The Transition from IBOR to Alternative Reference Rates
Inter Bank Offered Rates (IBOR) have long been the backbone of the financial industry, serving as key reference rates for various financial products. The three most prominent IBORs are LIBOR (London Interbank Offered Rate), TIBOR (Tokyo Interbank Offered Rate), and EURIBOR (Euro Interbank Offered Rate). These rates play a critical role in the global financial system, providing the basis for interest rates across a wide range of instruments, from OTC derivatives to loans and bonds.
Market Participants and Products
Market participants from stock exchanges to commercial banks, hedge funds, and insurance companies heavily rely on IBOR rates. The products referencing these rates are diverse and encompass OTC derivatives like interest rate swaps and cross-currency swaps, exchange-traded derivatives (ETDs) such as interest rate options and futures, loans including syndicated loans and mortgages, bonds and floating rate notes (FRNs), short-term instruments like repos and commercial paper, securitized products like mortgage-backed securities (MBS), asset-backed securities (ABS), and more.
The significance of reference interest rates in the financial industry is undeniable, with the total market exposure approximated at USD 3 trillion in all instruments, as reported by the MPG (Market Practitioners Group) report on reforming interest rate benchmarks. Remarkably, LIBOR and EURIBOR alone make up 80% of the total IBOR market exposure, showcasing their pivotal role in the global financial landscape. Furthermore, a staggering 97% of syndicated loans in the US market reference EURIBOR.
LIBOR Rate Reforms
In July 2017, the Financial Conduct Authority (FCA) in the UK outlined a compelling case for replacing LIBOR, signaling a shift in the global financial landscape. The FCA made it clear that after the end of 2021, it would no longer request panel banks to submit the rates required for LIBOR calculation. Consequently, market participants were tasked with reducing their reliance on LIBOR starting in 2022.
Several critical reasons were presented by the FCA and other stakeholders to justify this transition:
- The illiquidity of unsecured interbank market rates hindered fair price determination.
- The mischaracterization of LIBOR as a ‘risk-free rate’ when it actually wasn’t.
- The potential for manipulation by contributors of information due to the fragile rate determination system.
- Dependence on a group of banks for reference rates without active underlying markets.
- Relying on the judgment of panel banks rather than transaction volume to declare rates.
To replace LIBOR, the Bank of England introduced the Sterling Overnight Index Average (SONIA) in March 1997. SONIA reflects the average of interest rates that banks pay to borrow overnight funds from other financial institutions, making it a more reliable benchmark.
The Transition: LIBOR to SONIA
The transition from LIBOR to SONIA presents a set of challenges for market participants and institutions:
- Renegotiating existing contracts that reference LIBOR.
- Assessing the impact on asset positions affected by the transition.
- Adapting to the absence of liquid markets for alternative rates.
- Managing the operational costs associated with changing processes and systems.
The current LIBOR fixing process involves gathering rates from panel banks just before 11:00 AM GMT every London business day and computing the rate using a ‘trimmed arithmetic mean’ approach for five currencies across seven maturities, resulting in thirty-five rates daily.
In contrast, the SONIA fixing process calculates the rate as the weighted average of all unsecured overnight sterling transactions brokered in London by Wholesale Markets Brokers’ Association (WMBA) members between 12:00 AM and 03:15 PM London time. It’s important to note that SONIA is an overnight rate, but as of August 3, 2020, the Bank of England started publishing a SONIA compounded index.
Transitioning Legacy Contracts
Clients are advised to consult with their banks and advisors regarding transitioning their existing contracts to SONIA compounded in arrears or using an alternative reference rate. The SONIA rate compounded in arrears has gained traction, particularly for floating rate bonds due to its strong liquidity market.
To facilitate the transition of legacy contracts to new reference rates, the Bank of England has provided a decision tree model, offering guidance in this intricate process. As the financial industry embraces this transformation, market participants must adapt to ensure the stability and reliability of reference rates in the evolving financial landscape.
In conclusion, the shift from IBOR rates like LIBOR to alternative reference rates such as SONIA represents a significant transformation in the financial industry. It is essential for all market participants to understand the challenges and opportunities associated with this transition and to take proactive steps to ensure a smooth and seamless shift towards a more robust and reliable benchmark rate system.
