Challenges with the replacement of IBOR benchmark interest rates
Benchmark interest rates are an essential part of financial markets. These interest rates are used for numerous financial products, such as bonds, loans and derivatives, and in the construction of discount curves. This has applications in fair value calculations, hedge strategies, sensitivity analysis, treasury and risk management systems, and much more.
—UPDATE— On February 25, 2019 the European Commission announced that the EU institutions agreed on postponing the deadline for the benchmark rate reforms by 2 years. Providers of critical benchmarks, such as Euribor and EONIA interest rates, and third-country benchmarks are granted two extra years until 31 December 2021 to comply with the new Benchmark Regulation requirements. Market participants considered the previous transition date of January 2020 as ambitious. The new timelines are in line with the transition dates for other currencies.
The currently used benchmark interest rates are based on a survey and are not compliant with the European Benchmark Regulation (BMR). The market is therefore in transition to a transaction-based reference interest rate. What are the main challenges of this transition and what are the possible ways forward?
The Interbank Offered Rate (IBOR) comprises a series of benchmark rates based on values submitted by a panel of banks. For example, LIBOR is based on data submitted by banks in London and EURIBOR is the benchmark based on data from Eurozone banks. It represents the average interest rate at which a panel of banks say they borrow funds from one another. Ever since the crisis there have been calls to adapt or replace the benchmark interest rate. The benchmark rate is based on professional judgment instead of transactional data and therefore can be (and has been) manipulated.
“In our view it is not only potentially unsustainable, but also undesirable, for market participants to rely indefinitely on reference rates that do not have active underlying markets to support them.” – Andrew Bailey, Financial Conduct Authority (FCA)
Risk-free reference rate
To respond to the concerns about the reliability and robustness of the IBOR benchmarks, the Financial Stability Board (FSB), in its report in July 2014, recommended the development of an alternative (nearly) risk-free reference rate (RFR). This alternative RFR should be transaction-based. Central banks and advisory bodies have responded to the recommendations of the FSB and the first plans to develop replacements for the benchmark interest rates are being worked out.
The UK Financial Conduct Authority recently announced it has reached an agreement with the panel of banks to sustain LIBOR until the end of 2021. Thereafter, only the transaction-based overnight interest rate will be published as a reference rate.
The EURIBOR rates are also in the process of being replaced. The ECB’s Governing Council has decided to develop the euro short-term rate (ESTER). Not all currencies are at the same stage in the definition of an alternative RFR. The table below shows the status for a few major currencies.
The transition from IBOR rates to a new RFR benchmark imposes many big challenges for both financial institutions as well as corporates. In this paper we discuss six of them:
1. Renegotiation of financial contracts
The transition from IBOR to RFR impacts contracts with references to IBOR rates, such as floating rate loans/bonds and derivatives. Interest rates in these contracts cannot be automatically fixed or contract terms cannot be automatically rolled over, but terms and conditions must be renegotiated to renew the contract. Besides the negotiation itself, difficulties will arise in tracing all contracts that contain IBOR. It is advisable to determine the IBOR exposure in time and to be aware of the potential risks when contracts mature after the transition date.
2. Regulatory uncertainty
The transition from IBOR to RFR is not enforced by regulators. Clear and regulatory guidance is not provided by the regulators (yet), so the transition is being defined by the industry itself, while regulatory guidance is expected later. This implies great uncertainty in final regulatory rules that may slow down the transition process eventually as companies may want to wait for guidance by a regulator. Especially when companies encounter problems, legislation may be necessary to proceed. When companies do not renew their contracts and continue rolling over the current contracts, the number of non-renewed contracts increases, which could postpone the transition or the adoption.
3. Modeling, valuation and risk management
IBORs are being used for modeling purposes, e.g. in discount rates in pricing models and as proxy for interest rate risk in valuation and risk models. Due to the transition to the RFR, all models where the IBORs are applied, need to be redeveloped. Companies should be aware of the IBOR exposure of their models and prioritize them. It could take a while to map out all models and their complexity, so starting early with planning the redevelopment of pricing, valuation and risk models will be beneficial.
4. Market liquidity
IBORs offer an overnight rate as well as interest rates for terms of one week and one, two, three, six and 12 months. In contrast, the newly proposed RFR offers only an overnight rate. This means that, for interest rates longer than overnight, the RFR rates needs to be constructed by market transactions, for example in the RFR futures market. Market adoption and liquidity in new RFR derivatives is necessary for the transition to succeed.
5. Global consistency
The differences in transition timing across currencies may cause additional challenges in cross currency risk. Problems may arise, for example, in cross currency swaps. Companies should be aware of their exposure to cross currency products and how they want to minimize basis risks between currencies.
6. System infrastructure
The transition to the RFR also involves changes in the system infrastructure. All references to an IBOR must be identified and adjusted across all company systems. For many companies this will result in major projects to address functional and technical changes, impact assessments, testing, etc. Besides, the transition requires significant model and system changes in every area where IBOR is used, which is challenging due to the vast number of departments involved and the uncertainty about the desired timing and end state.
The transition involves many challenges and the way forward is still unclear. A transition is an ongoing process and involves several stakeholders. We discuss three possible transition scenarios:
1. Defined point in time
The transition from IBOR to RFR will take place at a specified date as part of a structured legal and regulatory framework. This would reduce legal risk, timing uncertainty and the reliance on the IBOR after the transition date but will also lead to a lot of work for and co-operation between all stakeholders.
2. Market initiative
The transition will take place because of the initiative of market participants. Before the specified transition date, market participants will proactively move to the RFR. Early adopters will move first, the final new market standards will settle when the majority follows and the last movers will transition shortly before the IBOR end date.
3. Multi-year transition
Only new contracts will be based on the RFR. New contracts will be concluded as current contracts mature and roll over. In this scenario the IBOR and the RFR will both be sustained until all contracts have been renewed, which will take several years.
Note, the first two scenarios require that the replacement rate and the market (liquidity) are available early enough. The last two scenarios imply that the IBOR rates will continue to be published in a certain way after the transition date.
The transition from IBOR to RFR has a large impact on contracts, models and systems. The terms and conditions of maturing contracts need to be renegotiated to renew the contracts and all models and systems where IBOR is used need to be adapted. Whether the market participants or the regulator will take the transition initiative is unclear. There is also uncertainty about the desired timing and end state. To be as well prepared as possible for the coming transition, it is advisable to start early with recognizing the scope and impact of the transition and, if possible, carry out preparatory actions.