Changes to Interest Rate Benchmarks: November 2019

Regulators expect market participants to limit their reliance on LIBOR and to prepare for the transition to alternative RFRs. 

Central banks, as well as industry committees and working groups, have taken a lead role in efforts to establish viable RFRs as alternatives to LIBOR.¹ RFRs are all overnight rates and have been identified for each of the LIBOR reference currencies. The pace of adoption of these RFRs will vary and market conventions to facilitate the use of RFRs in financial contracts are also being developed. 

There are fundamental differences between LIBOR and RFRs. 

• Interest rates that have been linked to LIBOR (such as 3-month USD LIBOR) are set for a term at the start of each floating rate interest period because LIBOR is a forward-looking rate. 
• When overnight RFRs are used for an interest period, the interest rate may not be known until, or shortly before the end of the term. That is because, under present market standards, RFR values are averaged or compounded over the interest period.  

Across the global financial markets, working groups are discussing the development of forward-looking term rates based on RFRs. The viability of these new rates is not assured, and their use is intended to be limited to cash markets. 

The transition to RFRs will also involve a number of large-scale changes to the way the cash and derivative markets currently function, including market infrastructure changes. 

LIBOR may be found not only embedded across firms’ assets and liability structures, but also in a wide range of applications and infrastructure used for valuation, pricing, performance evaluation and risk management. Market participants and their infrastructure providers are expected to develop or upgrade systems to accommodate the use of RFRs.

 

¹ RFRs are being established as alternatives for various interest rate benchmarks encompassing a bank credit component. Such benchmarks are commonly referred to as ‘IBORs’. Examples include Bank Bill Swap Rate and the Euro Interbank Offered Rate (EURIBOR). LIBOR is a subset of IBOR – for clarity, we refer to LIBOR in the text unless specified otherwise.

Contracts for various asset classes that reference LIBOR have typically included clauses to address the temporary unavailability of LIBOR. However, these contracts have not contemplated a permanent discontinuance of LIBOR. Various industry groups are now leading the effort to develop suitable ‘fall-back’ language to be included in contracts.  

Fall-back language defines an event that will trigger the transition away from LIBOR (or another benchmark) to a RFR. It also aims to define an appropriate spread adjustment to account for the difference between the RFR (which does not have a material credit element) and LIBOR (which does). The fall-back in the contract will set out a transition process to the alternative rate and reduce the risk of disputes between parties.

The International Swaps and Derivatives Association, Inc. (ISDA) sets standard documentation to be executed between parties transacting in derivatives. ISDA is expected to publish new fall-back language for derivative contracts at the beginning of 2020. This language will amend the 2006 ISDA definitions and will apply to any new derivatives transactions that reference LIBOR in ISDA standard documentation. ISDA will also publish a voluntary protocol to address the language of existing derivative transactions. 

The new ISDA fall-back language and protocol are expected to take effect in Q2 2020.

When a fall-back trigger (such as the discontinuance of LIBOR) occurs and LIBOR is replaced by a RFR, value transfer may take place from one party to another. 

This is primarily because the replacement rate, which is the sum of a replacement benchmark rate and spread, is expected to be based on average historical market conditions which may not match market expectations for future market conditions. 

Industry bodies of other asset classes are considering similar approaches, however, fall-backs are unlikely to be synchronised across different product types. This means that, in the event of fall back benchmark rates being triggered, there might be a mismatch in replacement rates and timing across products in your portfolio. 

Important work has gone into developing robust and effective fall-backs that can be used if a LIBOR cessation trigger is activated. 

However, the most effective transition from LIBOR is to move away from contracts that reference LIBOR to RFR-referencing contracts, without having to rely on fall-backs. As the liquidity in RFRs develops, The Commonwealth Bank will work with clients to manage the transition.

Since our previous communications, several announcements have been made by the relevant authorities regarding EONIA and EURIBOR respectively. 

From 2 October 2019, the European Over Night Index Average (EONIA) is being published T+1 and is redefined as the Euro short-term rate (€STR) + a fixed spread of 8.5 basis points. €STR is an overnight rate that is the risk-free rate for the Euro area. EONIA’s administrator has indicated that it will provide EONIA under the new methodology until 3 January 2022, the date on which EONIA will be discontinued.

The administrator of the Euro Interbank Offered Rate (EURIBOR) is reforming EURIBOR by moving to a ‘hybrid’ methodology.  However, while the data inputs and method of calculation of EURIBOR will change, the rate will continue to measure the same underlying interest, i.e. the market or economic reality that the rate seeks to reflect. The rate will continue to be published for the foreseeable future.²

 

² For further information we refer to the relevant publications of EURIBOR’s administrator, the European Money Markets Institute as well as this FAQ from ISDA.

Supervisory authorities³ strongly encourage market participants not to delay transition away from LIBOR.

You should identify the LIBOR-linked exposures within your organisation for the transition to RFRs. You should consider areas in your business that are impacted, including systems, documentation, risk management and accounting. 

Market participants are encouraged to stay up to date on market-led transition initiatives. 

The Commonwealth Bank is currently developing the capability to transact in RFRs to help you manage your risk and transition to the new rates. We are actively involved in industry transition efforts and have established a Commonwealth Bank Group-wide program to plan for the transition. 

We may also approach you in the near future to discuss relevant information regarding LIBOR reform, including the possible need for changes to contracts.

 

³ These supervisory bodies include the UK’s Financial Conduct Authority, the Federal Reserve Bank of New York and the Reserve Bank of Australia.