The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It is administered by ICE Benchmark Administration and supervised by the Financial Conduct Authority (FCA).
It is calculated based on submissions from selected panel banks and is published in 5 currencies and a range of tenors. It is a major interest rate benchmark which is referenced in a broad range of financial contracts including, derivatives, bonds and loans.
The underlying markets that LIBOR measures are not liquid. LIBOR has been used to hedge the general level of interest rates, for which it is inefficient given it includes a term bank credit component.
The FCA has secured panel bank support to continue submitting to LIBOR, but only until the end of 2021. Beyond this date the future of LIBOR is not guaranteed.
Around the world, national working groups have identified alternative nearly risk-free reference rates (RFRs) which can be used as an alternative to LIBOR. RFRs have been identified because these rates are robust and are anchored in active, liquid underlying markets.
Since the rates are overnight rates, and not term rates like LIBOR, important distinctions exist between LIBOR and the newly adopted rates, including in relation to coupon accrual, settlement, systems usage, and accounting, among other things.
Overnight RFRs have been identified for all major currencies as an alternative to LIBOR, but the pace of adoption and transition varies between currencies and between product types.
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.
The proposed fallback 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 fallback adjusted RFR.
Table reproduced from Financial Stability Board website.
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 this information is prepared for information purposes only it should not be taken to be advice. We encourage you to seek independent advice on these matters.
Regulators have provided guidance on what steps market participants can take to start preparing for the transition. These include:
For further information, please refer to the following resources:
The Commonwealth Bank has established a Group-wide transition program and developed the capability to transact in RFRs to assist in your transition.
We are currently contacting clients to discuss LIBOR, including the possible need for contractual changes.
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
For certain other major IBORs, authorities are encouraging efforts to develop robust RFRs and to make derivatives and other contracts more robust to discontinuation, but it is recognised that transition to RFRs may take longer. For example, authorities in the euro area are promoting a robust RFR in euro short-term rate (€STR) produced by the ECB. With respect to EURIBOR, its methodology has been reformed and its administrator received an authorisation under the BMR in July 2019, which allows its continued use for the foreseeable future.
In other currency areas, authorities do not at this time think that transition solely to RFRs is necessary and continue to support a multiple-rate approach. Examples include Australia, Canada and, with regard to TIBOR, Japan.
For the Australian dollar, the key interest rate benchmarks are the bank bill swap rates (BBSW) and the cash rate. Reforms have also been undertaken to enhance the robustness of these benchmarks.
The Reserve bank of Australia (RBA) has stated that:
‘the critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day to calculate a robust benchmark. Australia has an active bank bill market, where the major banks issue bills as a regular source of funding, and a wide range of wholesale investors purchase bills as a liquid cash management product’.
As markets transition from referencing LIBOR to RFRs, there may be some corresponding migration away from BBSW towards the cash rate. This will depend on how international markets for products such as cross-currency basis swaps end up transitioning away from LIBOR.
Note: These links are not comprehensive and do not cover all industries, supervisors or all of the issues associated with LIBOR transition.
Central Clearing Counterparty (CCP) Discounting Transition
As part of transition from LIBOR to Alternative Reference Rates (ARRs) the major clearing houses LCH, CME, and Eurex have previously announced they are in the process of making important changes affecting all cleared US dollar and euro-denominated products. Specifically, on 27 July 2020 they changed the reference interest rate on variation margin exchanged between clearing members and the clearing house on Euro OTC cleared swaps from EONIA to €STR flat. On 19 October 2020 they changed the reference interest rate on variation margin exchanged between clearing members and the clearing house on USD OTC cleared swaps from the Effective Fed Funds Rate (EFFR) to SOFR.
The reference interest rate for cash collateral used by clearing houses determines the discounting yield curve for the underlying exposure. These changes apply to all new and existing cleared transactions simultaneously. LCH has stated it plans to provide cash compensation payments to reflect the difference between the net present value of all future cash flows using new ARR discounting and the net present value used in EONIA or EFFR discounting.
ISDA fallbacks
Benchmark fallbacks are replacement rates that would apply to derivatives trades referencing a particular benchmark. These would take effect if the relevant benchmark becomes unavailable while market participants continue to have exposure to that rate. Specific fallback rates are set out in the 2006 ISDA Definitions. ISDA has been working with industry on new robust fallbacks that would apply in the event of a permanent cessation of a key interbank offered rate (IBOR). On 23 October 2020 ISDA published the IBOR Fallbacks Supplement and Protocol. The Supplement amends the 2006 ISDA Definitions to incorporate the new fallbacks. The Protocol enables market participants to choose to incorporate the fallbacks into their legacy non-cleared derivatives trades with counterparties that also adhere to the Protocol. The Supplement and Protocol become effective on 25 January 2021.
Source: ISDA 2020
Industry recommendations in the US and UK loan markets
Of the different asset classes, the loan market has been the slowest to adopt RFRs. Industry working groups have published various statements aimed at facilitating the transition to RFRs in the loan market specifically. These include specific timelines of transition.
Further discussion can be found here.
The UK Government announced that it intends to bring forward legislation to amend the Benchmarks Regulation (BMR) to give the FCA enhanced powers.
Disclosure for Derivative Trades
This information is published solely for information purposes and is not to be construed as a solicitation, an offer or recommendation by the Commonwealth Bank of Australia. The information may be incomplete or not up to date and may contain errors and omissions. It must not be relied upon as financial product advice and is not investment research. As this information has been prepared without considering your objectives, financial situation or needs, before acting on the information you should consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. We believe that this information is correct at the time of publishing and any opinions, conclusions or recommendations are reasonably held 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 the accuracy, reliability or completeness of any statement made.
