Interbank Offered Rates ("IBORs") including the London Interbank Offered Rate ("LIBOR") and the Euro Interbank Offered Rate are being reformed.
A wide range of financial products such as derivatives, bonds, loans, structured products and mortgages, use benchmark rates to determine interest rates and payment obligations. Benchmark rates are also used to value certain financial products and as a performance tracker for funds.
As the regulator overseeing the administration of LIBOR, the UK Financial Conduct Authority ("FCA") has reiterated its message that it will not require banks to submit to LIBOR after 2021. The FCA and the Bank of England have reconfirmed that firms cannot rely on LIBOR being published after the end of 2021.
Reason for the transition
A series of scandals has sealed the fate of the once dominant IBOR benchmark. In 2012, a group of banks were accused of manipulating their IBOR submissions during the financial crisis. In the wake of those scandals, the FCA shifted supervision of the index to the Intercontinental Exchange Benchmark Administration ("IBA").
Despite steps taken by the IBA to strengthen the benchmark, the ongoing slowdown in unsecured debt market activity has diluted IBOR's relevance - three-month US dollar LIBOR, the most heavily referenced IBOR benchmark, is supported by less than $1 billion in transactions per day. As such, LIBOR submissions were largely based upon expert judgement rather than transaction data. This led to concerns that LIBOR was unrepresentative and vulnerable to potential manipulation, which in turn culminated in a number of criminal actions brought in various jurisdictions around the world.
This concern has resulted in recommendations made by the Financial Stability Board in 2014 to reform major interest rate benchmarks and use near risk-free rates ("RFRs") that are based on more active and liquid overnight lending markets, instead of IBORs, where appropriate.
RFRs are typically backward-looking overnight rates based on actual transactions and reflect the average of the interest rates that certain financial institutions pay to borrow overnight either on an unsecured basis from wholesale market participants for unsecured RFRs, such as the Sterling Overnight Index Average or the average rate paid on secured overnight repurchase or "repo" transactions for secured RFRs, such as the Secured Overnight Financing Rate.
Differences between IBORs and RFRs
LIBOR and most other IBORs are intended to measure unsecured interbank lending rates and therefore include or imply a credit spread. On the other hand, RFRs do not require such a credit spread due to their overnight and near risk free nature. RFRs are, therefore, in most cases expected to be lower than their IBOR equivalents.
IBORs are "term rates", which means they are published for different periods of time such as 3 months or 6 months, and are "forward looking", which means they are published at the beginning of the borrowing period. Due to IBOR's "forward looking" nature, it incorporates a term premium to compensate for the risk of default over the term for which it is calculated.
Most RFRs are "backward-looking" overnight rates based on actual historical transactions. They are published at the end of the overnight borrowing period. RFRs therefore do not incorporate any term premium, which is imbedded in the IBOR calculation due to lending to another bank on a longer-term basis.
It is important to note that RFRs are not completely free of risk, hence they are considered "near risk-free". RFRs can rise or fall as a result of changing economic conditions and central bank policy decisions.
Impact on the global financial system
While firms are pivoting away from IBORs, trillions of dollars of debt and derivatives products will continue to reference the index after the 2021 deadline. The differences between IBORs and RFRs mean that the risk profile and valuation of trillions of dollars of financial contracts will likely change once they're benchmarked by RFRs.
To mitigate the uncertainty, firms will need to determine the appropriate spreads to be applied to RFRs ahead of the transition, requiring the recalibration of a wide range of financial and risk models. Adjustments for credit and term differences may need to be incorporated and applied to the alternate rate.
International Swaps and Derivatives Association ("ISDA")
ISDA is a trade organization created by the privately negotiated derivatives market that represents participating parties. It helps to improve the privately negotiated derivatives market by identifying and reducing risks in the market.
Introducing robust fallbacks for derivatives contracts is a vitally important step in mitigating the systemic risk that could arise from the cessation of a key IBOR. ISDA publishes a supplement to the 2006 ISDA Definitions (the "Supplement"), plus a related protocol - "ISDA 2020 IBOR Fallbacks Protocol" (the "IBOR Fallbacks Protocol"), as part of the financial markets industry's switch from IBOR to RFRs.
The Supplement amends the definitions of several of the floating rate options included in the 2006 Definitions by incorporating RFRs as fallback rates that will apply following the occurrence of certain trigger events i.e. permanent cessation of any of the specified IBORs.
The IBOR Fallbacks Protocol acts as a delivery mechanism for the Supplement, facilitating multilateral implementation of its terms in legacy transactions. By adhering to the IBOR Fallbacks Protocol, market participants would be agreeing that their legacy derivatives contracts with other adherents will include the amended floating rate option for the relevant IBOR. It facilitates inclusion of the new fallbacks in existing non-cleared IBOR derivatives transactions between counterparties that both adhere to the protocol. Any such protocol will be completely voluntary and will amend contracts only between two adhering parties (i.e. it will not amend contracts between an adhering party and a non-adhering party or between two non-adhering parties).
The fallbacks will be adjusted versions (with the spread adjustment added) of the RFRs identified by public or private sector working groups in each jurisdiction as alternatives to the IBORs. The adjusted RFR in the relevant currency would apply as a fallback following a permanent cessation of the IBOR in that currency.
The Supplement and the IBOR Fallbacks Protocol will become effective on 25 January 2021 (the "Effective Date"). The Supplement terms will only apply to derivative transactions executed after the Effective Date, except where they are incorporated into existing transactions (commonly known as legacy transactions) via the IBOR Fallbacks Protocol or a bilateral amendment agreement.
To address the risk that one or more IBORs are discontinued while market participants continue to have exposure to that rate, counterparties are encouraged to agree to contractual fallback provisions that would provide for adjusted versions of the RFRs as replacement rates.
The IBOR Fallbacks Protocol is the most efficient way for participants in the vast majority of non-cleared derivatives markets to mitigate against the risks associated with the discontinuation of a key IBOR, and is a critical part of addressing both individual firm risks and systemic risks associated with the expected discontinuation and/or non-representativeness of LIBOR in particular.
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