SUMMARY
As of 4 January 2022, the phase out of the London Interbank Offered Rate (“LIBOR”) has culminated in the cessation of:
- all Euro (“EUR”) and Swiss Franc (“CHF”) LIBOR settings;
- the overnight / spot next, 1-week, 2-month and 12-month sterling and Japanese Yen (“YEN”) LIBOR settings; and
- the 1-week and 2-month US Dollar (“USD”) LIBOR settings.
2022 will see the phase out of further LIBORs and hence an increased requirement for market participants to remedy affected transactions by transitioning to LIBOR replacements and keeping abreast of their legacy trades.
LIBOR IN A NUTSHELL
LIBOR is a globally accepted benchmark interest rate used by major banks across the world to lend to one another in the international interbank market for short-term loans. Thereby used to indicate borrowing costs, it is based on five currencies (USD, GBP, EUR, YEN, CHF) and covers 7 maturities—overnight/spot next, one week, and one, two, three, six, and 12 months.
This combination of five different currencies and seven different maturities leads to a total of 35 different LIBOR rates calculated and reported each business day by Intercontinental Exchange (“ICE”), after they take a trimmed average (which involves asking major market players how much they would charge other banks for short-term loans, removing the highest and lowest figures and then averaging the remaining figures). The most common LIBOR rate is the 3 month USD (“Current LIBOR”).
The three major drawbacks associated with the use of LIBOR settings are as follows:
- firstly, it has the potential for being rigged. The LIBOR scandal was a highly publicized scheme of financial collusion in which many leading financial institutions including Deutsche Bank, Barclays, Citigroup, JPMorgan Chase and the Royal Bank of Scotland were implicated. The scheme involved financial contracts for derivative trades plus transactions like mortgages and corporate fundraising being mispriced throughout the entire global financial system. It led to a substantial public backlash and placed permanent question marks over LIBOR’s credibility;
- secondly, it is based on a market that lacks sufficient activity; it was becoming normalised for financial institutions to submit estimates instead of actual transaction data; and
- finally, LIBOR is forward-looking (set at the start of the interest period) which led banks to incorporate premiums for market factors, credit risk and term liquidity.
Together, the above factors have undermined LIBOR’s validity and ultimately given rise to a process of its phase out and cessation.
RFR RECPLACEMENTS
Risk Free Rates (“RFRs”) are alternative reference rates developed for alternative use instead of LIBOR. The five LIBOR currency jurisdictions have published their preferred alternatives as follows:
- United States Dollar – Secured Overnight Financing Rate (“SOFR”);
- British Sterling – Sterling Overnight index Average (“SONIA”);
- Euro – Euro Short Term Rate (“€STR”);
- Swiss Franc – Swiss Average Overnight Rate (“SARON”); and
- Japanese Yen – Tokyo Overnight Average Rate (“TONA”).
There are some distinct differences to take note of between LIBORs and RFRs as follows:
- Reference Period: As noted, LIBOR is forward-looking whereas RFRs are backward-looking overnight rates.
- Methodology: LIBOR is derived from quotes submitted by bank panels, aiming to estimate where they could borrow funds from whereas RFRs are generally based on a broader range of actual transactions.
- Credit Risk: LIBOR and RFR reflect different elements of credit risk. As an unsecured borrowing rate, LIBOR includes the implied credit risk of the panel banks plus a liquidity premium related to the length of the interest period. As overnight rates, RFRs do not include either of these.
These differences combine to result in a credit and liquidity spread (or “pricing gap”) between IBORs and RFRs. This pricing gap is used when ascertaining risk levels in the interbank market and why RFRs have been heralded as relatively “risk free”.
The risk free component OF RFRS
Overnight indexed swaps (an “OIS”) is key to understanding an RFR’s reduced risk. An OIS involves:
- a fixed rate being paid in exchange for a floating RFR (based on a return calculated from a daily compounded interest); and
- the floating leg being reset on a daily basis.
The fixed rate referred to in point (i) above will be one used for overnight unsecured lending, which in the UK market will commonly be SONIA, EONIA, or SOFR.
An OIS rate is less risky than the corresponding IBOR because the parties to an OIS are not required to exchange the principal amount during the life of the transaction- only one party needs to make a single swap related net payment at maturity.
The LIBOR-OIS spread (known too as the FRA-OIS spread/ LIBOR-OIS basis/ FRA-OIS basis) involves taking an IBOR for a particular tenor (typically 3 months) and subtracting it from the fixed rate of an OIS of the same tenor. The resultant spread therefore shows the incremental rate of interest demanded by the interbank market over a close to risk-free rate (the OIS rate) to compensate for the increased credit risk.
MAIN RFRS in the UK market
As noted, USD derivatives and loans will use SOFR which differs to LIBOR by being based on trades in the Treasury Repo market. This method is deemed preferable over LIBOR as here, the rates are based on data from observable transactions rather than on estimated borrowing.
SONIA, as an overnight rate, will be replacing Sterling LIBOR (a term rate that indicates the cost of borrowing for a range of different periods (1 month, 3 months, 6 months, etc.)). Although reflective of actual market practice, SONIA does not produce an identical economic outcome to LIBOR because, as a backwards looking RFR, SONIA does not incorporate such premiums mentioned earlier, and so will usually be lower. To ensure that they are not worse off pursuant to the switch, lenders have commonly been prompted to increase their margins or add credit adjustment spreads, which trading counterparties will need to take into consideration.
STATUS OF THE TRANSITION
As of 2022, 24 out of the 35 LIBOR settings have now ceased and of the 11 remaining, the 6 most widely used GBP and JPY settings will be published using a changed methodology (“synthetic LIBOR”). The FCA’s stated goal for synthetic LIBOR is for it to act as an additional tool to facilitate “tough legacy” contract transitioning. Synthetic LIBOR will not involve a brand new calculation and rather, will follow any market consensus that emerges on how fair alternatives should be treated and this will mainly involve the applicable RFR to a currency area being adjusted for the relevant contract term and then a fixed credit spread adjustment added. In other words, the calculation would involve the addition of:
- either (i) IBA’s ICE Term SONIA Reference Rate or (ii) TONAR as provided by QUICK Benchmarks Inc; and
- the spread adjustment as published by Bloomberg Index Services Limited for use in fallback rates under Supplement 70 to the ISDA 2006 Definitions.
The FCA is permitting all contracts, except cleared derivatives, to rely on synthetic LIBOR up to the end of 2022, but has made clear that the focus of firms should be transitioning contracts away from LIBOR rather than relying on synthetic LIBOR.
Also key to the UK’s remediation progress is The ISDA IBOR Fallbacks Protocol (the “Protocol”). It came into effect on 25 January 2021, and has been instrumental to the transition effort by catching a huge array of legacy (and non-cleared) derivatives. Protocol adhering market participants are given a safety net through the robust fallback provisions that their adherence to the Protocol incorporates into their contracts. The provisions achieve this by describing the circumstances when references in a contract to the existing benchmark rate are replaced. When such circumstance arise, the fallback wording outlines a mechanism for determining the replacement and including a spread adjustment. Since its publication, the Protocol has gained widespread acceptance across the market; by December 2021 more than 14,900 parties across 90 jurisdictions had adhered and hence proven it to be a particularly efficient remedy and allowed huge systemic risk to be avoided.
THE UK’s remaining usd transition & FCA Framework
The remaining five USD LIBOR settings will continue to be calculated using panel bank submissions until mid-2023, after which their use in new trades will be banned, with limited exceptions. The FCA have offered a framework for how such exceptions will work:
- the exceptions will only apply when such market making use is in response to a client request to reduce or hedge USD LIBOR exposure on pre January 1, 2022 contracts;
- new single currency USD LIBOR basis swaps entered into in the interdealer broker market (to the extent they would constitute new use) will count as an exception; and
- market makers must make all reasonable efforts to both ensure clients know about the prohibition and engage with them regarding the extent to which they have taken it into account.
These 5 remaining USD LIBOR settings will be targeted for complete phase out on 23rd June 2023 (Phase II of the LIBOR transition) and by which time all legacy transitions will need to have been completed as well.
Next steps
In light of how the post-LIBOR landscape will not be one ruled by a single rate but an array of options, record keeping will be critical. The importance to regulators of trade economics has prompted a global requirement for market participants to report updated trade details, both when they trigger a fallback rate or make voluntary transfers to a RFR via bilateral contract amendments with their counterparty.
With the bulk of LIBOR settings in the derivatives market now phased out, the transition overall is considered to be going smoothly. The New York Fed estimated that about 80% or more of interdealer linear swaps risks were already linked to SOFR which is a big contrast to the slower moving loan markets (explainable in part, by lenders preferring benchmark rates that are more flexible around borrower-associated credit risks).
Going forward, market participants should keep watch for their exposure to potentially impacted IBORs and consider adhering to the ISDA Protocol module where they have not. For now, the focus for market players should be oversight, taking appropriate action in the face of exposures and ensuring their reporting obligations are met.
For more information, and any guidance or advice on LIBOR, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.
