IBOR transition – What you need to know
- Libor benchmarks since the 1980s are embedded in pricing of over $350 trillion of financial products including loans, mortgages, bonds, derivatives, ETFs and investment products.
- Overtime the validity of Libor has come into question as interbank lending markets became almost non existent and Libor became more subject to manipulation As a result in 2014 post instruction from the G20, the Financial Stability (international industry body) proposed more robust benchmarks, referred to as Alternative Reference Rates (ARR’s).
- The Alternative Reference Rates Committee (ARRC) was set up by the US Federal Reserve in 2014 to help govern and oversee the transition process.
- IBOR transition was triggered in 2017 by the announcement of the discontinuation of LIBOR (rates will no longer be published) at the end of 2021 initially by FCA (UK regulator) but now includes USD, EUR, JPY, and CHF LIBORs, with the replacement benchmarks being the identified alternative risk free rates in each jurisdiction.
What we know so far
- Each country’s regulator is producing their specific alternatives to Libor and some are further down the path than others, but almost all are bringing in some reforms.
- The US & UK are leading the changes and selected SOFR (Secured Overnight Financing Rate) and SONIA (the Sterling Overnight Index Average) as their respective benchmark replacements.
- SOFR has been chosen in US because it is based on a deep underlying market, based entirely on transactions (rather than estimates), in compliance with international best practices and covers multiple market participants.
- These changes will require the contracts of some products to be changed so that they reference the alternative Risk Free Rates. Regulators have stressed that this is a complex and time-consuming process and have encouraged all users of financial products to take action now to prepare.
The difference between IBORs and RFRs
- Libor was a forward looking measure of unsecured interbank lending rates and therefore included a credit spread and “set in advance”. New RFRs are largely based on overnight wholesale rates that are risk free and therefore exclude a credit spread. The rates are based on actual historic transactions and are therefore backward looking and “set in arrears” at the end of the borrowing period.
- To transition existing contracts and agreements that reference IBORs to the alternative benchmark rates, adjustments for credit and term differences may need to be incorporated and applied to the alternate rate. Industry working groups are reviewing methodologies for calculating these so-called “spread adjustments”.
- Post adoption of the RFR companies will face operational issues as interest amount will not be known until the end of the period
How does this impact me and what should I do?
Click here to see how this impacts you and the steps you can take to prepare