Preparing for the transition from IBOR to risk free rates.
Interbank Offered Rates (IBORs), such as the London Interbank Offered Rate (LIBOR), have been used to set interest rates on a global basis for a wide variety of financial products, including derivatives, loans, bonds and structured products. However, as you may be aware, a number of central banks and international financial authorities have taken the view that these interest rate benchmarks represent a potential systemic risk and therefore need to be replaced or reformed. In particular:
- LIBOR “is expected to cease after end-2021”, following the announcement by the UK Financial Conduct Authority (FCA) that it would no longer persuade or compel LIBOR panel banks to continue making LIBOR submissions after 2021 (see: https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/factsheet-calling-time-on-libor-why-you-need-to-act-now.pdf );
- EONIA (Euro Overnight Index Average) was reformed in October 2019 and will no longer be published after 31 December 2021; and
- EURIBOR (Euro InterBank Offered Rate) was reformed in 2019 and is now compliant with the European benchmark regulation.
Regulators in a number of key jurisdictions (including the US, the EU and the UK) have a strong preference for IBORs to be replaced by rates based on overnight risk-free rates (RFRs).
Given the short timeline, the differences between IBORs and RFRs, the complexity of transitioning and the variety of products impacted, regulators around the world have been sending clear messages that market participants should prepare for the IBOR transition now.
Societe Generale is fully aware of these challenges and we are actively involved in industry efforts to manage the transition. We focus, in particular, on identifying and addressing the impacts on our clients’ transactions and on our operational capabilities.
As always, Societe Generale is committed to accompanying you throughout this transition period. We will continue to monitor industry developments and will keep you informed on the progresses and conclusions of the industry regarding the IBOR transition process.
Contact for any queries: firstname.lastname@example.org
What are IBORs?
"IBOR" stands for InterBank Offered Rates. The IBOR is an average rate that is representative of the rates at which large, leading internationally active banks with access to the wholesale unsecured funding market, could fund themselves in such market in particular currencies for certain tenors. They are used to set interest rates on a global basis for a wide variety of financial products, including derivatives, loans, bonds and structured products.
LIBOR (the London interbank offered rate) and EURIBOR (the Euro interbank offered rate) are both examples of commonly used IBORs.
Why are IBOR rates being replaced?
Further to the 2007 financial crisis, in particular, there was a decline in the volume of transactions on the unsecured interbank lending market. These transactions underpin IBOR rates. Due to the disappearance of these transactions, today’s daily publication of IBOR rates relies heavily on "expert judgement" instead. The public sector is concerned that this situation represents a potentially serious source of vulnerability and a systemic risk. Therefore, such IBOR rates need to be replaced or reformed. The UK Financial Conduct Authority (FCA) announced that it would no longer persuade or compel LIBOR panel banks to continue making LIBOR submissions after 2021. Market participants should not rely on LIBOR being available after 1 January 2022.
What are the alternative solutions for IBOR rates?
The public sector, industry bodies and trade associations have identified risk-free rates ("RFRs") as possible replacements for IBORs. These alternative RFRs are at different stages of implementation, depending on their currency.
What are Risk Free Rates (“RFR”)?
The table below lists the historical IBOR rates for major currencies and the corresponding alternative RFRs:
What are the main differences between RFRs and IBORs?
The main differences between RFRs and IBORs are the following:
- Whereas IBORs are forward looking term rates that can apply across multiple tenors: overnight, 1 week, 1 month, 2 months, 3 months, 6 months and 12°months, RFRs are overnight rates with no term element. The only possibility to use RFRs with tenors, as of now, is on a backward looking basis, as averages over a given past period. The methodology recommended by public authorities and working groups to calculate such averages is with compounded interests.
- IBORs contain a premium for bank credit risk (and potentially other premiums – liquidity, term and funding) whereas, in general, RFRs contain little or no such additional premiums;
- Whilst IBORs rely also on expert judgement, RFRs rely exclusively on transactions.
Will there be forward-looking RFR term rates and, if so, when will these be introduced?
As of now, no forward-looking term rate is available in respect of any of the RFRs. The desire to develop forward-looking RFR term rates has been expressed by a number of industry working groups or private companies. However, so far:
- GBP: The Bank of England working group is the only one that has indicated that it planned making available forward-looking term rates complementing SONIA, possibly by the end of Q3 2020;
- USD: The ARRC (the working group with the NY Federal Reserve Bank) is working on a forward-looking SOFR term rate that could perhaps become available by late 2021;
- JPY: The Bank of Japan’s working group is assessing the possibility to provide a forward looking TONA term rate;
- CHF: The working group of the Swiss National Bank has made it known that there would be no forward-looking term rate for SARON;
- EUR: The European Central Bank working group is assessing the possibility to provide a forward looking €STR term rate.
What are the main milestones of the IBOR transition?
Further to the Financial Stability Board recommendation in 2014, strongly relayed by Central Banks since then, LIBOR, EURIBOR and EONIA have been reformed and may be replaced by Risk Free Rates over the coming years, due to a structural weakness (insufficient underlying interbank transactions).
I am a client. What will change for me with the IBOR transition?
Once an IBOR cease to be published by its administrator or is declared non representative any more by its supervisory authority, any new transactions on such IBOR may become impossible. The move away from IBOR may also generate the need to amend some of your existing transactions maturing beyond 2021 in order to replace IBOR.
Such replacement interest rate benchmark can be either proposed by market associations such as the ISDA or the LMA or can be recommended by the central bank working group for the concerned currency. Several regulators proposed legislations that would allow certain contracts to either continue referencing a reformed LIBOR (synthetic LIBOR computed based on RFR) or provide a statutory fallback automatically applied to the contract at the time of cessation or when the IBOR becomes non representative of the underlying market. The details and conditions of these initiatives are not know at the time of this writing but it could only be applicable to certain type of contracts such as “tough legacy” contracts, contracts regulated under the European Benchmark Regulation or under the law of the state of New York.
I am a client. What practical steps should I take for the IBOR transition?
As advised by supervisory authorities of LIBOR, it’s important to prepare ahead of such changes and to use, where possible, alternative risk free rates instead of LIBOR.
While the exact impact of the IBOR transition on products and services is not known yet, clients may wish to take certain steps to prepare for the transition:
- Understand your exposures and risks, including:
- Conducting a documentation review of existing contracts (with banks and non-banks) to identify references to IBORs or other affected interest rate benchmarks;
- Assessing the need for short-term liquidity facilities;
- Conducting a review of IT and other tools relying on IBOR benchmarks;
- Drawing on external advice (banks, professional associations, external advisers…) to consider what steps need to be taken to ensure operational readiness;
- Actively reduce your reliance on IBOR, including:
- Considering when to transact in products or services referencing new RFRs or other alternative solutions;
- Engage with transition effort, including:
- Staying informed of industry developments, including new protocols.
Why is the IBOR transition not “just” a benchmark replacement?
The IBOR transition is not a one-to-one benchmark replacement. IBOR rates include a bank credit premium and a term liquidity premium, whereas Risk Free Rates do not. As a consequence, IBOR benchmarks and Risk Free Rates may not have the same fixing level. In other words, the interest rate applicable to a given transaction may not be the same under an IBOR benchmark and under an RFR. This gap entails an economic risk at the time of transitioning, and a potential transfer of economic value from one party to the other. This risk can be mitigated with appropriate mechanisms such as the addition of an adjustment spread to the Risk Free Rate compensating for the historical difference with the IBOR.
The RFR working groups are aware of the issue and are working on it. As stated by the Working Group on euro risk-free rates, in its revised report on the transition from EONIA to €STR (March 2019): “A successful transition path would also […] protect users, especially the least sophisticated, by mitigating potential value transfers in the system.” Therefore, in order to recommend the best possible transition approach, the Working Group has considered different criteria, including for economic risks: “a potential value transfer as a result of the benchmark transition from EONIA to €STR should be mitigated to the maximum extent possible.”
Are RFRs forward looking as LIBORs are?
While several industry working groups organized by central banks have declared that they wish to propose a forward looking RFRs term structure, none are currently available. However, certain of these working groups suggested that the use of these potential term RFRs could be limited to specific products (e.g. export finance, mortgages, Islamic finance).
Therefore, in the absence of term RFRs availability and as RFRs are overnight rates, the calculation of interests based on RFRs over a period of time can only be done at the end of the interest period, for instance by compounding these daily RFRs in arrears.
Alternatively, borrowers may consider using a fixed rates known in advance as an alternative to IBOR rates.
I am a client with different IBOR products. Will the transition be the same for all my products?
Customers which have different products that reference IBOR benchmarks may potentially face the risk of a “de-synchronised” transition, whereby all products or services do not necessarily transition at exactly the same time and in the same way. This may prove an issue in different cases.
A frequent example is where a customer has two related products: a variable interest loan and the corresponding hedging instrument. In case the loan does not transition to a RFR in exactly the same way than the hedge (often governed by the ISDA Definitions), there arises the risk of a mismatch between the loan and its hedge.
The transition of multiple products or services is a complex issue which requires careful planning for each customer in anticipation of the transition. Such transition may be made more complex where a customer has multiple products with different banks.
The key to smoothing the transition is to anticipate it as far as possible.
What is the purpose of “fallback clauses”? What are the limits of such clauses?
A “fallback clause” provides for a replacement solution in case the IBOR rate in an agreement should disappear on a permanent basis or in case the IBOR is declared as non representative by a competent authority. The purpose is to ensure the continuation of the agreement at the time of discontinuation of the IBOR rate.
To date, fallback clauses are considered as mitigating the risk of abrupt contract termination, upon the cessation of an IBOR publication. However, fallback clauses are not a panacea. As Andrew Bailey, Chief Executive of the Financial Conduct Authority, puts it: “Fallback language to support contract continuity or enable conversion of contracts if LIBOR ceases is an essential safety net – a 'seat belt' in case of a crash when LIBOR reaches the end of the road. But fallbacks are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”
Indeed, fallback clauses entail many difficulties. One is the quality of the replacement rate, which depends on each agreement, and which may be suboptimal, especially in older contracts. Another one is the risk of de-synchronised transition (see previous question “I am a client with different IBOR products. Will the transition be the same for all my products?”).
This is why it is recommended to anticipate, at two levels:
i. By including robust fallback clauses in all new IBOR agreements, and
ii. By re-negotiating IBOR agreements upfront, in order to move them to alternative solutions prior to the end of an IBOR benchmark, and without awaiting the trigger of a fallback clause.
Societe Generale is here to assist customers diligently moving their agreements away from IBOR benchmarks.
How does the proposed ISDA fallback mechanism work?
For derivative products governed by the ISDA Definitions, a new fallback provision is currently under discussion. The purpose is to provide ISDA documentation users with a hardwired fallback mechanism triggered at the time of cessation an IBOR or when it is declared non-representative of the underlying market.
After numerous discussions and market surveys, the ISDA preferred fallback rate seems to be as follows:
- The RFR compounded in arrears over the correspondent tenor of the replaced IBOR rates.
- Plus a spread adjustment corresponding to the median of the historical daily difference between IBOR and compounded in arrears RFR, as observed over a 5-year period. This historical spread adjustment is necessary to compensate for the difference between such IBOR and the corresponding compounded RFR and as a consequence avoid value transfer between counterparties. This spread adjustment is fixed at the time of announcement of the cessation or non representativeness.
As a practical matter, Bloomberg has been selected to publish the value of the ISDA fallbacks for each IBOR and maturity. Bloomberg and ISDA announced on July 21st that Bloomberg Index Services Limited (BISL) has begun calculating and publishing fallbacks that ISDA intends to implement for certain key interbank offered rates (IBORs).
This supplement to the ISDA Definitions and the associated protocol are currently under discussion for LIBOR. They are expected in 2020. If you wish to include these ISDA fallbacks into existing transactions, you may consider adhering to the associated ISDA protocol after conducting detailed analysis of its content and the impact on your activity.
How does Societe Generale plan to manage legacy swaptions following CCPs discounting switch?
Ahead of the EONIA cessation at the end of 2021, major central counterparties (“CCP”) changed the discounting rate of EUR cleared derivatives to €STR on July 27, 2020. This change may affect the value of certain EUR swaptions entered into at a time when such transition was not contemplated.
Societe Generale has been closely following and participating in the work of the EUR RFR Working Group which recommended that compensation be exchanged on a voluntary basis ahead of the CCP transition.
While we supported that recommendation and saw benefits in the exchange of such compensation, it does not appear that there is a market-wide consensus on a voluntary compensation scheme for such swaptions.
As a consequence, Societe Generale will not request nor offer a compensation on legacy EUR swaptions to avoid any discrepancy in our counterparties treatment. Societe Generale will simply honor the terms of the original swaptions contracts.
As major CCPs are planning on October 16th 2020 a similar transition of discounting rate from Effective Federal Funds Rate (EFFR) to the Secured Overnight Financing Rate (SOFR) for cleared derivatives denominated in USD, Societe Generale will consider the ARRC recommendation that compensation should be exchanged on a voluntary basis for swaptions traded prior to March 30, 2020. However, if a market-wide voluntary compensation scheme is not effective by Oct 16 2020, we will, as a default position, adhere to the existing terms of the contracts that we have in place with our clients, and not participate in an additional exchange of cash on these transactions.
Links to central bank working groups
- New York Federal Reserve (USD) : Alternative Reference Rates Committee (ARRC)
- Bank of England (GBP) : Working Group on Sterling Risk-Free Reference Rates
- Swiss National Bank (CHF) : National Working Group on Swiss Franc Reference Rates
- European Central Bank (EUR) : Working Group on Euro Risk-Free Rates
- Bank of Japan (JPY) : Study Group on Risk Free Rates
This webpage dedicated to the IBOR reform, including the Q&A, has been prepared by Societe Generale (SG). The information it contains is general and does not constitute advice. It was first prepared prior to the date it is sent and may not have been updated to reflect recent market developments. It contains information on IBOR reform that is intended for the use of SG clients only and it should not be shared with third parties. SG accepts no responsibility or liability to you with respect to the use of this webpage or its contents. If you have questions in relation to the contents of this webpage, you should consider seeking independent professional advice (legal, tax, accounting, financial or other) as appropriate.