What is the “IBOR transition”?
This transition phase refers to the ongoing preparations by the financial sector for the upcoming replacement of the reference rates (or benchmarks) known as "IBOR" (InterBank Offered Rate) by alternative "risk-free rates". This transition has many implications for the interest rates industry, investors and economic agents. IBOR rates have been used as a benchmark for decades to calculate variable rates for a wide range of financial products (issues, loans, treasury, vanilla and exotic derivatives), so why this reform?
IBOR rates measure the cost of borrowing of banks from banks and other financial institutions on the money market on several maturities (day to day, 1 week, 1 month, 3 months, 6 months, 12 months). Libor (London interbank offered rate), Euribor (Euro interbank offered rate) are among those rates that have played a key role in financing the economy and markets in recent decades. In fact, IBOR-related financial contracts have reached hundreds of billions of dollars. However, these rates are "predetermined" (forward-looking) and constructed on the basis of the declarations of the contributing banks on the basis of actual transactions observed, supplemented by observations of other transactions or market parameters if these transactions are not sufficiently numerous. Since the financial crisis of 2007-2008, the loan market has suffered a drastic fall in its transaction volumes. This led market authorities to express concern about the reliability of the IBOR construction method that is based mainly on market data observation. This situation led the Financial Stability Board (FSB) to recommend in 2014 to reform and strengthen these benchmarks and to develop alternative reference rates anchored on real transactions.
Since 2014, working groups led by central banks chose risk-free rates (RFR) as alternatives to IBOR. RFRs are "backward-looking" rates constructed on the basis of overnight deposits with banks. Traded on the very liquid money market, overnight loans, whether guaranteed or unsecured, present a very low counterparty risk compared to longer maturities.
In light of the colossal amounts of financial products linked to IBOR, the transition to these RFR rates is an important transformation. Since 2017, the work of the working groups have intensified.
In Switzerland and Japan, the already existing Saron (Swiss Average Rate Overnight) and Tonar (Tokyo Overnight Average Rate) were chosen to become the RFR rates and take over the Swiss franc and Yen Libor rates.
In April 2018, the UK reformed the Sonia (Sterling Overnight Index Average) to replace the Sterling Libor. In late 2019, the UK market authority, the FCA, announced the end of mandatory Libor contributions after the end of 2021. However, doubts remain on the market about the operational feasibility of a Libor shutdown, particularly on the Dollar Libor, despite the creation in the United States of a new rate, the SOFR (Secured Overnight Financing Rate).
In Europe, the Ester (Euro Short Term Debt) was created to replace the Eonia, which is due to be last published on 3 January 2022. In parallel, the Euribor was reformed in July 2019 (hybrid method). The Euribor in its current form complies with the European Directive on benchmarks and can therefore be used in transactions without an end date being considered by the authorities at this stage. Today, the RFR rates markets are not yet mature. The UK is the most advanced with well-developed debt markets and swaps indexed on Sonia.
RFRs are alternatives to IBOR for most market products but may not be suitable for instruments requiring a knowledge of the rate at the beginning of the interest period. The lack of forward-looking term risk free rate (forward-looking term risk free rate) has fueled market participant concerns, leading working groups in Europe, Japan, the US and the UK to work on alternatives.
In view of the tight regulatory deadlines, market authorities have called on investors to prepare as best as possible by adopting risk-free rates in new financial contracts as soon as possible and to reduce their exposure to old rates in existing contracts.