and diversity, securing it can withstand times of stress and being resilient as markets evolve, ensuring it cannot be easily manipulated
When assessed against this last attribute, it is quite clear why LIBOR is inadequate. In particular, over the four decades since LIBOR was formally developed, the wholesale funding market that it seeks to measure has withered. The Global Financial Crisis of 2007-2009 accelerated the decline of LIBOR’s underlying market, as banks found more stable ways to fund themselves. With so much economic value riding on a thin market, the incentive to manipulate LIBOR increased and such exploitation ultimately became a reality.
Even though extensive reforms have been undertaken to make LIBOR more robust, its production primarily relies on expert judgement rather than eligible funding transactions. The U.K.’s FCA, which regulates LIBOR, has noted that panel banks are not fully comfortable providing submissions. So despite the sprawling use of LIBOR today, the FCA in March 2021 has announced the dates that panel bank submissions for all LIBOR settings will cease, after which representative LIBOR rates will no longer be available. This is an important step towards the end of LIBOR, market participants are urged to continue to take the necessary action to ensure they are ready for transition from LIBOR to the Fallback Rates.
All LIBOR settings will either cease to be provided by any administrator or no longer be representative:
- immediately after 31 December 2021, in the case of all GBP, EUR, CHF and JPY, and the 1-week and 2-month USD settings; and
- immediately after 30 June 2023, in the case of the remaining USD settings.
The FCA statement represented an index cessation event under the IBOR Fallbacks Supplement and protocol, triggering a fixing of the fallback spread adjustment at the point of the announcement. This spread adjustment is an important part of the overall fallback rate, and reflects a portion of the structural differences between interbank offered rates (IBORs) and the ARRs used as a basis for the fallbacks – IBORs incorporate a credit risk premium and term liquidity risk, while RFRs are risk free or nearly risk free. The Fallback Rate for each IBOR setting will be based on the relevant RFR compounded in arrears to address differences in tenor, plus a spread adjustment to account for the credit risk premium and other factors, calculated using a historical median approach over a five-year lookback period from the date of an announcement on cessation or non-representativeness. While the LIBOR spread adjustments were fixed at the point of the FCA announcement (05/03/2021), the fallbacks will apply when each LIBOR setting ceases or becomes non-representative – so, after December 31, 2021 for outstanding products that continue to reference all EUR, GBP, CHF and JPY LIBOR settings (with tenor nuances in USD LIBOR mentioned above).
Now the deadlines and spread adjustments for the fallback rates are fixed, firms can push forward with their transition initiatives. With only months to go until 24 LIBOR rates completely cease and another six become non-representative, there’s not much time left.
IBOR Transition Overview
|Jurisdiction||Currency||IBOR||Expected Cessation Date||ARR||Go-live Date||Transition Committee|
|GBP||LIBOR||31.12.2021||SONIA||23.4.2019||Sterling Working Group on Risk-Free Rates|
|US||USD||LIBOR||30.6.2023||SOFR||3.4.2017||Alternative Reference Rates Committee (ARRC)|
|Switzerland||CHF||LIBOR||31.12.2021||SARON||XX.12.2017||The National Working Group on Swiss Franc Reference Rates|
|Japan||JPY||LIBOR||31.12.2021||TONAR||Cross-Industry committee on Japanese Yen Interest Rate Benchmarks|
|Europe||EUR||LIBOR||31.12.2021||€STR||2.10.2019||ECB Working Group on Euro Risk-Free Rates
European Money Markets Institute (EMMI) and Euro RFR Working Group
|Sweden||SEK||STIBOR||Remains||SWESTR||Mid 2021||The Working Group for Alternative Interest Rates (AGAR)|
|Denmark||DKK||CIBOR||Remains||DESTR||2022||The Working Group for a new Danish Kroner Risk-Free Reference Rate|
|Norway||NOK||NIBOR||Remains||NOWA||XX.1.2020||Working Group on Alternative Reference Rates in Norwegian Kroner|
Alternative Reference Rates
ARRs are benchmark rates that are being developed as an alternative to IBORs. The ARRs have been identified by various authorities and industry working groups as recommended alternatives or fallbacks for IBORs and/or in some cases it is being considered how an existing benchmark rate can be reformed in accordance with applicable regulation. For each existing IBOR and the identified ARR, the proposals of transition are at different stages and will continue to evolve. Hence, the transition is expected to happen gradually and at varying times across IBORs/ARRs (as outlined in the IBOR Transition Expectations Overview above).
One of the main differences between IBORs and ARRs is in terms of the calculations method, and ARRs can therefore not be considered as like-for-like replacements. IBORs are calculated at (or prior to) the commencement of the interest period they are relating to by submission of panel banks or expert judgement, which allows clients to be certain on the amounts that will be due at the end of the interest period. ARRs are – in contrast – calculated on the last day of the related interest period and will entirely be based on transaction data in the market in the corresponding period. In a nutshell it means the market is moving from a forward-looking calculation method based on panel bank submissions towards a backward-looking calculation method based on transaction data.
Taking LIBOR as an example, below is a non-exhaustive list of some differences between LIBOR and its ARRs:
- LIBOR is a term rate benchmark across multiple tenors (O/N, 1W, 1M, 2M, 3M, 6M, 12M), whereas ARRs are overnight rates with no term element
- LIBOR is a forward-looking rate, whereas ARRs are backward-looking rates
- LIBOR contains a premium for bank credit and term liquidity risk. In contrast, while the precise nature of each ARR may vary, in general the ARRs contain little or no such additional premiums because they are overnight and sometimes secured
- LIBOR is administered by a single administrator for all currencies, following a single set of characteristics, whereas ARRs have distinct characteristics and administrators
While the cessation of LIBOR/EONIA is not expected to come into effect until the end of 2021 (certain tenors of the USD LIBOR are expected to discontinue immediately after 30th June 2023), it is important for clients, counterparties, investors and other stakeholders to develop an understanding of what the transition from IBORs to ARRs means and how it might impact your portfolio. This will allow all parties to act proactively towards the changes and thus ensure the change is not affecting positions in an unwanted way. The industry in general will continue to consider how and when it will actually transition legacy contracts to ARRs, and it is important to note that when decisions are made, it might differ across currencies, products and participants involved. Hence, the best response is to take early action by understanding any EONIA/LIBOR exposure in the portfolio – this is also the broadly recommended approach by regulators of financial markets participants.
Impacted clients should reach out to their relationship manager in Nordea to initiate a review of their portfolio with Nordea, as it is important for clients with LIBOR/EONIA exposure to understand financial as well as operational impacts of the IBOR Transition.
It is suggested that clients can start considering the following:
- What products and services have an IBOR reference
- What relevant contracts have a maturity date beyond 2021 (USD LIBOR (tenors other than one (1) week and two (2) months, beyond 30th June 2023)
- Whether the documentation includes any terms such as fallback terms that provide adequate risk mitigation
- The accounting and tax consequences of changes to the terms of products or services
- The appropriateness of alternative benchmark interest rates, such as the ARRs
Nordea encourages clients to follow the latest market developments on the IBOR transition, such as through participation in initiatives run by industry bodies, and to seek own professional advice on legal, financial, accounting and tax matters.
Clients should review their documentation carefully to determine what elements of their portfolio and services reference an IBOR, what fallbacks would apply and consider seeking independent professional advice (legal, tax, accounting, financial or other) as appropriate. Nordea can support in the review of agreements between the client and Nordea.
Nordea is currently scoping IBOR-impacted contracts and assessing whether amendments may be needed to cater for IBOR discontinuation and how best to make these amendments. At the same time, various initiatives are under way to establish industry standards for ARRs. However, it is not possible to say at this stage when industry standards for ARRs will be available in all markets. Nordea encourage clients to undertake a similar scoping and review exercise and to take appropriate independent professional advice (legal, tax, accounting, financial or other) so clients fully understand the impact of the discontinuation of any IBOR on their portfolio with Nordea, but also their business more generally.
This will be determined on a per contract basis and depend on the financial product and the existing fallback language used. Clients should review their documentation carefully and seek independent professional advice (legal, tax, accounting, financial or other) as appropriate when considering whether a transition to ARRs is best achieved by (1) amending the contract to introduce fallbacks, either bilaterally or by participating in a market initiative (for example by adhering to relevant ISDA protocols), or (2) replacing the product with a financial product that references the preferred ARR.
This will depend on many things, including the contractual provisions for the financial product or service and the alternative ARR solutions available. Clients should review their portfolio carefully and consider seeking independent professional advice (legal, tax, accounting, financial or other) as appropriate.
The impact of the IBOR Transition will vary from client to client, depending on which products and exposure their portfolios have, as that will outline what changes are required. It is likely that certain products (such as LIBOR referencing corporate loan agreements that mature beyond the expected LIBOR discontinuation dates) impacted by the IBOR transition will require contract amendments in order to complete the IBOR transition and such contract amendments are likely to incur legal drafting costs on the clients. As each client will need to conduct their own preparations and readiness, the timescale, extent and costs of these activities will differ between each client. Nordea encourages clients to take early action in understanding the impact from the IBOR Transition to ensure a smooth transition.
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