IBOR Reform: What is IBOR…?
The first of JDX’s ‘Preparing for life after LIBOR’ insights series
Background to IBOR reform and its phase-out
For more than four decades, global financial institutions have been using interbank offered rates (IBORs) as benchmark interest reference rates, to lend to one another on an unsecured basis in the international inter-bank market for short-term loans. It has also served as a reference rate in over-the-counter (OTC) derivative contracts, particularly interest rate swaps, foreign currency options and forward rate agreements.
The London Interbank Offer Rate (LIBOR) is the most prevalent benchmark and, along with EURIBOR, is the primary benchmark for short-term interest rates around the world.
In 2012, the LIBOR fixing scandal emerged following evidence that the rate was being manipulated by some of the largest global banks during the financial crisis. Some banks were falsely submitting artificially low or high interest rates, to either benefit their derivatives traders, or to artificially enhance their creditworthiness. Financial firms have paid almost $10 billion in penalties as a result of this scandal.
In the wake of those scandals, a regulatory review, led by the UK Financial Conduct Authority (FCA), resulted in the oversight and supervision of LIBOR being transferred from the British Bankers Association (BBA) to the UK regulators through the Intercontinental Exchange Benchmark Administration (ICE BA). The rate is now calculated by the Intercontinental Exchange and published by Thomson Reuters.
Despite steps taken by the ICE BA to strengthen the benchmark, the fixing scandal and post-crisis decline in liquidity in interbank unsecured funding markets undermined confidence in the reliability and robustness of existing interbank benchmark interest rates. The result of which is that banks are merely using it as a reference rate for other loans.
Against this background, the G20 asked the Financial Stability Board (FSB) to undertake a fundamental review of major interest rate benchmarks and plans for reform to ensure that those plans are consistent and coordinated, and that interest rate benchmarks are robust and appropriately used by market participants.1
To take the work forward, the FSB established the Official Sector Steering Group (OSSG), comprised of regulators and central banks. The OSSG is responsible for coordinating and maintaining the consistency of reviews of existing interest rate benchmarks and for oversight of the Market Participants Group, which in turn, was tasked with examining the feasibility and viability of adopting additional reference rates and identifying potential transition issues. The FSB determined that the OSSG should focus its initial work on the interest rate benchmarks that are considered to play the most fundamental role in the global financial system, namely LIBOR, EURIBOR and TIBOR.
GBP LIBOR’s replacement, the Sterling Overnight Interbank Average Rate (SONIA), recommended by the Bank of England’s “Working Group on Sterling Risk-Free Reference Rates” in April 2017, is calculated in a notably different manner. It is not based on quotes from market participants stating what they would expect to be charged for borrowing, as is the case with LIBOR; it is instead based on averages taken from daily transactional data. Thus, it is a daily rate, and, unlike LIBOR, it has no term structure or credit spread. This makes it more difficult to manipulate as it is an average of a larger number of actual transactions and provides less of an incentive to do so as any transactions deliberately executed to manipulate the rate would be made off-market price.
Together with the FCA, the Bank of England are working with market participants to catalyse a transition to using SONIA as the primary interest rate benchmark in sterling markets, by the end of 2021. Many other countries are planning to do the same, but as is typically the case with large scale industry changes, there is a lack of global coordination.
The transition is happening.
Timeline and Risk-Free-Rates replacements
In July 2017 Andrew Bailey set a timeline at which the FCA would stop compelling the panel banks to make LIBOR submissions – by the end of 2021 the market needs to stop using LIBOR and transition liquidity to Risk-Free-Rates (RFRs). However, timelines are not yet clearly defined for all replacement benchmarks.
IBOR > RFR Table
Industry backdrop and scope
The financial services industry continues to see unprecedented transformation. The post-crisis regulatory framework has yet to hit steady state. The volume of changes, coupled with cost pressures, means that the industry is close to maximum operational capacity. LIBOR transition will only add to this burden.
Despite regulators turning up the pressure by stating that firms should treat the discontinuation of LIBOR as a certainty, they see the transition to RFRs as a voluntary, industry led-initiative. As a result, divergent market approaches could emerge and without coordination, the risks of transition may increase. Progress could also slow if banks deem “wait and watch” to be the most prudent strategy.
Transition is not just about new business but about converting outstanding – or legacy – LIBOR contracts. This is harder in some markets than in others. For example, a large number of bond issuances require either a majority of or unanimous noteholder consent – a costly and difficult exercise to conduct.
The breadth and depth of change associated with the transition is significant. Given the degree of uncertainty and complexity, LIBOR transition is likely to be one of the biggest transformation programmes many firms have undertaken.
Organisations need a clear understanding of how IBORs are used, referenced and should have suitable planning & resourcing in place to manage the transition.
Institutionally, key impacted businesses include investment banking, commercial lending, wealth management, investment management, insurance, retail banking, and corporate treasury.
In terms of product scope, loans and derivative instruments (e.g. swaps, options, swaptions, forward rate agreements (FRAs), swap futures, cross-currency swaps and interest rate futures/options) are affected.
The largest outstanding volumes of IBOR related products are those which relate to OTC derivatives, with Exchange-traded derivatives (ETDs) forming a still substantial proportion of reference rate linked derivatives, however. Estimates show between 60-90% of all interest rate OTC derivatives and ETDs are linked to LIBOR, EURIBOR, or TIBOR.3
As per the ‘Dear CEO’ letter published by the FCA 4, “…the extent to which LIBOR is deeply embedded in current business practices means transition will be complex and will take time.”, and “… insufficient preparations for transition to alternative rates could have a negative impact on the safety and soundness of firms and cause harm to their clients and to the markets in which they operate.”
Whilst the legal and operational challenges which this change will pose for banks are not unprecedented, they are wide-ranging and of huge scope. LIBOR has been referred to as the “world’s most important number” and it affects tens of millions of contracts, which will need to be repapered, rewritten or renegotiated.
Large repapering projects have been undertaken recently in preparation for Brexit and margin requirements for uncleared derivatives, so financial institutions have an awareness of the scale of the work which could be involved. Indeed, JDX has been involved with and has assisted financial institutions with significant legal repapering & renegotiation efforts.
Financial institutions’ experience of repapering as a result of Brexit serves to underline the importance of planning for such change—those organisations that have had to prepare for Brexit/margin reform and have begun the process of digitising their contracts, will have an advantage in terms of easing the repapering effort for IBOR. Considerations ought to include the prioritisation of collating impacted documentation, due to the potentially wide-ranging scope of such documentation. LIBOR-based contracts are pervasive; to the extent that even if an institution does not have contracts directly referencing LIBOR, it could nevertheless be affected by the changes. This is because LIBOR is frequently used to help calculate discount rates for financial reporting purposes. Thus, the amount of work required simply to collate affected documentation is clear. Institutions that have managed, via manual review or document digitisation, to create a database of IBOR references that can be easily updated will have an advantage compared to their peers as transition kicks off in earnest over the course of 2020.