What is happening with LIBOR?
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 sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
- immediately after 30 June 2023, in the case of the remaining US dollar settings.
Can I continue to transact in USD LIBOR after the end of 2021?
Regulators have stated that, barring some exceptional circumstances, firms should cease entering into new contracts that use USD LIBOR as a reference rate no later than 31 December 2021. The publication of most USD LIBOR tenors was extended to the 30 June 2023 primarily to allow a natural run down of legacy USD LIBOR contracts maturing before that extended cessation date.
What may happen to my LIBOR contracts prior to LIBOR ceasing or becoming non-representative?
As long as LIBOR continues to be published as a representative rate, there is unlikely to be a direct impact on your exposures. However, liquidity in LIBOR-referencing contracts may decline in advance of LIBOR’s cessation. This is in part because supervisors in respective jurisdictions expect initiation of new LIBOR contracts to gradually cease prior to 1 January 2022. This may affect your ability to manage your LIBOR exposures through, for example, trading or hedging.
Could LIBOR be published in some form after the cessation date?
The UK’s Financial Conduct Authority (FCA) is currently seeking market input on its proposal to continue the publication of GBP LIBOR and yen LIBOR in the 1, 3 and 6-month tenors for some time after 1 January 2022. However, if such a ‘synthetic rate’ were to be published, the FCA has stated it would not be a ‘representative’ rate and its use would be limited to contracts that genuinely have no, or inappropriate, alternatives and no realistic ability to be renegotiated or amended. As such, you should not count on a synthetic rate as being a viable option of transition.
What are the key differences between the RFRs and LIBORs?
RFRs are overnight rates. Therefore an RFR ‘interest rate’ or ‘coupon rate’ will typically be based on an average or a compounding of daily observations of the RFR throughout the interest period. In contrast, LIBOR is a forward-looking rate that provides the ‘interest rate’ or ‘coupon rate’ at the beginning of the interest period.
Since LIBOR rates are based on bank borrowing costs, they may rise in times of financial stress. The low volume of transactions presently underlying LIBOR increases its vulnerability to short-term market illiquidity and amplification of price moves.
Will a ‘term rate’ be available?
Forward looking RFR ‘term rates’ are available in the GBP, USD, and yen markets but their use is expected to be limited. In several jurisdictions regulators have stated that the use of term rates in the derivatives market will be limited to certain types of hedging transactions. In the UK term SONIA is not recommended for use in the institutional loan market.
How is value transfer avoided when transitioning LIBOR contracts to reference new rates?
LIBOR is available in multiple tenors while RFRs are overnight rates. LIBOR also incorporates a bank credit risk premium and other factors. Adjustments are therefore needed to the RFRs to ensure contracts originally negotiated to reference LIBOR continue to meet the original objectives of the counterparties to the maximum extent possible once the new rate takes effect.
A general market consensus has been established across multiple jurisdictions that a fair way to approximate the expected future difference between LIBOR and RFRs from the point that LIBOR can no longer be published, is to take a historical median of that difference.
For derivatives, the International Swaps and Derivatives Association (ISDA) will use a credit adjustment spread based on the median over a five-year period of the historical differences between LIBOR in the relevant tenor and the relevant RFR compounded over each corresponding period. This method has been endorsed by supervisory bodies for use in other asset classes as well, both for active transition and for use in fallbacks.
That said, the approach to the credit adjustment spread for active transition is for both parties to agree.
What may happen to my hedges?
Market conventions and fallbacks may vary between asset classes and between your contracts. It is therefore important to consider carefully the implications of LIBOR transition on your contractual exposures and cash flows.
What should I consider for my transition?
To manage your LIBOR exposures some of the matters that you may wish to consider include:
- Adhering to a contractual fall-back solution adopted industry-wide, such as the ISDA 2020 IBOR Fallbacks Protocol for derivatives transactions, or entering into a bilateral amendment agreement.
- Restructuring your portfolio to reference RFRs instead of LIBOR
- Relying on the fallbacks or other provisions within your existing documentation, if suitable; or
- A combination of these and other actions.
You should be taking the appropriate steps to be prepared for the 31 December 2021 LIBOR cessation and considering carefully the timing of any transition of your exposures to the USD tenors that cease on 30 June 2023.
We encourage you to do your own due diligence regarding your LIBOR exposure and to ensure that any additional LIBOR exposure is carefully justified. You should consider areas in your business that are impacted, including systems, documentation, risk management and accounting. Even if you have no balance sheet exposure to LIBOR, you may still be exposed to other risks in connection with LIBOR cessation or LIBOR becoming non-representative including operational, legal and financial challenges. For example, you may need to change your pricing and valuation systems if a LIBOR rate is a key input.
Additionally we encourage you to seek independent advice regarding any legal, commercial or regulatory implications which LIBOR cessation or LIBOR becoming non-representative may have. Please also refer to your relevant authorities and independent advisors in relation to any accounting and tax implications of transition. These requirements may apply to you and us differently in different jurisdictions.
We look forward to hearing from you regarding your transition.
What if I have more questions?
Please contact your Commonwealth Bank representative or the Commonwealth Bank, Interest Rate Benchmark Reform Program directly at IRBR@cba.com.au as soon as practicable.