ISDA, ICMA, AFME, SIFMA and SIFMA AMG have launched a roadmap highlighting the key challenges involved in transitioning financial market contracts and practices from interbank offered rates, or ‘IBORs’, to alternative risk-free rates (RFRs).
What is the background to the benchmark survey 2018 transition roadmap being published?
Interbank offered rates (IBORs) such as LIBOR, EURIBOR and TIBOR act as reference rates to many types of transaction. Benchmark reform initiatives however mean that the financial markets are starting to have to move away from reliance on the IBORs to select alternative nearly risk-free reference rates (RFRs) and are having to plan on how to successfully transition away from using IBORs to RFRs.
For more detailed information on the background to this, see news analysis: Replacing LIBOR: current position and implications for loan agreements.
In July 2017, Chris Salmon, executive director, markets at the Bank of England spoke to the Bank of England roundtable of sterling risk-free reference rates saying:
We do not underestimate the complexity of reducing the financial system’s LIBOR dependency. We are at the beginning of the process, and at this early stage the challenges are not all clearly in focus. That is why the engagement, help and support of the wider community of users of sterling interest rate benchmarks – issuers, investors, banks, as well as dealers – will be essential. The Working Group needs your help to identify the impediments to transition as you see them – and, equally, to identify where there are opportunities
In response to this, ISDA, AFME, ICMA, SIFMA and SIFMA AMG (together, the Associations) have published a roadmap. The intention is that this roadmap will raise awareness of some of the challenges to be solved as part of the transition plan and provide a central resource of information for benchmark transition across market sectors. The ideal end result for the Associations would be minimal disruption in the market in transitioning from IBOR to an RFR.
What does the benchmark survey 2018 transition roadmap do?
The roadmap collates and summarises existing analysis to provide a single point of reference for market participants who want a high-level summary of global initiatives taken to date.
The roadmap has three main objectives:
- to centralise information
- to facilitate market education, and
- to act as an input to the Global IBOR Survey and Report
It covers eight benchmarks by currency:
- GBP LIBOR
- USD LIBOR
- EURO LIBOR
- CHF LIBOR
- JPY LIBOR
- JPY TIBOR, and
- EUROYEN TIBOR
It covers seven types of product:
- over the counter (OTC) derivatives
- exchange traded derivatives (ETDs)
- bonds and floating rate notes
- short-term instruments
- securitised products, and
- other (to include late payments, discount rates, overdrafts)
Market participants that it covers includes:
- central counterparties (CCPs)
- government-sponsored enterprises (GSE)
- investment banks
- commercial banks
- retail banks
- asset managers
- pension funds
- hedge funds
- regulated funds
- non-bank lenders
- supranationals, and
What is the global use and impact of IBOR reference rates?
Section 3 of the roadmap sets out the background and impact of the IBOR reference rates. It sets out how the different IBORs are defined (LIBOR, TIBOR and EURIBOR) and how LIBOR is the main interest rate benchmark for USD, GBP, CHF and JPY derivatives and EURIBOR for EUR contracts. Derivatives are the primary focus of the roadmap since they account for 80% of LIBOR-linked contracts, although in time the focus will broaden to include other products such as securities, loans and mortgages.
The roadmap differentiates how IBOR is used by different market participants and sets out some of the uses of IBOR including:
- hedging exposures by trading derivatives
- banks acting as market makers for OTC derivatives or intermediaries between end users and exchanges for ETDs
- banks acting as intermediaries between clients where the sell-side institution is a clearing member
- offering deposits, credit cards, mortgages and other loans
- issuing floating rate notes and callable debt referencing IBORs
- securitising assets or offering securitised products linked to IBOR
- obtaining loans referencing IBORs, and
- clearing and settling trades
The roadmap refers to the Market Participants Group Final Report on Reporting Interest Rate Benchmarks in 2014 which demonstrated that IBOR benchmarks have a broad market footprint across jurisdictions, tenors and products.
What are the key global initiatives driving the review and reform of major IBORs?
Section 4 of the roadmap sets out the key global initiatives that are pushing forward the review and reform of major IBORs. The main driver for IBOR reform has been that existing interbank benchmark interest rates are seen as not reliable and robust enough. There has therefore been a push towards restoring the governance and oversight of major interest rate benchmarks in line with the recommendations set out by the Financial Stability Board (FSB).
The roadmap sets out in some detail the key reports issued by the global regulatory community to review and reform the major IBORs starting with the Wheatley review of LIBOR in September 2012. It also sets out the jurisdictional working groups set up to help the industry follow the FSB recommendations.
The industry has divided work into four components:
- enhancing the major interbank interest rate benchmarks:
- to enhance the current rates, initiatives are required to strengthen the existing rates and these enhanced rates are termed IBOR+
- the initiatives have not succeeded in resolving underlying issues surrounding the IBORs especially because of a lack of market transaction data
- identifying alternative RFRs:
- the RFR must be IOSCO compliant and new or existing alternative RFRs have been considered for use instead of IBORs
- strategies need to be identified to create liquidity in the newly identified RFRs
- developing transition strategies to adopt alternative RFRs, and
- increasing contractual robustness:
- initiatives are required to ensure that when an IBOR is discontinued, contractual certainty is not weakened
- this includes ensuring adequate fallback provisions are used
Why is transition appropriate and beneficial?
Section 5 of the roadmap sets out why transition is seen as appropriate and beneficial. The key reason is that transition is required to improve robustness and durability, as well as to address systemic risk concerns. Certain benefits are expected to come from the transition to alternative RFRs:
- the alternative RFRs are seen as very robust and durable, based on very liquid underlying markets
- alternative RFRs are more appropriate for products and transactions that do not need to include an embedded credit risk premium
- basis risk should be reduced as the alternative RFRs will be based on overnight rates and IBORs
What potential challenges does the roadmap set out?
The nine key challenges set out in the roadmap are:
- the market adopting alternative RFRs, which will require a great deal of education and devotion of resources
- institutional infrastructures to support the alternative RFRs being established
- legacy transactions not being appropriately hedged or with market valuation issues with the differences between the IBORs and the alternative RFRs
- changes in the amount of tax due
- regulatory regimes may need to be modified to take account of the transition to alternative RFRs (eg additional requirements may be triggered)
- robust governance and controls being in place to manage the transition
- complications arising relating to value designation and accounting
- liquidity issues, and
- contractual amendments and administrative efforts to do this may lead to increased costs and operational risks
What alternative RFRs are the various RFR working groups proposing to use?
Working groups have been set up in the UK, US, Europe, Switzerland and Japan. They have all recommended that robust, alternative RFRs should be set up to transition away from IBORs (except Europe). These will be overnight, rather than in term rates (which is how the IBORs are currently used).
In the UK, the group has promoted a broad-based transition to SONIA over the next four years across sterling bond, loan and derivative markets. SONIA is intended to be the primary sterling interest rate benchmark by end-2021.
In the US, the preferred alternative RFR is SOFR—regulatory approval is required however for CCPs to clear futures contracts and cleared overnight index swaps (OIS) referencing the new rates.
In Europe, it has not yet been decided which the preferred alternative RFR is. However, EONIA, a new repo benchmark and a new unsecured overnight rate could be among the possible alternatives.
In Switzerland, the preferred alternative RFR was confirmed as SARON for TOIS fixing in January 2016 and CHF LIBOR in October 2017. TOIS fixing was terminated on 29 December 2017 and so the Swiss working group’s focus is now on developing the transition from CHF LIBOR to SARON.
In Japan, TONA has been confirmed as the JPY alternative RFR.
What are the next steps?
The Associations will shortly initiate a global survey of buy—and sell—side firms and infrastructure providers, which will feed into an in-depth report aimed at supporting industry interest rate benchmark transition planning efforts. As the transition away from LIBOR progresses, the Associations will continue to update, and expand upon, the roadmap.