Risk-Free Rate movements in RFRs reflect changes in interest rates, whereas movements in LIBOR reflect both changes in interest rates and bank funding costs. By using a rate that is more closely aligned with actual interest rate movements, our customers are better able to manage their exposures, and are not exposed to sudden spikes in bank funding costs.
Liquidity in LIBOR-referencing products is expected to decline as the market approaches LIBOR’s discontinuance on 30 June 2023.
RFRs are overnight rates. Therefore an RFR ‘interest rate’ or ‘coupon rate’ for an interest period will typically be based on an average or a compounding of daily observations of the RFR throughout the interest period and is therefore determined at the end of the calculation period. In contrast, LIBOR is a forward-looking “term” rate that sets the interest rate or coupon rate at the beginning of the interest period. Forward looking RFR term rates are available in the GBP, USD, and yen markets but their use is expected to be limited. In the sterling market UK, term SONIA may be used for trade finance and export finance facilities but is not recommended for wider use in the institutional loan market. In the USD market, term SOFR may be used for most types of lending facilities and the derivatives used for hedging these facilities.
A number of industry groups have been working to develop clauses (“fallbacks”) to help contracts better address LIBOR’s discontinuance by referencing a specified RFR as a fallback in the event LIBOR is discontinued permanently (or, in some cases, is no longer deemed ‘representative’ by the regulator).
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 are required to be made to the applicable fallback RFRs to ensure that contracts referencing LIBOR will continue to function as closely as possible to the original agreement, in the event that the fallbacks are activated.
ISDA launched the IBOR Fallbacks Supplement (“Supplement”) to the 2006 ISDA Definitions and the ISDA 2020 IBOR Fallbacks Protocol (“Protocol”) on 23 October 2020. CommBank adhered to the Protocol shortly after. The provisions of the Supplement are included in all new derivative contracts as of 25 January 2021 so that all IBOR derivatives contracts entered into on and after that date referencing the 2006 ISDA Definitions will contain the new fallbacks. Legacy non-cleared derivatives contracts (those entered into pre 25 January 2021) will only incorporate the new fallbacks if both parties to the contract adhered to the Protocol, or otherwise bilaterally agreed to include the new fallbacks in their contracts. The Protocol remains open for adherence.
The fallback clauses typically incorporate mechanisms for making the required term and spread adjustments and also define the ‘trigger’ that ends the contractual reference to LIBOR (being permanent cessation including non-representativeness of the rate) and ‘switches’ to the relevant fallback adjusted RFR.
Additional information can be found here: