June 2020 update

Below are some of the industry developments over the last six months and some of the issues for your consideration.

Recent developments

The transition to risk-free rates (RFRs) continues across all LIBOR currencies and asset classes. Among the different currencies, the sterling market has progressed the most, while of the different asset classes, the loan market has been the slowest to adopt RFRs. The UK’s Financial Conduct Authority (FCA), responsible for oversight of LIBOR, has stated that the impact of COVID-19 has not changed the central assumption that firms cannot rely on LIBOR being published after the end of 2021 1

In March, the Federal Reserve Bank of New York commenced publishing Secured Overnight Financing Rate (SOFR) averages and a SOFR index. The Bank of England has announced the intent to publish similar data, which is anticipated to help facilitate the adoption of RFRs across contracts. 

While RFRs, compounded in arrears, are expected to be the primary method for replacing LIBOR, it is possible that in some jurisdictions forward-looking term rates derived from RFRs (‘term rates’) may be developed. It is anticipated that the use of term rates will be limited and regulators have urged market participants not to delay transition in the hope that term rates may arrive. Regulators have also recognized that compounding interest rates in arrears may be challenging for some SMEs, who may choose alternatives, including fixed rates. 

Contractual fall-backs

A number of industry groups have been working to develop clauses (‘fall-backs’) to help contracts better address LIBOR’s discontinuance by referencing a specified RFR as a fall-back in the event LIBOR is discontinued permanently2. However, there are fundamental differences between LIBORs and RFRs. For example, RFRs are overnight rates, while LIBORs are available in multiple tenors. Additionally, LIBORs incorporate a bank credit risk premium while RFRs do not. As a result of these differences, both term and spread adjustments to the applicable fall-back RFRs are required to ensure that contracts referencing LIBOR will continue to function as closely as possible to the original agreement, in the event that the fall-backs are activated. 

The proposed fall-back clauses incorporate mechanisms for making the required term and spread adjustments and also define the ‘trigger’ that ends the contractual reference to LIBOR and ‘switches’ to the relevant fall-back adjusted RFR. 

The International Swaps and Derivatives Association (ISDA) has stated that it plans to amend the 2006 ISDA Definitions through publishing a supplement, which will incorporate the adjusted RFRs as the fall-backs for all new LIBOR referencing derivatives contracts that utilise those definitions3

ISDA also expects to publish a voluntary protocol (or protocols) to allow for the insertion of these amended 2006 ISDA Definitions into all legacy derivatives contracts between parties that adhere to the protocol. 

ISDA has selected Bloomberg to calculate and publish adjustments related to RFR fall-backs that ISDA intends to implement. The publication of indicative fall-back rates is targeted to commence prior to the publication of amendments to the 2006 ISDA Definitions and related protocol(s).

Despite being designed to limit net present value transfer arising from replacing LIBOR with an RFR, the ISDA fall-backs may still result in unexpected outcomes. That is because the relevant RFR and associated adjustments are, at best, an approximation of the discontinued LIBOR. In addition, the ISDA fall-back methodology, which involves a linear adjustment, may be ill-suited for volatility products. 

Industry bodies for other asset classes, such as the loan market, are considering similar approaches to contractual fall-backs in their documentation, although the implementation may be less standardised than it is in the derivatives market.

Fall-backs may have differences across different product types and asset classes. Therefore, there may be a potential mismatch in replacement rates across products in your portfolio4.

Transition and market liquidity

Between now and 2022, we expect market liquidity to shift increasingly to RFRs. 

Contracts referencing LIBOR may not continue to perform as expected, both when LIBOR ends and potentially before that, as liquidity in LIBOR-referencing instruments could decline prior to LIBOR’s expected discontinuance. 

The continued development of liquidity in RFR markets, and the publication of industry-wide fall-backs will assist in your consideration of transition options. 

Transition options include: 

  1. Adhering to a contractual fall-back solution adopted industry-wide (such as the ISDA protocol for derivatives transactions) or entering into a bilateral amendment agreement; 
  2. Restructuring your portfolio to reference RFRs instead of LIBOR;
  3. Relying on the fall-backs within your existing documentation, if suitable; or
  4. A combination of these and other actions.

Regulators have recommended transitioning contracts to RFRs prior to LIBOR discontinuing permanently, thereby avoiding the need to rely on contractual fall-backs altogether.

Other implications

The transition away from LIBOR raises a number of 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.

You may wish to seek independent advice regarding any legal or regulatory obligations which may arise through implementing different transition options, including but not limited to derivatives transaction reporting rules, margining and collateral requirements or clearing obligations. These requirements may apply to you and us differently in different jurisdictions.

Accounting standard boards have considered various measures to facilitate the transition to RFRs. The measures that are being proposed, or have been adopted, affect financial reporting in the period during which there is uncertainty about contractual cash flows arising from the reform. Other measures that have been proposed would apply during the time when actual changes are made to contractual cash flows and hedging relationships. Please refer to your relevant authorities and independent advisors in relation to any accounting and tax consequences of transition.

As nothing in this document should be taken to be advice, we encourage you to seek independent advice on these matters.

What Commonwealth Bank is doing to prepare for LIBOR transition

Commonwealth Bank has established a Group-wide transition program and developed the capability to transact in RFRs to assist you with your transition needs. 

We may approach you in the near future to discuss LIBOR, including the possible need for contractual changes.

What if you have more questions? 

If you have any further questions regarding benchmark reform, please contact your Commonwealth Bank representative or the Interest Rate Benchmark Reform Program directly, on IRBR@cba.com.au.

Previous communications

Things you should know

1. As communicated by the FCA

A specified RFR may also be referenced upon a stated determination by the FCA that the LIBOR is not deemed ‘representative’ of an underlying market or economic reality. This could occur shortly prior to LIBOR’s permanent discontinuance. We refer to isda.org for details.  

3. The fall-backs would apply to a number other ‘IBORs’, as well – we refer to isda.org for details.

So-called ‘triggers’ that end the contractual reference to LIBOR and ‘switch’ to the relevant fall-back adjusted RFR may vary as well. 

This information is published solely for information purposes. It is not to be construed as a solicitation, an offer or recommendation by the Commonwealth Bank of Australia (the “Bank”). As this information has been prepared without considering your objectives, financial situation or needs, you should before acting on the information, consider its appropriateness to your circumstances. It must not be relied upon as investment research. The Bank believes that the information is correct and any opinions, conclusions or recommendations are reasonably held or made, based on the information available at the time of its compilation, but no representation or warranty, either expressed or implied, is made or provided as to accuracy, reliability or completeness of any statement made. Commonwealth Bank of Australia ABN 48 123 123 124. AFSL and Australian Credit Licence 234945.