On 14 November 2018, the Financial Stability Board (FSB) issued a report on progress in reforming major interest rate benchmarks. This analysis summarises the key points in the report, looking in particular at the current position in relation to LIBOR and Euribor.
Reform of interest rate benchmarks—what is the state of play?
In 2014, the FSB issued a report entitled Reforming major interest rate benchmarks (the 2014 report). This contained recommendations for strengthening existing benchmarks for key Interbank offered rates (IBORs) and for the development and adoption of risk-free reference rates (RFRs) where appropriate.
In addition, in 2016, the FSB launched an additional stream of work to improve contractual robustness to cater for the discontinuation of interest rate benchmarks with the least disruption. The report issued on 14 November 2018 (the FSB report), sets out progress on the recommendations in the 2014 report and the workstream as regards contractual robustness, and provides a useful snapshot of the current state of play across the various major interest rate benchmarks.
What does the FSB report cover?
The first section of the FSB report sets out international coordination of the work on benchmark reform and key cross-jurisdictional themes. In particular it highlights areas where the approach taken to different IBORs is diverging. For example, while it is envisaged that LIBOR will be phased out by the end of 2021, other jurisdictions (for example Australia and Canada) are taking the view that a wholesale transition to RFRs is unnecessary. Many jurisdictions are therefore supporting a multiple-rate approach. As a result, work to transition to RFRs in LIBOR currencies is on the whole more advanced compared to most other IBORs.
The next section of the FSB report focuses on moves to base the IBOR benchmarks more firmly in transaction data and other developments. It discusses developments relating to LIBOR, EURIBOR, TIBOR, and to the relevant IBORs in the following jurisdictions—Australia, Canada, Hong Kong, Brazil, Mexico, Singapore and South Africa.
The third section discusses the development of and transition to RFRs in the LIBOR, and other IBOR, currencies.
The final section discusses development of fallback rates to address contractual risks where interest rate benchmarks are discontinued.
What is the current position for LIBOR?
Currently, it is envisaged that LIBOR will be discontinued from the end of 2021. Work is therefore ongoing to identify appropriate RFRs that can take its place across the LIBOR currencies and adapt them where necessary for use across sterling bond, loan and derivatives markets.
SONIA has been selected as the RFR for Sterling markets and progress has been made in promoting its wider use already in certain areas of the financial markets. For example, three providers now offer SONIA-linked future contracts and several SONIA linked Floating Rate Notes (FRNs) were issued in Q3 2018.
SONIA is a less obvious fit for the loan market, where documentation and processes are geared towards a forward looking term rate such as LIBOR. The development of a Term SONIA Reference Rate (TSRR) is therefore an important workstream. The consultation on a TSRR, issued by the Working Group on RFRs in July, suggests that the short-dated SONIA Overnight Indexed Swaps market provides the best potential source of pricing inputs for the development of TSRRs in the near term. The Working Group anticipates that a TSRR could be available in the second half of 2019.
The FSB report also covers transition progress made in the other LIBOR currencies, highlighting, for example, efforts by the Federal Reserve to promote use of the Secured Overnight Financing Rate (SOFR) for US dollar transactions following SOFR’s selection in June 2017 as the US's Alternative Reference Rates Committee’s (ARRC) recommended alternative to LIBOR.
The FSB report also highlights other developments relating to LIBOR. Work continues to move panel banks to using the waterfall methodology which standardises the rate submission process by panel banks—this is being done gradually to minimise operational and technology risks and is due to be completed in Q1 2019.
In addition, on 28 December 2017, the European Commission added LIBOR to the list of critical benchmarks under the EU Benchmark Regulation. Therefore, relevant provisions of the Benchmark Regulation relating to critical benchmarks now apply to LIBOR, including powers of compulsion over the submitting banks and ICE Benchmark Administration.
What is the current position for Euribor?
Reform of Euribor is also progressing, with the benchmark’s administrator, EMMI, introducing a ‘hybrid methodology’ combining transactions, market data and expert judgment which prioritises the use of real transactions whenever available and appropriate. This is due to be phased in 2019.
At the end of June, EMMI confirmed that some Euribor tenors (2 week, 2 month and 9 month) would cease, and also that publication of individual panel banks’ submissions would be discontinued. Both of these are to take place as of 3 December 2018. A public consultation, published in October, provides the final blueprint for the hybrid methodology. Feedback will be published at the end of the year.
In terms of work towards transitioning to a RFR, it has been confirmed that EONIA (the Euro Overnight Index Average) is currently not meeting the requirements of the Benchmarks Regulation. This means that its usage in new contracts will be prohibited as of 1 January 2020 making it an unsuitable candidate for an alternative to Euribor. Instead, the working group on euro RFRs has selected the new Euro Short-Term Rate (ESTER) as the euro RFR—this will serve as a replacement for EONIA and fallback for Euribor in due course. The ECB has indicated that it will produce ESTER by October 2019 at the latest.
The looming prohibition of EONIA in new contracts means that the transition from EONIA to ESTER is more urgent than the transition from Euribor to a RFR. However, work is on-going to ensure it is a suitable fallback for Euribor—in particular, the euro working group has outlined the need to develop a derivatives market based on ESTER as soon as possible in order to enable the establishment of a term rate on the basis of ESTER.
What is the position as regards contractual fallbacks?
The FSB is encouraging work by market participants, including ISDA and other trade associations, to increase contract robustness for various financial products to cater for the risk of a major benchmark being discontinued.
ISDA has been leading this initiative and has determined that the appropriate contractual fallback will be to the RFR identified by the relevant currency working groups as an alternative to the relevant IBOR. The two triggers, determined by ISDA, for the fallback to be applied are:
- a statement by the administrator that it has ceased or will cease to provide the relevant IBOR permanently or indefinitely, or
- a statement by the relevant administrator’s regulator, currency central bank or other competent authority that the administrator of the relevant IBOR has ceased or will cease to provide the relevant IBOR permanently or indefinitely
ISDA launched a consultation in July on a set of potential options for term and spread adjustments designed to account for the differences between term IBORs and the overnight RFRs. ISDA will publish the final approach for review and comment before any changes are made to its standard documentation.
In the UK specifically, various associations have been involved in work on contractual fallbacks, including the Loan Market Association (LMA), the International Capital Markets Association (ICMA) and the Association for Financial Markets in Europe (AFME). For example, the LMA has issued new slot in Replacement of Screen Rate working which is intended to make the process of amending documents easier in the future by permitting amendments to be made by Majority Lender consent only in a wider range of circumstances than the existing clause. In particular, it allows amendments to be made to facilitate inclusion of a replacement benchmark which (a) is formally selected as a replacement for LIBOR, (b) is otherwise selected by the relevant market, or (c) is deemed appropriate by the requisite majority of lenders and the obligors.
In relation to USD, the ARRC is seeking to finalise recommendations for safer contract language in various products including FRNs, business loans and securitisations. It published two public consultations on contract language in September and is in the process of receiving responses (see eg ICMA’s response on the 16th November 2018.)
Where can I find out more information?
The FSB report itself contains a helpful table setting out the alternative RFR candidates and key future development dates in relation to each currency.
The LMA has published a LIBOR microsite which contains information it publishes in relation to LIBOR (eg the new Replacement of Screen Rate clause). This is available on the LMA website to its members.
In relation to developments on Term RFRs, on 10 October 2018, ICE Benchmark Administration Limited (IBA) launched the ICE Term RFR Portal.
Our LIBOR developments tracker (Lexis subscription is needed) is kept up to date and is a useful first port of call for developments in relation to LIBOR and other benchmarks.
Our industry body trackers, Loan Market Association (LMA)—latest news on documentation, ISDA—latest news on documentation and ICMA—latest news on documentation (Lexis subscription is needed) set out any publications or updates made by these bodies in relation to reform of benchmarks.