An announcement by the FCA that panel banks will no longer be required to submit rates used for the calculation of LIBOR after 2021 has resulted in dedicated working groups across the various FSB members' jurisdictions selecting and developing alternative risk-free rates (RFR) to replace the existing benchmarks. Michael Tuohy, Audit Partner, Mazars Financial Services Division and his colleague, Audit Senior Manager Gemma Rocliffe discuss the progress to date and say that all eyes are now set on the financial services industry, which is expected to lead the transition.
WHAT ARE INTER-BANK OFFERED RATES (IBORS)?
Inter-Bank Offered Rates (IBORs) are used to determine the unsecured short-term funding cost in the interbank market for a combination of currencies, tenors and maturities. They include the London Interbank Offered Rate (LIBOR) (published for 7 tenors across 5 currencies), the Euro Interbank Offered Rate (EURIBOR) and the Euro Overnight Index Average (EONIA), amongst others.
IBORs are still 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.
WHAT IS THE PROBLEM WITH IBORS?
In his speech in July 2018, the FCA’s Andrew Bailey outlined 4 reasons why LIBOR (and by association, other IBORs), required reform:
Financial markets have changed causing the international interbank market to decline as post financial crisis bank funding has moved away from the interbank market and are no longer sufficiently liquid.
Eurocurrency markets are no longer distinct from domestic financial markets. IBORs are used to price the majority of the interest rate derivatives market but they are a proxy for risk-free rates plus bank risk, when a risk-free rate should have been used.
Banks rarely lend to each other on an unsecured basis; therefore LIBOR is not measuring the rate that banks are borrowing from each other, but is reliant on the judgement of 20 panel banks.
The system for determining IBORs is more vulnerable to misconduct. This was demonstrated by the LIBOR manipulation scandal during the financial crisis.
IBOR REFORM, WHAT IS IT AND PROGRESS TO DATE
The LIBOR manipulation scandal revealed the limitations of this benchmark and raised questions about its reliability. The Wheatley Report in 2012, followed by the FSB’s report two years later, the new European Benchmark regulation and finally the announcement by the FCA that panel banks will no longer be compelled to submit rates used for
the calculation of LIBOR after 2021, have all set a path toward the benchmark reform. And now, dedicated working groups across the various FSB members’ jurisdictions are selecting and developing alternative risk-free rates (RFR) to replace the existing benchmarks.
The key difference between IBORs and alternative RFRs is that alternative RFRs represent the overnight near risk- free rates and are based on historic transactions while IBORs are forward looking and are published for different terms and include bank risk.
The table below details the current IBORs and the replacement alternative RFR by currency.
Recent consultations on IBOR reform indicates that progress is being made. The International Swaps and Derivatives Association (ISDA) issued another round of consultations for Inter-Bank Offered Rates (IBORs) trying to solve the issue of the spread and term adjustments in fall-back provisions for derivatives referencing IBORs and pre-cessation trouble before the end of 2021.
The International Accounting Standards Board (IASB) published its first Exposure Draft, “ED/2019/1 Interest Rate Benchmark Reform”, proposing amendments to IFRS 9 and IAS 39, which was shortly followed by the European Financial Reporting Advisory Group’s (EFRAG) draft comment letter. With the proposed ED, the IASB focused on the IBORs pre-replacement issues and tackles, in particular, the forward-looking hedge accounting requirements.
The FSMA authorised the new hybrid methodology for EURIBOR in July 2019, allowing EU supervised entities to continue to use EURIBOR for the foreseeable future although fallbacks are still required.
Although relevant fall-back rates have been announced in different countries, the US are moving at a faster pace than Europe to transition toward the Secured Overnight Financing Rate (SOFR) – the alternative risk-free rate (RFR) for the USD LIBOR. RFR working groups in the US, such as the Alternative Reference Rates Committee (ARRC), have consulted the industry and in April and May 2019 published templates for fall-back language. This included pre-
cessation triggers that will apply to new cash products’ contracts such as bilateral business loans, floating rating notes, securitisation and syndicated loans.
The working-group on the euro risk-free rates has taken the initial steps regarding EURIBOR fallbacks including the recommendation on a specific forward-looking term structure methodology based on €STR and in the UK, the
Financial Stability Board (FSB) and the Official Sector Steering Group (OSSG) wrote to ISDA in March 2019 seeking further market opinion for the spread-adjusted fall-back rate for LIBOR. The Financial Conduct Authority (FCA) encouraged market participants to consider including LIBOR contract pre-cessation fall-back triggers, in addition to fall-back triggers based on permanent cessation. Dutch Central Bank and Netherlands Authority have also requested financial institutions to provide roadmaps and details for their transition, as per the example of the FCA’s and PRA’s “Dear CEO letter” sent to major banks and insurers in September 2018.
Working groups have started to prepare for pre-cessation fall-back. Some strategies include closing out as much of their exposures to an IBOR as possible to avoid potential cessations of the rates. Alternatively, some banks have decided not to offer contracts with maturities of more than 5 years, in the light of future heavy capital requirements and holding up to 75 times more in Risk-Weighted Assets under the new Fundamental Review of the Trading Book (FRTB).
The ISDA Consultation on Pre-Cessation Issues for LIBOR and Certain Other Interbank Offered Rates released on 16th May, includes possibilities for companies to continue using LIBOR rate after cessation. However, not only would this create legal and accounting issues, but regulatory authorities would also have no means to curb the
unprecedented problems created. Hence, ISDA actively seeks opinion on publishing a protocol in pre-cessation and fall-backs to allow both counterparties to preliminary agree to include certain transactions only. A separate consultation is currently ongoing with regard to the spread and term adjustments applied to fall-backs in derivatives contracts.
While high level directions have been agreed, technical issues to determine length of forward spread curve, duration period of historical static look back period and methodologies of spot spread calculations are to be further developed by the industry.
Regulators in the Asia-Pacific region are also seeking to work and strengthen the contractual fall-backs for their interest rates. Already Australia’s Bank Bill Swap Rate (BBSW), Japan LIBOR and Tokyo IBOR (TIBOR) have been included in the 2018 ISDA consultation and it is very likely that Hong Kong IBOR (HIBOR) and Singapore Swap Offer Rate (SOR) will follow.
WORK ON STRENGTHENING BENCHMARKS NOT WITHOUT PROBLEMS
Considerable work is being undertaken to strengthen benchmarks and build robust fall-backs, to ensure that alternatives comply with the new European Benchmark Regulations and can be used and cleared within the European Union. Yet while progress is being made, the liquidity of the new RFRs remains an issue which, may be partially due to continued uncertainty around the alternative rates.
All eyes are now set on the financial services industry which is expected to lead the transition. But it should not be forgotten that for each transaction there is a counterparty (corporate firms or investor). With time marching on, it is of the utmost importance that all market participants are equally informed and educated on transition issues.
Broader and louder communication now might be the key towards a smoother transition.
TRANSITION CHALLENGES AND PLANNING YOUR TRANSITION
The reforms could cause multiple challenges within the financial services industry to transition contracts and products referencing IBORs to alternative RFRs requiring adjustments for both term and credit risk, assessing their continued effectiveness, as well as the knock-on requirement to update contracts and the potential adaption of IT systems. The approach to deal with legacy instruments that extend beyond 2021 will also present challenges on whether to replace the IBOR with an alternative RFR or a suitable “fallback provision”.
Considerations when planning your transition include:
This article appeared in the November 2019 edition of Finance Dublin.