LIBOR transition – end of an era

What is (L)IBOR?

Interbank Offered Rates (IBORs) are benchmark interest rates that are intended to represent the cost of short-​term, unsecured, wholesale borrowing by large international banks. LIBOR, the London Interbank Offered Rate, is the most widely used interest rate benchmark in the world.

LIBOR is determined by a bank survey administered by the Intercontinental Exchange (ICE). Every business day, ICE asks a panel of about a dozen contributing banks the rate at which they can fund themselves in various tenors up to one year in five currencies: the Swiss franc (CHF), euro (EUR), British pound (GBP), yen (JPY) and U.S. dollar (USD). ICE then collates the results, eliminates the top 25% and bottom 25% of submissions, and averages the remainder to arrive at the published LIBOR.

What is the IBOR Transition?

There are concerns about the level of subjectivity involved in the LIBOR submissions. The size of the interbank lending market is typically less than $1 billion a day – tiny compared to the size of the market that uses LIBOR resets, which exceeds $200 trillion. The small size of the London interbank lending market, the limited number of contributors and the fact that LIBOR is often not backed by transactional data have led regulators to look for a more robust benchmark rate.

In 2013, following accusations of rate rigging by certain contributing banks, the G20 asked the Financial Stability Board (FSB) to undertake a fundamental review of major interest rate benchmarks. This work led to the realisation that declining transaction volume in the markets that underpin IBORs undermined this as an approach to setting a representative and robust benchmark.

In 2017, the Financial Conduct Authority (FCA; the UK body that regulates LIBOR) declared that after 31 December 2021 it will no longer compel banks to continue making LIBOR submissions. As a result, the market has been primed to expect that LIBOR publication may cease entirely, and the process to determine alternate benchmarks commenced.

What is the LIBOR transition timeline?

The UK regulator has identified the 31st of December 2021 as the watershed date beyond which EUR, CHF, JPY and GBP LIBOR may cease to be published, whereas USD LIBOR may continue till 30 June 2023. It is possible that LIBORs may be deemed to be unrepresentative prior to these dates. Further, market practitioners may be unwilling to enter into LIBOR based contracts that extend beyond 2021 well before December, as doing so would add to the burden of migrating to the new reference indices.

The below provides a high-​level overview of milestones that have been or are expected to be completed as the IBOR Transition moves forward:

What is a LIBOR fallback?

It is anticipated that over the next years, LIBOR and potentially various other IBORs will be discontinued. To address the risk that counterparties may have exposure to a discontinued IBOR, they are encouraged to agree to contractual fallback provisions. Such provisions set out the broad principles (or in some cases, the detail) underlying the approach the counterparties would take in replacing references to LIBOR in loan and other financial products’ contracts.

What will IBORs be replaced with?

Various new ARRs (Alternative Reference Rates) have been defined to replace LIBOR. These new benchmarks are considered nearly risk free and also referred as RFR (Risk Free Rates). The table below lists the RFRs for some of the major currencies.

 

Currency

ARR/RFR

Secured?

Publication time

Sterling (£)

SONIA (Sterling Overnight Index
Average)
SONIA reform was completed
on 23 April 2018

N

09:00 GMT

T+1

Euro (€)

ESTER (Euro Short-Term Rate)
This is a new overnight rate by
the ECB, published  since 
October 2019

N

09:00 CET

T+1

US Dollar

SOFR (Secured Overnight
Funding Rate)
This is a new rate which has
been published since 3 April
2018

Y

08:00 ET

T+1

Swiss Franc

SARON (Swiss Average Rate
Overnight)
This replaced TOIS fixing in
December 2017

Y

12:00, 16:00

and 18:00

CET same day

Japanese Yen

TONA (Tokyo Overnight Average Rate)

N

10:00 JST

T+1

What is the difference between LIBOR and the new benchmarks?

IBORs differ from ARRs in several very important ways: 

  • IBORs are forward looking term rates, known and set at the beginning of an interest period. In contrast, ARRs are overnight interest rates.When used to set a rate for an interest or coupon period, an observation will be taken each day (possibly adjusted for lookback days) and a compound average calculated. A significant consequence of this approach is that the final rate will not be known until the end of the coupon period – a few days before payment is due.
  • IBORs include a credit spread or margin, as they represent unsecured bank credit risk. ARRs, on the other hand, include little or no credit risk, as they are very short-term rates (overnight) and in some cases, secured.
  • A key driver of suitability for regulators is that the rate should be able to be evidenced by actual transactions, and hence are not subjective or judgement based. The ARRs were selected in large part due to the volume of transactions that occur daily in the markets underpinning these rates.

    LIBOR

    New Benchmark (ARR)

    Based on panel bank
    quotes for unsecured
    interbank term lending (IBOR)

    Nearly risk free rate (RFR),
    secured overnight rate based on transactions

    Forward looking rate
    (fixed in the beginning of the period)

    Backward looking, compounding in
    arrears, interest is calculated at the
    end of the period

    Already contains credit risk
    and liquidity premium

    Term and spread adjustments
    are required

    Has a term structure
    (1, 3, 6  month LIBOR)

    Not all new benchmarks have
    a term structure only overnight

What is the benchmark adjustment spread and why is it needed?

Since ARRs are structurally different from IBORs, certain spread adjustments are required to preserve the economic value of the contracts. These adjustments are to account for:

(i) The fact that an ARR is an overnight rate while IBORs have term structures (e.g., 1, 3, 6-month LIBOR); and

(ii) Historical spread differential between IBORs and their ‘term equivalent’ ARR compounded rates.

ISDA announced that Bloomberg will be the adjustment services vendor for IBOR fallback calculations. Consequently, Bloomberg will calculate and publish the term and spread adjustments for the fallbacks that ISDA intends to implement for certain IBORs.

The calculations are based on the methodology developed by ISDA through a series of market consultations, and can be viewed on ISDA’s website. The following are published:

  • Compounded setting in arrears for each RFR for each relevant term (Adjusted RFR) – daily compounding of publicly available Risk Free Rates (RFRs) published by central banks (e.g. SOFR, SONIA)
  • Spread Adjustment – median of the historical differences between the IBOR for each tenor and the compounded RFR for that tenor over a five-year period prior to an announcement triggering a fallback
  • The “all in” fallback rate.

What is QNB’s approach to LIBOR transition?

QNB has established a Global LIBOR transition programme, which is responsible for coordinating and directing the actions of the business in migrating away from LIBOR-based product pricing. The programme affects all aspects of QNB’s businesses (Sales, Product Development, Treasury, Operational, Finance, Risk, IT etc.) across multiple jurisdictions. The challenge includes the development of new products and operational processes, upgrade of the Bank’s systems, legal contract remediation and the migration of legacy products onto ARRs in a controlled and ordered manner.

I am a QNB client. How will the IBOR Transition impact me?

We are assessing how the transition may impact IBOR-linked transactions and products, while closely monitoring market developments. It is not yet possible to be prescriptive about the full and precise impact of the LIBOR transition, although we can state that loan and other financial products’ contract documentation will need to change, as will rate setting and valuation processes.

In the meantime, we recommend that you periodically monitor the news emerging from the relevant trade bodies and consider the potential impact on your products. Other actions that you may consider undertaking are:

  • Review your existing contracts to identify IBORs related transactions.
  • Consider what actions need to be taken to ensure operational readiness, whether external support will be required, and the time required to ensure preparedness.
  • Consider whether the applicable timescales work in relation to those dictating market changes.

For further information on specific QNB products and services, including those to which you may have exposure, please contact your sales representative or relationship manager.

How do I monitor developments?

The following websites regular feature developments as they occur. Large legal firms involved in the financial industry also often publish articles and may provide advice. Other jurisdictions not mentioned below may find information pertinent to their market on the regulator’s website.

 

Country

Entity

Link

United States

ARRC – The Alternative
Reference Rate Committee

FRBNY/ARRC

United Kingdom

The Bank of England

BOE

FCA – The Financial Conduct Authority

FCA

Europe

The European Central Bank

ECB

Global Trade Bodies

ISDA – The International Swaps
and Derivatives Association

ISDA

LMA – The Loan Market Association

LMA

LSTA – Loan Syndications and
Trading Association

LSTA

Disclaimer

Whilst we have taken measures to ensure the above is accurate and up-to-date, QNB Group does not accept any liability for any loss or damage caused to any person. Further, the above may contain references to certain laws and regulations. Laws and regulations will change over time and should be interpreted only in light of particular circumstances. Finally, the above is provided for information purposes only and should not be relied upon as offering advice under any circumstances.  QNB Group recommend that you should obtain legal, tax, accounting, financial or any other professional advice or services for your specific needs.